While Turkey's slide into recession in 2018 captured headlines this week, foreign capital has already begun returning to the former emerging market star amid signs of a stabilizing currency and shrinking trade gap.
Turkey entered recession in the fourth quarter of 2018 with a 2.4% decline in economic output that followed a 1.6% third-quarter contraction. However, its current account deficit narrowed to $0.8 billion in January, the smallest on an annualized basis since March 2010, and the lira strengthened to almost 5 to the dollar from a record low close of 7.2362 per dollar August 13, 2018.
Turkey's rapidly shifting economic picture comes as the country's central bank, Türkiye Cumhuriyet Merkez Bankası AS, belatedly responded to spiraling inflation and a plunging lira by hiking interest rates to 24% on Sept. 13, 2018. Turkey had been an emerging market darling for many years, but President Recep Tayyip Erdoğan's rejection of orthodox monetary theory with repeated call for lower rates has undermined central bank independence and pummeled the lira.
"The Turkish outlook is slowly turning for the better. We expect interest rates to decline and the currency to stabilize," APQ Global CEO Bart Turtelboom said. "We see particularly appealing opportunities in long-dated government bonds denominated in local currency."
Turkish benchmark 10-year bond yields closed at 15.31% on Mar. 13, down from 21.53% on Aug. 13. The yield was as low as 6.87% in January 2015.
Turtelboom is not the only investor to see opportunities in Turkey. In January, capital flows into Turkey were $6.1 billion, the highest since April 2018, Muhammet Mercan, chief economist at ING, said in a March 11 research note.
For Sergey Dergachev, a portfolio manager at Union Investment, the economic picture in Turkey is less important than U.S.-Turkey relations and the credibility of the central bank, which remains under attack from Erdoğan.
The Trump administration doubled tariffs on Turkish steel and aluminum in response to a dispute over the imprisonment of U.S. pastor Andrew Brunson. While he has since been released, the tariffs remain in place. On March 5, the U.S. Trade Representative's Office said it had removed Turkey's and India's preferential trading status, which gives the countries tariff-free access to U.S. markets for certain products because they are "sufficiently economically developed." The U.S. is trying to persuade Turkey to abandon its purchase of Russia's S-400 missile defense system.
Dergachev has identified Turkish corporate eurobond issuers as potentially attractive investments. "Most of them have shown prudent risk management strategies such as diversifying away from Turkey like Arcelik-LG Klima Sanayi ve Tic. A.S. or re-focusing on digitalization strategy like Turkcell Iletisim Hizmetleri A.S."
Despite a more stable lira, underlying improvements in Turkey's economic situation may not persist, according to the Institute of International Finance. "Much of the current account adjustment is cyclical, due to falling GDP and import compression, not genuine rebalancing to exports," the organization said in a research note.
S&P Global Ratings said in a research note on Mar. 14 that it is too soon to say if the Turkish economy has bottomed out. "Other countries' experience suggests that credit-fuelled economic overheating is often followed by prolonged deleveraging, which harms growth," the report said. "Our base case remains that Turkey will post negative annual growth in 2019."
In the near term, while consumers have been deleveraging and business investment has fallen, relatively low levels of government debt provide a potential tool to support the economy amid global threats to growth. Private consumption shrank 4.6% in the fourth quarter of 2018 after steadily slowing from a peak of 10.5% growth in the third quarter of 2017.
Gross fixed investment growth was negative 4.2% in the third quarter of 2018 and negative 5.4% in the fourth quarter. Government consumption grew 7.4% and 4.6%, respectively, in those two quarters.
"Turkey will likely remain sensitive to shifts in global risk appetite on the back of still sizable external financing needs, mostly due to private debt amortization, though the government's increasing external leveraging recently should help to ease the pressure," Mercan said.