Exchange-traded funds providing exposure to Turkish equities are the worst performing ETFs on European exchanges this year on the back of a tumultuous domestic political landscape, dwindling investor confidence, and a 23.5% depreciation in the lira versus the dollar.
President Erdogan has sought to move Turkey from a parliamentary democracy to an executive Presidency.
The iShares MSCI Turkey UCITS ETF (IDTK LN), Europe’s largest pure-play Turkey ETF with $250 million in assets under management, is down 35% year-to-date.
The fund had seen inflows of about $209m across May and June – perhaps signalling that some investors thought the country’s fortunes might be reversing – but flows turned negative again in July with $60m pulled out.
The Lyxor Turkey (DJ Turkey Titans 20) UCITS ETF (TURU LN) has experienced similarly woeful performance, down 35% YTD. It is a smaller fund, with $105m in assets.
The HSBC MSCI Turkey UCITS ETF (HTRD LN), which tracks the same index as the iShares fund, is understandably also down more than a third.
All three ETFs have also seen a sharp spike in risk from around 22%-24% 1-year rolling volatility at the start of the year to around 31%-32% now.
The fundamentals
The country’s stock market misery reflects the uncertainty caused by an unprecedented level of political turmoil in Turkey’s modern history. Having survived a coup attempt in June 2016, President Erdogan declared a state of emergency and has systematically moved the country away from a parliamentary democracy and towards an executive Presidency.
On the one hand, Erdogan has sought to crush his critics, censor the media, and enact constitutional amendments that place an increasing amount of power within his grasp. On the other, he has forced through accommodative policies to boost the economy (and the ranks of his supporters) ahead of elections in 2019.
The government’s ultra-loose policies (both fiscal and monetary through Erdogan’s control of the central bank) have been labelled unsustainable, leading to a build-up of vulnerabilities within the Turkish economy.
According to Lucas Irisik, portfolio manager and senior analyst at Nikko Asset Management: “The clear policy error of excessively loose monetary policy, together with the ongoing and elevated political uncertainty, has led to a significant weakening of the Turkish Lira. The large FX pass through from the currency weakness, together with higher commodity prices and strong domestic demand, has resulted in a significant deterioration of domestic pricing behaviour.
“To arrest further Lira depreciation and to prevent inflation from spiralling out of control, the Central Bank of Turkey, belatedly decided to (or was finally “allowed to”) tighten monetary conditions in a shock fashion, lifting the average cost of funding by a total of 500bps since the turn of the year.
“The significant rise in the average cost of financing to the real economy, has, as expected, put the brakes on credit creation and, in time, is expected to slow the pace of economic expansion.”
The weakening lira poses a major problem to the corporate sector as the previous abundance of external liquidity and low domestic interest rates has seen Turkey’s companies increase their leverage from 30% of GDP in 2008 to more than 70% today.
Irisik warns that with over 50% of newly accumulated debt denominated in foreign currency, the weakening lira is the key vulnerability to the Turkish corporate sector in the near future.
London-based investment research firm ABP Invest echos similar concerns in a recent country report into Turkey.
Thanos Papasavvas, the firm’s founder and chief investment officer, commented, “We believe the government has two options. Option A: to adopt an orthodox economic policy to correct the imbalances which will inevitably lead to a slowdown or even a potential recession; or Option B: to pursue business as usual, worsening the current imbalances and most likely triggering a full blown financial and currency crisis later this year, requiring the IMF to intervene over the next 12 months.
“The honeymoon period of a newly installed government is the most opportune time for these difficult decisions to be taken, despite the 2019 local elections looming. We hope the government acts swiftly as any sign of procrastination would bode poorly for market sentiment.”
The underlying indices
The iShares and HSBC ETFs track the MSCI Turkey Index. The index targets Turkey’s large- and mid-cap universe, covering approximately 85% of the country’s total market cap through 24 constituents. The iShares fund comes with a total expense ratio (TER) of 0.65%, 5bps higher than the 0.60% charged by HTRD.
The Lyxor fund tracks the Dow Jones Turkey Titans 20 Index. The index includes 20 of the largest and most liquid constituents that are listed in Turkey. TURU has a TER of 0.65%
The two indices (and thus the three funds) have a very high correlation, as the chart below attests.
Year-to-date performance for IDTK, TURU and HTRD.