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Brighter Times for Turkey?

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The nation’s economic stability has fueled a stock-market rally, though, as in all emerging markets, risks remain

Turkey’s stocks are appreciating at a rapid clip. Straddling Europe and Asia, Turkey teeters between Western secular democracy and ancient traditional culture. But this vast nation of 73 million has a modern, robust economy and may one day join the European Union.

The incumbent Justice&Development Party’s (AKP) resolute, general election victory in mid-July appears to indicate that Turkish voters support the party’s fiscal reforms, which have resulted in economic stability and growth for the past five years. Prime Minister Recep Tayyip Erdogan’s program of budget discipline and EU membership talks also seemed validated by the public, and they rewarded him with another five-year term.

Indeed, in response to AKP gaining an unprecedented 47% of the popular vote, the Istanbul Stock Exchange (ISE) soared to an all-time peak and the Turkish currency, the new lira, reached a six-year high the day after the election.

However, Turkey’s emerging-market status and its long history of political turmoil means it remains subject to many investment risks. Between the powerful military, right-wing nationalists, secular leftists, Kurdish separatists, and Islamic fundamentalists, Turkey seems permanently embroiled in social and political crises.

Good for the Market In fact, Erdogan triggered this national election when he nominated his foreign minister, Abdullah Gul, as president. AKP’s opponents protested and Turkey’s military warned it might intervene–all because Gul is perceived as an Islamic radical and a threat to Turkey’s traditional separation of religion and state. On May 1, the Constitutional Court barred Gul’s candidacy. These events took the ISE-100 index down by 7.1% in just two trading days. Consequently, Erdogan was forced to move the election to July from November.

“This election result was the best we could have hoped for,”says Daniel Grana, portfolio manager and head of the emerging-markets equity team at Putnam Investments.”If AKP fell short of a majority, it might’ve brought back Turkey’s bad old days of weak coalition governments. If AKP had scored more than a two-thirds majority, they might’ve been able to push through some constitutional changes, which would likely have prompted the Turkish military to step in and challenge the government–something the markets would react very negatively to.”

Turkey’s chronic political instability is precisely what makes its economic recovery since the financial crisis of 2001 nothing short of astonishing. The AKP (which took power in November, 2002) instituted a series of economic reforms in tandem with a $10 billion loan from the International Monetary Fund.

First Term Results Grana says AKP enacted fiscal discipline and showed a willingness to privatize and use interest rates to cool inflation. The party launched discussions with the IMF on economic reforms, and with the EU to enact political reforms.

Indeed, under Erdogan’s first regime, according to data from Deutsche Bank Research (DB), Turkey’s $400 billion economy delivered real gross-domestic-product growth of about 7% annually; inflation dropped from 21.6% in 2003 to 9.5% last year; net foreign direct investment soared from $1.3 billion in 2003 to a record $19.2 billion in 2006; and the country’s public debt, as a percentage of GDP, fell from 79.8% in 2003 to 62.8% last year.

In addition, the ISE has quintupled in value since Erdogan took office. Turkey’s central bank has kept its policy rate at 17.5% (among the highest in the emerging markets) for the past year, but in mid-July indicated it may cut rates in the fourth quarter. Erdogan has also accelerated privatization, including the sale of the state-owned phone operator, and plans to find buyers for state-owned electricity grids and a state-owned lender.

Top-Performing Emerging Market”Turkey has recognized the merits of liberalization,”says Julian Mayo, co-manager of the U.S. Global Investors Eastern European Fund and director of London-based investment manager Charlemagne Capital.”Foreign direct investment has increased multifold, trade with the EU has risen markedly, and some of the huge, state-run inefficient businesses have been privatized. Moreover, by Turkish standards, the decline in inflation has been remarkable.”

Despite the kinetic growth of Turkey’s stock markets, equities remain cheap. The MSCI Barra Turkey index soared 61.8% year-to-date through July 23, making Turkey one of the top-performing emerging markets. Over the one-year period, the index skyrocketed 98.2%. However, according to S&P/Citigroup Global Equity Indices, Turkish equities sported a 12-month price-to-earnings ratio of only 11.4 as of June 29, vs. 14.6 for the Eurozone and 16.0 for the U.S.

“Turkey remains an emerging market, hence the risk premium,”Grana notes.”Politics are still unstable, economic policies are not as institutionalized as in the West, and corporate governance, while improving, is still not that great. Hence, the low price multiples for Turkish stocks, despite good underlying earnings growth and some decent fundamentals.”However, he adds that if AKP continues to be fiscally disciplined and attract foreign investors, the multiple will expand as the risk premium declines.”This is exactly what happened in Brazil, and Turkey is about five years behind Brazil,”Grana says.

Climbing Deficit Noting that Turkey’s equity markets are dominated by financials and industrials, Mayo adds that,”Two-thirds of the free float [shares freely available on the market] is held by foreigners, which means we collectively have significant influence as far as issues such as corporate governance are concerned.”

One major economic obstacle facing Turkey is its unwieldy current account deficit. According to Deutsche Bank Research, this deficit climbed steadily from $8 billion in 2003 to $31.3 billion last year, and could reach $33.1 billion in 2008.

Mayo believes overall risks in Turkey have eased.”The economy should continue to boom, supported by strong trade and domestic demand,”he says.”Profits are strong–about 25% annually–and the market remains one of the cheapest emerging markets.”The biggest risk facing Turkey’s economy lies with the future policy of AKP, Grana says.”If they don’t continue with market-friendly measures, Turkey goes backwards,”he notes.”Also, if the global risk appetite for emerging-market assets decreases, due to exogenous incidents, Turkey will be hurt.”

Member of the Club? Turkey’s multidecade struggle to join the EU has received much media attention, but Mayo doesn’t think club membership is critical from a stock market perspective.”It is the economic integration that matters. For example, Turkey’s trade agreement with the EU,”he says.”What matters is that living standards in Turkey keep rising, and the current AKP policies, including the nation’s relationship with the EU, are enabling this to happen.”Grana believes Turkey will probably not be granted entry into the EU for at least another decade because of opposition from most European countries.

“[Yet,] as Turkey develops its economy and makes meaningful democratic reforms, the EU has to eventually accept it,”he concludes.”Once that happens, Turkey will benefit immediately.”


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