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A rough ride on a roller coaster

"Sell in May and go away": Investors in Turkish assets would have done well to act on the old traders' dictum this year. In May and June 2006, Turkey experienced one of the worst drops of both its equity markets and its currency. Amid fears of a global liquidity dry-up due to a sharp rise in interest rates led by the Fed, the Istanbul Stock Exchange's ISE100 index dropped by 29.5 %, from a high of 45,353 points on the April 25 to a six-month low. Meanwhile, with an outflow estimated at $8bn to $9bn (€6bn), the New Turkish Lira lost more than 20 %. Since then, markets have recuperated, but are still far away from the levels that they enjoyed in the months prior to the tumble.

Although over the past five years, Turkey has seen both drastic regulatory reforms and a healthy rejigging of the economy in general and the financial sector in particular, the recent hiccup shows that it remains vulnerable to global market volatility. In addition to structural weaknesses including a high current account deficit and the government's considerable debt, political insecurity helped to fuel this latest downturn. Although the Turkish public sector borrowing requirement has fallen tremendously under the auspices of the IMF, even reaching a lower level than in many western European countries, the overall debt burden remains high. With a central government debt of nearly $228bn, interest rate fluctuations remain an immediate concern for Turkey's Treasury; especially considering its high share of external debt, amounting to 28 % by mid-2006. More than half of the external debt is in bonds. Increasing maturity and a more stable base of bondholders, however, helps the government to keep debt servicing costs lower than they used to be.

More of a concern to investors seems to be Turkey's gaping current account deficit, estimated by the IMF to reach $27bn in 2006 and an even higher $27.5bn in 2007. Yarkin Cebeci, chief economist at JPMorgan Chase Bank in Istanbul, attributes the rise to high energy prices, but also to an increase in imports of capital goods following a long period of economic normalisation. Although the widening current account deficit has scared investors away, the good underlying performance of the Turkish economy suggests it may be rather a reflection of changing production patterns, or at least, such is the opinion of Serhan Cevik, an influential commentator on the Turkish economy and vice president at Morgan Stanley, that he argues in his weblog. In his view, decreasing costs of capital due to more efficient financial intermediation and globalisation putting competitive pressure on labour-intensive sectors are gradually favouring more capital-intensive activities. Manufacturing cars, for instance, requires a comparatively high share of imported goods. Additionally, with Turks profiting from economic normalisation and decreasing inflation, imports of consumer goods have witnessed a hike, further deepening the current account deficit.

The recent depreciation of the Lira, widely considered to have been overvalued for a long time, however, may not only be beneficial for the current account deficit, but may also help corporates to operate at realistic costs. With cleared-up balance sheets and less short positions in foreign exchanges, Turkish companies are much better prepared to cope with a level of volatility than some years ago, says Serhat Gürleyen, research manager at IS Investment, the investment banking arm of IS Bank.

Economic normalisation on the macroeconomic level has also left an imprint on companies' earnings. With an average price/earnings ratio of below 15, Turkish companies still trade cheaply, as Hilmi Cinar Sadiklar, vice president of the board of Gedik Securities points out. These improvements in productivity, according to Serhan Cevik, represent a key factor in rising GDP by a cumulated 32 % over the past four years, and are mirrored by an increase in corporate tax collection. So the microeconomic restructuring of Turkish companies has advanced considerably and made them less vulnerable to external shocks as well as the economy as a whole.

Another important reason for the high volatility of Turkish assets may be found in the structure of its financial markets, which despite their modern regulatory framework, still suffer from a scarcity of both long-term investors and hedging instruments. With the private pensions system still in its infancy, often short-term oriented mutual fund managers and day-trading retail clients, Turkey lacks a stable domestic base of asset holders. In recent years, retail mutual funds have seen considerable interest from the public. However, as Emir Sarpyener, CEO of Raymond James Securities in Turkey, remarks, funds still lack a track record, which makes it difficult for both local and foreign investors to invest in them, despite a growing interest in locally administered funds.

Meanwhile, over 65 % of the market capitalisation of the ISE belongs directly or indirectly to foreigners, making it vulnerable to the withdrawal of investments. Hinting at the fact that more mature markets further limit volatility by isolating and trading risk on secondary derivative markets, Turkey also needs to have a more diversified spectrum of fixed income and equity instruments, says Cornelia Weinmann of Deutsche Bank Asset Management in Frankfurt. Izmir-based Turkdex, founded in 2001 as a private company owned by the Big Four banks (AKbank, IS Bank, Kocbank and Garanti), the ISE and a number of semi-public bodies, gives firms and investors the opportunity to do so. Sarpyener says he has seen increasing interest from the side of Turkish corporates to use derivatives to hedge real operations. Although the volume of traded instruments has increased significantly from YTL94m (€49m) in May 2005 to YTL1.4bn a year later, the liquidity of certain instruments remains insufficient. Brokerage houses and investment banks bemoan the need to further educate investors about different capital market instruments. More branded products could help, according to Yarkin Cebeci at JP Morgan Chase. According to Emir Sarpyener, hiccups in the market may delay but not prevent financial innovation. Ironically, market slumps may be the very instances triggering investors' need for hedging. He therefore foresees the first stock options emerging within a period of 12 months.

As structural conditions that limit the volatility of Turkish markets improve, the main factor disturbing the pricing mechanism remains politics. Although the current government under Prime Minister Recep Tayyip Erdogan, head of the Justice and Development Party (AK Party), has pushed through important institutional reforms, the secularist establishment distrust its Islamic background and grass routes popularity.

One of the major concerns for investors are the presidential elections in May 2007, says Ilhami Koc, CEO of IS Investment. With a parliament whose term runs until November 2007 and which is dominated by the AK Party, investors fear the successor of the current President Ahmet Necdet Sezer, a steadfast secularist, may be an AK party man, thus removing another safeguard of the country's strictly secular system as established by the revered founder of the republic, Kemal Ataturk. Worse still, investors fear what the reaction of an AK party victory might be on the part of the secularists.

The Turkish military still sees itself as the guardian of Ataturks' legacy and has not been shy of deposing Islamic governments in the past. In terms of economic policy, however, the fronts are not as clear as foreign analysts want them to be. Despite the government's attempt to soften the separation of state and religion by unsuccessfully trying to lift the ban on headscarves in public institutions and to install a central bank governor with a background in Islamic Finance, the AK Party also has been a strong supporter of privatisation, EU accession and the modernisation of the state. On the other hand since the AK Party came to power, the secular president has vetoed important pieces of legislation concerning a rising of the retirement age, an IMF-encouraged tax amnesty and the merger of small municipalities, all laws necessary to stabilise Turkey's financial situation. With more than 40 vetoes, President Sezer ranks first among all Turkish presidents since the establishment of modern Turkey, adding his share of insecurity to the political process and, finally, to the markets. As so often in emerging economies, however, politics cloud the huge opportunities of the Turkish market, says Ata Köseoglu, CEO of TEB Investment, one of the big domestic investment banks. Turkish markets will experience some general volatility in the last quarter of 2006 and 2007, adds Emir Sarpyener, reminding investors that Turkish markets never perform well in election years. Yet, a bumpy road ahead for the next couple of years should not make investors forget the unmatched growth opportunities Turkey has compared with other emerging markets, he says. In order to take these opportunities and to manage the risk associated with them, advice from local asset managers is needed. Returning to normal valuation levels and to a more sideward development in the market also puts more emphasis on the importance of good asset management. Selling in May and going away may be many traders' favourite strategy. In order to trade and succeed in a market which is as fluid and surprising as the Grand Bazaar, however, western investors had better show some patience.

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