Thursday, 9 May 2019

Turkey update, Lira outlook, and keeping one's eye on the ball

In recent weeks/months, Turkey has again been making headlines for all the wrong reasons. This time the focus has been on the acrimonious outcome of local elections; the further recent weakening of the Lira from about 5 to more than 6 vs. the USD (after having recovered from over 7 in August last year, touched on the day I first blogged about Turkey); controversy about the sufficiency of the Turkish central bank's foreign currency reserves; a March spike in overnight Lira swap rates; and the debate on the willingness or otherwise of the CBT to tighten sufficiently to ward off seemingly intractably high inflation (19.5% YoY at present - down from a peak of 25.5% in October 2018, but still elevated).

However, predictably, less focus has been placed on the factors that actually matter - at least from an investment and currency stabilisation perspective. Unlike bygone eras, investors today live in a world of information overload, and it is increasingly no longer access to information that determines an investor's edge, but rather their ability to accurately determine what information matters and what should be disregarded - an ability to separate the signal from the noise, so to speak. And there is a lot of noise in markets. 

So far as the outlook for the Lira is concerned - an therefore Turkey's much-discussed 'currency crisis' - the main area of focus and reporting should be on the evolution of the country's current account. From a deficit as high as 6.5% of GDP by mid 2018, with monthly deficits ranging between US$3-7bn during 1H18, Turkey actually ran four months of current account surpluses during August-November 2018 (ranging from US$1.0-2.6bn/mth), after a combination of sharp currency weakness, reduced domestic demand, and falling oil prices, drove a much needed rebalancing. 

Following the currency's recovery back towards 5 to the USD, as well as potential seasonal factors, modest deficits were then booked through Dec 18-Feb 19 (up until the latest data available). Jan-Feb 2019 monthly deficits averaged US$0.6bn, down from US$5.75bn/month in Jan-Feb 2018 - an order of magnitude reduction. The recent recovery in oil prices will not help (Turkey is a net oil and energy importer), but the currency has fallen a further 20% since that time as well, which is likely to more than offset the oil price impact. This dramatic reduction in the current account deficit is the real story, and suggests that the majority of the necessary rebalancing has now already occurred. And it means the currency ought to now be beginning to stabilise (but as we know, in financial markets prices don't always do what they ought to do, so this is not a prediction).

The demand and supply factors which drive currencies can be broadly categorised into two buckets. In the first bucket are what can be regarded as 'economic' factors; in the second, 'liquidity' factors. With respect to the former, the balance of goods and services trade and net international investment income (collectively, the current account), as well as the normalized flow of net FDI, drive sustainable underlying 'fundamental' demand and supply for the currency. Turkey's net FDI is currently running at a bit over 1% of GDP (US$13bn last year), which is slightly above the current modest run-rate current account deficit (US$7bn or so). Consequently, the economic demand and supply flows are now already roughly in balance, which augers well for currency stability. 

However, the other significant driver of demand and supply for currency are liquidity factors. This bucket includes the pace of inward or outward portfolio investment activity and other speculative capital flows; central bank interventions; and Fx borrowing or repayment. Even if economic demand and supply is in balance, a currency can still sharply depreciate if people seek to dump the currency for speculative or sentiment reasons, or individuals or companies seek to repay Fx loans to an extent that exceeds the sum total of the current account surplus plus net FDI flow. At present, liquidity factors are still placing downward pressure on the Lira, despite sufficient economic rebalancing having already occurred, as investor confidence is low (one contributor has been local Turks converting domestic Lira bank deposits into Fx deposits, as years of currency depreciation have undermined confidence in the security of the real value of their savings).

No one can predict liquidity factors with certainty, as they are driven largely by market sentiment (as well as liquidity factors in overseas markets, such as the Fed's actions in the US). However, what can be safely predicted is that any further material liquidity outflows will drive the currency meaningfully below fair value, to an equilibrium where the current account surplus (plus net FDI) equals the pace of net capital outflows and Fx net debt reduction. And the inherent dynamics involved here are that the more acute the outflows and the more undervalued the currency becomes, the larger the ongoing outflows that will be required merely to keep the currency suppressed, let alone drive further depreciation. At some point the currency will stabilise, and as confidence starts to return, a rebound will quickly follow. Value investors should pay attention to these factors, because if a currency is say 30% undervalued, then all domestic (as opposed to export) stocks are actually 30% cheaper than they look (a stock at 10x is actually trading at 7x if you normalise the currency to fair value). If you can buy an undervalued stock in an undervalued currency, you get a much more significant bargain. 

The fact that Turkey's current account is now roughly in balance (adjusting for FDI) - indeed perhaps even in marginal surplus - suggests that the degree of needed economic depreciation has already occurred, but that the level of undervaluation is not yet significant, and that there is still a relatively limited margin of safety buffer against further outflows, as the current account surplus is not yet meaningful enough to accommodate major continuing outflows. Depending on the sentiment flux, further downside therefore could lie ahead, but this is impossible to predict, and for long term investors, the important thing to understand is that future real currency depreciation is likely to be temporary and liquidity driven, not structural.

What about inflation? The above pertains to real currencies. Clearly if Turkey sustains 20% inflation year after year, the nominal currency will need to decline by 20% a year in order to sustain a constant real currency rate and keep the relevant economic flows in balance (the absence of nominal depreciation would drive real currency appreciation, which would manifest in a rising current account deficit as export competitiveness was undermined). However, there are good reasons to believe Turkey's current 20% rate of headline inflation is both unsustainable and overstated.

In more developed countries, the majority of consumer incomes are spent on services, but in lower income developing economies, a greater share of the consumption basket is dedicated to food, energy and other basic commodity-intensive goods. In other words, tradeables make up a larger share of the consumption basket, and local tradeables prices are far more sensitive to 'imported inflation' price adjustments than domestic non-tradeables (even if the goods are not actually imported, arbitrage forces will still push up local prices). 

Immature emerging markets therefore have a tendency to see headline inflation spike alongside major declines in the currency, as energy/gasoline prices, food prices, etc, reprice in local currency to reflect a given, more stable level of international prices. However, this inflation invariably drops sharply after a period of currency stability - witness Brazil for instance - inflation dropped from 10.5% in early 2016 to 2.5% by late 2017 after its currency stabilised and recovered. 

The problem with CPI is that it measures price changes that conflate two independent factors: (1) a general decline in the purchasing power of money, due to its reduced scarcity relative to goods and service availability; and (2) a rise in the real price of certain commodities, which results in a necessary rationing of their consumption and an implicit decline in real incomes.

When a rebalancing is occurring such as in Turkey at present, what needs to happen is that domestic consumption and imports need to fall, exports need to rise, and national saving (business, government, and household) in the aggregate needs to rise. However, in order for consumption and imports to fall, the real price of goods has to rise, in order to convey the necessary price signal. These sorts of price rises are functionally equivalent to real incomes falling (constant incomes with rising prices yields the same ultimate outcome as falling incomes with constant pricing). 

With the currency sharply down, the price of imports is way up, and that price signal can and has reduced consumption - both in absolute terms, and via import substitution towards cheaper locally-produced goods. The CPI inflation reading does not take into account these adaptations to higher real prices (i.e. reduced consumption and substitution), and so is therefore an overstated measure of structural inflation.

The better metric to focus on to get a sense of true inflation is the change in productivity-adjusted nominal average hourly wages. If wages are flat but CPI is printing 20%, and real consumption is down 20% as a result, there actually isn't any genuine inflation happening at all. Real prices have merely risen. However, in practice, imported 'translation' inflation often creates genuine cost-push domestic inflation via a wage-price spiral, which occurs when higher consumer prices are reflected in increased wage settlements (particularly with respect to mandated minimum wage adjustments, as well as other government CPI-linked adjustments in pensions etc). This CPI-indexing thwarts the needed decline in real incomes and hence necessary rebalancing, forcing the currency to devalue another 20% to 'try again'. This is what creates a more structural inflation problem, and it occurred even in the (highly-unionized at the time) US during the 1970s, where wage settlements were CPI indexed. This is one reason why imported inflation is seldom reversed when the currency subsequently stabilises/recovers - the inflation gets permanently 'capped in' to nominal wages.

However, in practice, wages will not perfectly adjust to CPI even if many wages are CPI linked. While those employed by the government, or receiving government-mandated payments (whether it be indexed pensions or minimum wage benefits) will contribute to the spiral, private sector real wages (excluding minimum wages) will come down, as most are not on CPI-linked contracts, and individuals will also lose jobs in a recession and have to acquire new ones at lower real wages. And it is the private sector that is driving the necessary external rebalancing (rising exports). 

How are wages tracking in Turkey? I don't know - I've been unable to find good data. However, my estimate would be that it's closer to 10-15% (if someone has a good data source, please point me to it), which is a better measure of the sustainable loss of purchasing power. I would not be surprised to see inflation settle down at that level within the next 12-24 months, although that outcome is of course path dependent (it depends on the extent to which the currency weakens, which in turn is sentiment dependent). From there, inflation and wages ought to be able to normalise back into the single digits over time. And for all the criticism, it should be remembered that CBT short rates are 24% in Turkey at the moment - almost 5% real - an so arguments they aren't taking inflation seriously appears a bit ridiculous to me.

All told, Turkey is on the right track and has made major progress over the past six months in undergoing some much-needed rebalancing, despite what you read in the papers, which suggest conditions are hopeless and seem to be forever going from bad to worse. The country is not out of the woods yet, and there could well be a further leg down in the currency coming, but the country is far enough along in its rebalancing efforts that I feel comfortable enough running Lira exposure in well managed companies trading at cheap-enough valuations.

I invested about 3-4% in Turkey in August 2018, and took profits and trimmed that back to about 2.5-3.0% by early this year near recent highs. I'm currently looking to increase my exposure again.



  1. Great analysis and share your assessment on noise vs signal 100%. Thank you for this great write-up!

    Just don't agree with your opinion that undervaluation is not yet significant. Based on real effective exchange rate, TRY is the cheapest EM currency globally and at levels that suggest nominal TRY could appreciate over next 3-5 years while we're able to pick up those high teens yields.

    I think another interesting way to implement the idea - and from my opinion having a more attractive risk/reward profile than buying the ETF or Garanti - is to buy TRY-denominated supranational bonds with maturities in 2027-29 (eg from EIB, IFC). Typically in such situations (Russia 2015 comes to my mind) they deliver a sharp rebound much faster than equities as companies typically feel real economic pain during the adjustment process.


    1. Thanks Patrick - I agree with you - my assessment that the Lira is 'not yet significantly undervalued' is a relative one & one viewed in the context of liquidity flows. The current account surplus is not yet say 5-10%, which it is in Russia (the Ruble is deeply undervalued in my view), and the level of surpluses reached in many Asian economies after the Asian Financial Crisis.

      However, I do agree with you that the Lira is oversold and cheap. I think your bond investment thesis is a good one.

      Lots of bears out there at the moment are arguing markets are expensive and late cycle, but they are only looking at the US & at tech. Many parts of the world, like ]Russia & Turkey, are already many years into a deep downturn. People just aren't looking in the right places IMO.


    2. On your last paragraph, it's interesting that Howard Marks is one of those bears. Interesting because he makes much noise about contrarianism and has said, in his books and memos, that words like 'never', 'always'etc should not be part if an investors vocabulary, and that some of the greatest opportunities lie in those markets/sectors where everyone says 'never'.

  2. Great post!
    Have you looked into the Argentine peso?
    this part should also apply
    "Immature emerging markets therefore have a tendency to see headline inflation spike alongside major declines in the currency"

    With all this talk about MMT and fixing short term interest rates at 0%, these high yield bonds look very alluring...

  3. Hector Mustache11 May 2019 at 16:52

    Mr Taylor thanks a lot for your macroeconomic insights. Needed about 30min to digest this but feel 15% smarter now.

  4. What you think about russian oil companies ( Lukoil, Rosneft) and PBR?

    Main problem with Turkey, that they ( government) still doing many wrong things and investors a little bit worried right now. Turkey want to fix their problems with additional credit injection, but this is not a good solution

  5. Excellent article, thank you for sharing.

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