GEM strategy - Turkish rally has legs, the yields to fall 200bp and stocks to add 20%

Against a fairly bearish outlook for global growth

The bond yields in Turkey are way too high to compensate for what is essentially a fairly bearish outlook for global growth. We reckon mispricing in Turkish assets is significant. First, the market underestimates the strength of the country's private consumption based economy, which singles out Turkey, at a time growth is scarce globally, from fellow EMs, which rely heavily on trade. Second, the market participants, remaining unconvinced that Turkish inflation will reverse its trend and start falling, require larger discount on inflation risk than it warrants.

Growth - Turkey stands out

Turkish growth is to outperform the global growth probably significantly, not only in 2016 but also over the next three years. We expect growth in GDP and corporate earnings across larger investable emerging markets including China, Brazil, South Africa and Russia to fall short of growth in Turkish GDP and earnings for the foreseeable future. With private consumption at 70% and her exports making up only 15-16% of its GDP, Turkey relies far less on demand from export markets than most other EMs do. We see domestic private consumption and corporate capex driving GDP growth in Turkey in 2016 and 2017. 

Inflation to surprise for better

Inflation expectations are also misguided. This is in part due to unprecedented volatility in commodity markets on which Turkish inflation depend heavily. Volatility in commodities and currency, though important, is masking a far more powerful trend, namely the secular decline in global growth. That is what should help Turkey curb inflation at home. We believe the market is too conservative on inflation and expect faster decline in consumer prices rest of the year than the market gives credit for. There are three specific forces, which should help alter the inflation trend, both near-term and well into 2017. First, we project moderation and then reversal in devaluation pass-thru. Second, we see decline in imported inflation on year-on-year comparisons. Third, we foresee deflation in food prices in the next four months. 

The yield curve to shift south by 200bp before year-end

The market valuations are not fully factoring in the outlook we promote here. With Turkish GDP growth outstripping its peers, consumer price inflation steadily improving between now and the year end, and the market not having a strong view on either, Turkish assets should outperform global benchmarks. We project the Turkish Lira yield curve to shift down by at least 200bp by December. 

Even with 200bp decline, the macro policy would remain relatively tight in a world of negative interest rates

Even with Turkish Lira interest rates falling, on our assumptions, by as much as 200bp, the macro policy in Turkey will remain tight relative to monetary policies by a host of other nations, DM and EM alike. Most DM Central Banks are reducing their policy rates below zero percent mark and we have reasons to expect negative or extremely low interest rates will last a while longer, and, over a longer time horizon than the market is anticipating. We expect high yielding Lira assets to attract fresh inflows until arbitrage opportunities disappear or by December 2016.

Equity valuations to improve

The equity valuations should also improve 20-25% by year-end in line with falling rates. The benchmark share price index (BIST 100) is currently trading at 8.9x on 2017 consensus earnings. We see both the numerator and the denominator of PER to expand. The BIST benchmark Turkish banks index is at 6.0x on 2017 consensus estimates. We have uploaded in the margin an up to date PBR v ROE scatter diagram using consensus estimates.

Risks local - oil to offset tourism-related risks to Turkey's current account deficit

Turkish tourism going into the summer months is likely to experience one of its weakest seasons in recent memory, arguably the most important source of downside risk to external accounts and aggregate demand in Turkey this year. Oil price, on the other hand, would work in the opposite direction as far as Turkey's external accounts are concerned and potentially offset part of the shortfall in tourism revenues. Behavior of oil price is probably the best input in predicting Turkey's external accounts and imported inflation and, to a lesser degree, corporate margins. A $10/bbl decline in oil price reduces the Turkish current account deficit by 50bp (0.5% of GDP), its CPI by 35bp and raises corporate gross margins by an estimated 150bp, with all else being held constant. A $20/bbl decline in (year-average) oil price would fully offset 100bp (1% of GDP) decline in 2016 tourism revenues.

Risks global - both U.S. and China are and remain sources of downside risk to global growth

Our investment idea predicates on low growth globally. Global growth is scarce and should disappoint further to the downside with no obvious positive catalyst on the sight for the foreseeable future. We see downside risk to both U.S. and Chinese growth and anticipate further downgrades to GDP projections by economists rest of the year. The US data points are at best mixed. The wage growth is weak; and the employment readings are looking good only optically. The numbers are actually a lot worse when "statistically employed" population is added back to the official unemployment rate. China is no help with its growth structurally slowing and stock of debt multiplying. The contribution of China to global production capacity remains massive and it could take years to reduce the excess. Assuming there are no additional government controls and any other impediments over trade, the burden of adjustment falls on prices, which should decline to clear the market.