Resilient Yet Vulnerable

TURKEY - Forecast 01 May 2016 by Murat Ucer and Atilla Yesilada

After a very rough start into the year, Turkish markets are benefitting greatly from the dramatic improvement in global risk appetite. Thanks to this supportive backdrop and with headline inflation in cyclical decline, largely owing to lower food prices and base effects, the CBRT has started another – and characteristically premature -- easing cycle, providing the domestic pillar to the rally.
While this dynamic may continue a while longer, thanks to investor herding and the negative interest rate environment globally, fundamentals point to a different story. First and foremost, Turkish politics is storing bad energy for a summer eruption. The referendum vote on a new Constitution in June or July could mark the point where markets discount rising political risks. Terror will remain a nagging downside for the economy for the rest of 2016. On the macro side, the overarching risk of Turkish macroeconomics is a familiar one: the economy is in need of adjustment in terms of reducing its well-known vulnerabilities -- of a large external financing requirement and above-target inflation -- but growth is given the priority, which, in turn, is of low quality.
Predicting Turkey’s macroeconomic fortunes – particularly the growth outlook -- largely draws on guessing how this “unstable equilibrium” or the tug of war between a bullish global sentiment and fragile domestic fundamentals plays out. This naturally makes forecasting a very difficult exercise as well, but we nevertheless try. We forecast growth slowing to about 3% this year from last year’s 4%, assuming headwinds such as lower confidence and tighter credit conditions will more than offset the boost from the huge minimum wage increase, as the U.S. monetary policy normalization continues and domestic political risks intensify in the background. We forecast inflation easing to just under 8%, from 8.8% last year, on the back of relatively benign food inflation, but core and service inflation staying relatively elevated, with expectations unmoored and growth at close to potential. We expect the current account deficit to remain largely unchanged this year, at about $32 billion or some 4.4% of GDP. The lira looks at or close to fair value by standard indicators, but we see further nominal weakness before the end of the year.
A secular investment story calls for a change in the "growth model", which, in turn requires tighter policies and significant transformation of the supply side. But the current climate is not conducive, neither politically nor intellectually for structural reform. True, the government is making some positive reform noise -- notably on the saving side – but with institutional environment undergoing unparalleled deterioration, these well-intentioned measures are unlikely to be game changers.
We expect Turkey to retain two investment grade ratings this year, though should the second half of the year unfold as we envisage here, a downgrade from Moody’s cannot be ruled out.

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