Turkey ETF Down But Not Out After Election

Turkey’s potentially historic election, which is likely to broaden the power base in one of the Middle East’s most stable and modern countries, should give investors hope that Turkey's equity market is likely to be as promising in the next decade as it was in the last. It’s right now that’s the problem.

“If you think of Turkey over the medium term, it’s a country that will do extremely well,” Darshan Bhatt, an advisor at Jersey City, New Jersey-based Glovista Investments, said in an interview, stressing that the country’s young demographic is likely to fuel growth going forward. “But in the shorter term, it has challenges.”

The only exchange-traded fund canvassing the country, the iShares MSCI Turkey ETF (TUR | B-100), has lost more than 6 percent since Sunday’s polling. That adds to a downside bias since 2013’s “taper tantrum” that sparked capital flows out of emerging markets and into the U.S. as investors began to grasp that the post-financial crisis era of ultra-low U.S. interest rates was drawing to a close.

But, Bhatt says, Turkey has more homegrown problems as well. Those begin with the question of whether a coalition government that the less-than-clear election outcome necessitates will materialize in the coming weeks. The country has 45 days to pull that together and, if it doesn’t, voters are likely to go to the polls again in the hopes of forging a clearer way forward.

Markets, as the saying goes, can’t stand uncertainty, and the post-election uncertainty is just the most immediate challenge, said Bhatt, who argued that markets are particularly concerned about a lack of Turkish central bank independence that has hurt its currency—the lira—in international markets.

While the Turkish electorate’s check on President Recep Erdogan’s plans to concentrate more power in the Turkish presidency could well enhance central bank independence in the coming months and years, that’s not yet assured. Erdogan’s ruling party lost its parliamentary majority, upsetting the president’s increasingly authoritarian approach to governance and, again, requiring a coalition government.

The chart below shows that investors view Turkey’s challenges as perhaps more significant than the macro head winds that emerging markets are facing since the taper tantrum.

Chart courtesy of StockCharts.com

Rough Neighborhood

The lack of central bank independence resonates among investors with particular strength because almost half of the Turkish stock market and funds like TUR are in the financial sector, Bhatt notes. That’s two-thirds as much as in the emerging markets in general as represented by the holdings of a broad developing market fund like the iShares MSCI Emerging Markets ETF (EEM | B-94).

More broadly, the country finds itself in a rough neighborhood. For example, it is involved in efforts at controlling the spread of the Islamic State. The Syrian Civil War that began in 2012 and growing instability in Iraq have led refugees to seek safety within Turkey’s borders.

Moreover, Its relations with other neighbors, notably Israel, have grown less warm in recent years. Also, its historical role as an unambiguous Muslim-country ally with the U.S. has grown more conditional since the Iraq War. Additionally, Turkey’s historic ability to check Russian projections of power and influence in the region is less sure-footed now, according to private and government security analysts.

“Turkey's relatively high current account deficit, domestic political uncertainty, and turmoil within Turkey's neighborhood leave the economy vulnerable to destabilizing shifts in investor confidence,” according to the CIA World Fact Book.

Plenty Of Hope

That said, the election over the weekend, while clearly shining light on a plethora of problems Turkey faces, suggests that voters are projecting middle-class aspirations into a society that has already experienced significant modernization of life and of its economy in the past few decades. Given the rough neighborhood, it’s easy to overlook, for example, that Istanbul has a modern subway system wending its way under the streets of that ancient city that’s considered a gateway between East and West.

That is to say that the favorable demographics that Bhatt emphasizes really do mean something when it comes to Turkey and its markets.

This country, the only functional democracy in the Middle East, will almost surely continue its program of privatization of industry and services that have done so much to fuel growth and modernization there. What’s more, low commodity prices are likely to help make future growth less expensive to finance, since Turkey is a net importer.

It’s just 1.5 percent of the MSCI Emerging Markets Index, but it is poised to deliver solid returns. It belongs in every investor’s portfolio, Bhatt says, but it may take some time for any noteworthy outperformance to materialize.