Global Multi-Asset Viewpoint Will Turkey be the Brazil of 2017?

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1 Global Multi-Asset Viewpoint Will Turkey be the Brazil of 2017? SOLUTIONS & MULTI-ASSET GLOBAL MULTI-ASSET TEAM MACRO INSIGHT MAY 2017 In 2016, after five years of underperformance, Brazilian assets staged a spectacular rebound, outperforming almost all other assets. The Brazilian real rose 22% against the U.S. dollar, while Brazilian stocks rose 69% and local bonds rose 58%, beating global stocks and bonds which rose only 9% and 2%, respectively. 1 The 2016 rebound in Brazilian asset prices came after a tumultuous time for Brazil s markets, economy, and political leadership. Brazilian stocks had lost three quarters of their value in the prior five years. Inflation had doubled from 5% on average in 2010 to over 10% at the end of Interest rates had doubled to 14.25%. 2 The economy had contracted 8% in the deepest recession Brazil has experienced in 85 years. The budget deficit had widened to 10% from 4% a few years prior. The popular support of Dilma Rousseff, reelected as president in 2014, sank to a low of 8% in August 2015, the lowest approval rating for any president since polling began in During 2015 and 2016, millions of Brazilians took to the streets in a wave of anti-government protests against widespread corruption at state-run oil company Petroleo Brasileiro SA, or Petrobras, culminating in the largest demonstration in São Paulo s history in March 2016, with 500,000 protestors in the city alone. 4 By December 2015, impeachment proceedings against Rousseff had begun. So how did Brazilian assets become the best performing in the world in 2016? AUTHORS Will the Turkish lira follow the path of the Brazilian real? Index CYRIL MOULLÉ-BERTEAUX Portfolio Manager Head of Global Multi-Asset Team Managing Director SERGEI PARMENOV Portfolio Manager Global Multi-Asset Team Managing Director Turkey FX Total Return Brazil FX Total Return (Led 16 Months) This index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results Source: MSIM GMA Team analysis; Factset; As of April 30, 2017.

2 MACRO INSIGHT First of all, asset valuations were extremely cheap. By the end of 2015, Brazil s currency was the cheapest it had been in a dozen years (nearly 20% cheap to fair value on some metrics). 5 Brazilian equities were trading at an all-time low of 7.2x forward earnings, half their long term average relative to global equities. 6 And local bond yields exceeded 16%, the highest levels since Second, extreme uncertainty had led to massive risk reduction and capitulation on the part of investors by the beginning of According to survey data, investors moved to a substantial underweight in the currency by early 2016 from a strong overweight in mid In May of 2016, foreigners had pulled nearly $20 billion out of Brazil in the prior 12 months. A year earlier they were pouring money in at a $40+ billion annual run rate. 8 Third, fundamental improvements helped restore investor optimism. After Rousseff s impeachment and removal from office in August 2016, former Vice President Michel Temer from the centrist Brazilian Democratic Movement Party (PMDB) took over, and began to pursue an aggressive reform agenda. Temer s government has been focused on restoring business confidence and tackling Brazil s weak point: government finances. In order to stabilise Brazil s long term government debt profile, he passed a law limiting future increases in budget spending, and proposed reforms to the country s social security system that would lift the retirement age from an average of 54 to 65 years and reduce pension benefits; though some of these reforms may be at risk if Temer s position becomes vulnerable following the recent corruption allegations. The government has also reined in government banks such as BNDES and Caixa, whose lending growth had exploded to % YoY in Public bank lending fell to 0% in 2016 and is currently shrinking by -10% YoY. 10 Brazil s central bank has also focused on regaining credibility under the leadership of its president Ilan Goldfajn, nominated by president Temer in June Having hiked rates in to 14.25%, or 7% in real terms, the central bank did not cut, despite massive unemployment, until October 2016 when actual inflation peaked and inflation expectations fell back to the central bank target of 4.5%. Then, Brazil got lucky: oil prices doubled, iron ore prices nearly tripled, and global growth rebounded from 1.7% in the fourth quarter of 2015 to 2.8% by the fourth quarter of 2016 led by China, but also by the U.S. and Europe. 11 In response, Brazil s currency appreciated 32% from the low reached in September 2015, 10yr yields fell 650 basis points to 10.3%, stock prices more than doubled, and the economy grew for the first time in 13 quarters. 12 Can Turkey follow a similar path? We believe Turkey can pull off a mini-brazil. Valuations are cheap and investors are bearish, but a key question is whether the fundamental catalysts will prove sufficient. First, much like Brazil in early 2016, valuations for Turkish assets are extremely cheap today. The currency has fallen by 68% since 2008 and, in inflation adjusted terms, is close to record low levels, trading at an 18% discount to fair value and nearly 30% below 2008 and 2010 peaks. 13 Turkey Real Effective Exchange Rate Index stdv Source: BIS, MSIM GMA Team analysis; Factset; As of April 30, mean -1 stdv Five-year local swap rates have sold off to a 12% yield, above the latest core inflation of 9.4% (and headline of 11.9%). 14 And Turkish banks stocks are trading at just 6.2x forward earnings, and at half their historic relative book value (vs. global stocks). Second, similar to Brazil in early 2016, sentiment and positioning in Turkish assets has been bearish. Turkey has been one of the most disliked markets by equity and bond investors. After being underweight TRY for most of last year, investors have only recently moved to mild overweight positioning. 15 At the beginning of 2016, 12-month foreign outflows from Turkish assets reached -$18 billion, down from a peak of +$53 billion of inflows in May 2013 (though they have rebounded somewhat to +$9 billion of inflows as of February 2017). 16 Third, some fundamentals are improving in Turkey, but the data isn t uniformly positive, and thus may not be sufficient for more than a minor rally: On the positive side, President Erdogan has recently acknowledged the weakness of the currency as undesirable, calling on Turks to cash in foreign exchange holdings in December He has also allowed The Central Bank of the Republic of Turkey s (CBRT) to raise overnight lending rates by 400bps (to 12.25% for the late liquidity window or 11.80% for the average lending rate). 2 MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

3 WILL TURKEY BE THE BRAZIL OF 2017? In addition, the balance of payments is likely to improve as tourism rebounds. Amid an attempted military coup and repeated terrorist attacks, tourist arrivals fell by 40% YoY in June 2016, hitting tourism receipts. Arrivals have begun to improve they are down only 4% YoY as of March 2017 and with the referendum passed, there is less risk of political instability. 17 A tourism recovery could add up to 1% of GDP, and could help the current account improve to a deficit of less than 3% of GDP. 18 Turkey Current Account % of GDP GMA Team Estimate: -2% Latest -3.5% Seasonally Adjusted. Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Source: MSIM GMA Team analysis; Factset; As of April 30, On the other hand, the fundamental data is not entirely positive. Inflation is climbing faster than expected. This has mostly been expected as the result of past currency weakness from the last couple of years, which means inflation should reverse; but the central bank has exceeded its target every year for over 10 years, and will thus have to keep real rates high. In order to support growth and boost popularity, Erdogan is planning to offset monetary tightening with fiscal expansion, which would make it harder to tame inflation. Lending by public banks could also fuel inflation. State-owned banks have massively increased loans by 27% this year as of March 2017, while private banks have increased loans by 18% during that time period. 19 And the unorthodox way in which rates are being increased (i.e. not the traditional overnight repo rate) has caused investors to doubt the central bank s commitment to getting inflation back to target (currently 11.9% vs. target of 5%). 20 Residual political instability following the April 2017 referendum could also flare up. The referendum result was very close (52.4% voted Yes vs. 48.6% who voted No ) and reported irregularities on voting day and accusations of manipulated results suggest discontent remains high. Moreover, most of the support for Erdogan came from rural areas, while voters in major cities tended to vote No. There are potential upside risks. Lower oil prices would boost the lira. A $10 drop in the price of oil translates to a 1% narrowing of Turkey s current account deficit as a share of GDP, all else equal. We expect Brent crude oil prices to fall to $40 per barrel by the end of 2017, from ~$50 today, which could reduce the current account deficit by 1% of GDP. 21 Increased services exports (i.e. tourism) could also surprise to the upside as a consequence of easing political and social tensions. A moderate amount of higher public spending could also boost growth if the government takes advantage of Turkey s low government debt levels, provided inflation remains in check. Downside risks to the currency include U.S. rate hikes and the impact of 2019 elections. Turkey s gross external debt (public and private) was 47% of GDP at the end of 2016, therefore rate hikes would affect the cost of funding for the banking system as well as for the economy as a whole. 22 Should Erdogan decide that the economy needs more stimulus in advance of 2019 elections, he could abandon responsible monetary policy, forcing rates lower and causing inflation to pick up again. But overall, we believe that Turkey s currency can appreciate 5-10% from current levels, that bond yields can rally 200 basis points in anticipation of eventual rate cuts, and that bank stocks can outperform by 30%. 23 But a Brazil-style rally will have to wait for orthodox economic policy, which appears to be unlikely under Erdogan. The government recently has created a Credit Guarantee Fund (KGF), which acts as a guarantor for loans to nonfinancial companies. This could further boost credit growth and potentially lead to overheating and higher inflation. This also means the government may ultimately be forced to absorb losses in the event corporates aren t able to repay loans. According to the government, the KGF could be responsible for as much as 250 billion liras of loans (USD 70 billion). SOLUTIONS & MULTI-ASSET MORGAN STANLEY INVESTMENT MANAGEMENT 3

4 MACRO INSIGHT Note: All data is as of April 30, 2017, unless otherwise noted. 1 Bloomberg: Brazil stocks measured by MSCI Brazil in U.S. dollar terms; local Brazilian bonds measured by JP Morgan GBI-EM Broad Brazil Index, USD Unhedged; Global stocks measured by MSCI ACWI in local currency; global bonds Barclays Global Aggregate unhedged. 2 MSIM Global Multi-Asset (GMA) Team analysis; Bloomberg LP. 3 MSIM GMA Team analysis; Datafolha. 4 5 MSIM GMA Team analysis; Datastream. 6 MSIM GMA Team analysis; Factset; Datastream; MSCI (data based on MSCI Brazil Index). 7 MSIM GMA Team analysis; Bloomberg LP. 8 MSIM GMA Team analysis; EPFR; All flows quoted are on a 12-month trailing basis 9 MSIM GMA Team analysis; Banco Central do Brasil MSIM GMA Team analysis; Bloomberg LP. 12 MSIM GMA Team analysis; Bloomberg LP; MSCI Brazil in USD terms. 13 MSIM GMA Team analysis; Banco Central do Brasil MSIM GMA Team analysis; J. P. Morgan EM Local Markets Survey, March MSIM GMA Team analysis; EPFR. 17 MSIM GMA Team analysis; Bloomberg LP. 18 MSIM GMA Team analysis. 19 MSIM GMA Team analysis; Bloomberg LP; Central Bank of the Republic of Turkey MSIM GMA Team analysis MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

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