Economy

Chart 1 Inflation And Bond Yields Are Headed Lower Inflation And Bond Yields Are Headed Lower Turkey’s financial policymakers have pursued a disciplined and restrictive policy mix so far, delivering high real interest rates and curbing fiscal expansion even as the economy slows. This commitment to inflation control has paved the way for a pronounced decline in price pressures, prompting BCA’s Emerging Markets Strategy team to upgrade Turkish domestic bonds to overweight in its EM domestic bond portfolio. Similarly, Moody’s has recently upgraded Turkey’s credit rating and outlook. The lagged effects of the restrictive stance are now increasingly evident: real bank lending rates hover near 30%, real domestic demand growth is decelerating, and fiscal expenditure increases are barely keeping pace with inflation. Collectively, these conditions point to further disinflation and declining bond yields in the coming quarters (Chart 1).From an FX strategy perspective, the Turkish lira (TRY) presents a less precarious profile than many fear and what the forward markets currently imply. Chart 2 Weak Domestic Growth Means Narrow CA Deficit Weak Domestic Growth Means Narrow CA Deficit First, the current account deficit has narrowed considerably in recent years. As tight policy weighs on domestic demand, it will further curb goods imports and keep the current account deficit in check (Chart 2). This improvement should offset much of the expected export contraction due to slowing demand from the European manufacturing sector, reducing pressures on the lira from external balances. Second, the combination of receding inflation and very high nominal yields creates a compelling environment to attract sizable foreign portfolio flows into local currency debt. With foreign ownership of Turkish domestic government bonds currently low by historical standards, there’s significant room for new inflows (Chart 3). As such, the TRY depreciation over the next year will likely fall well short of the 26% pace currently implied by forward markets vis-à-vis the USD. Historically, periods of falling inflation have coincided with slower lira depreciation (Chart 4). A weaker trade-weighted US dollar could reinforce this trend, further curbing pressure on the currency. In this context, short-end local currency bonds are becoming increasingly attractive to global investors. Chart 3 Foreign Holdings Of Securities Are Low Foreign Holdings Of Securities Are Low Chart 4 Falling Inflation Supports The Lira Falling Inflation Supports The Lira Bottom Line: Falling inflation and a narrow current account deficit in Turkey have historically gone hand-in-hand with a less vulnerable currency. This time should be no different: the pace of the lira’s depreciation against the US dollar will likely ease in the coming months.

We maintain our 12-month US recession probability at 60%. However, until the “whites of the recession’s eyes” are more clearly visible, we would refrain from moving to a fully defensive stance.

Economic activity and hiring cooled significantly in the first half of the year. The most important question for investors is whether this signals an imminent increase in labor market slack.

MacroQuant is recommending that equity investors keep their finger near the eject button but avoid pressing it for now. The model is warming up to the dollar again and sees scope for oil prices to rise.