Turkey - Winter is Coming

Summary Points

-The Turkish central bank recently cut interest rates, as opposed to other central banks that are now hiking to stem a rising tide of inflation

-The current energy crisis will get worse and spiking natural gas prices will further affect the Turkish economy which imports most of its gas

-TRY will further devaluate with significant pressures on the Turkish USD sovereign bonds and local equity market

Turkey cuts rates - an economic paradox

The Turkish central bank recently surprised the markets with an interest rate cut, as opposed to other central banks which are raising rates in the face of increased inflation. The basic principles of monetary policy advocate for an increase in rates as inflation picks up. Not in Turkey. President Erdogan installed an obedient central banker back in March, after firing Naci Agbalfired after only 5 months on the job. Naci's biggest mistake was raising interest rates to stem a slide in the Turkish currency, the lira (TRY). Erdogan's reasons for disliking high rates (which to be honest are indeed high - they were 19% in local currency) reside in a populist approach - the everyday man on the street does not understand monetary policy, but he/she sees a high rate on the credit card bill or for a mortgage. That unhappiness translates into a negative vote for Erdogan, which must be avoided. The erosion in purchasing power, the economy and general wellness of the state is gradual and can always be attributed to external factors. In a nutshell that is the reasoning behind the central bank lowering rates while other central banks are hiking them. Both Poland and Romania just raised rates to contain inflation. New Zealand and Norway also have raised rates in the past weeks to both contain inflation as well as move away toward interest rate normalization.

Turkey and Natural Gas

Turkey ranks as the 7th highest natural gas consumer in the world, with household consumption continuing to increase. At the same time Turkey imports ~70% of its natural gas needs with 30% of imports in the LNG form. That is an astounding amount just in itself, but when considering the enormous increase in natural gas prices in the past months (the EU market has seen a 3x increase in prices) one can understand the pressures on the Turkish economy and more specifically inflationary pressures. Through its Black Sea discovery Turkey is set to access another source (this time local) of natural gas, but this will not happen until 2023 the earliest. This winter will be fully served by existing sources and will be a brutal one from a pricing perspective.

Affected Assets

Most of the pressure will be felt by TRY, which has already depreciated 20% this year and will continue to face the brunt of the underperformance in the Turkish economy and the underlying inflationary undercurrents.

The next in line are going to be the equities of local banks, which have significant Eur and Usd denominated debts but local TRY assets. As TRY depreciates their costs of funds are going up, and their liabilities are also increasing. In past events of market anxiety their pure ability to roll funding was also questioned. Expect stock prices in this sector to be depressed.

Thirdly the Turkish Eurobonds (Usd denominated debt) are also going to be under pressure. We have seen this sort of action before in 2018 when yields spiked to 8%+ on 7-year bonds, which translates to 6%+ of a spread over treasuries.

Conclusion

Winter is coming indeed, not only from a calendar perspective but also from a predicted performance of Turkish financial assets. With a global energy crisis in development that has seen European natural gas prices jump three fold since the beginning of the year inflation is building up. With over 70% of local natural gas consumption coming from imports and a central bank which just lowered rates, we expect inflationary pressures to manifest themselves through a weaker TRY and lower valuations for Turkish financial assets in general with local bank equities and Turkish Eurobonds being the most liquid forms of that expression.