Turkey

Highlights Continued upgrades to global economic growth – most recently by the IMF this week –will support higher natgas prices.  In our estimation, gas for delivery at Henry Hub, LA, in the coming withdrawal season (November – March) is undervalued at current levels at ~ $2.90/MMBtu. Inventory demand will remain strong during the current April-October injection season, following the blast of colder-than-normal weather in 1Q21 that pulled inventories lower in the US, Europe and Northeast Asia. The odds the US will succeed in halting completion of the final leg of the Russian Nord Stream 2 natural gas pipeline into Germany are higher than the consensus expectation.  Our odds the pipeline will not be completed this year stand at 50%, which translates into higher upside risk for natural gas prices.  We are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close.  The probability of Nord Stream 2 cancellation is underpriced, which means European TTF and Asian JKM prices will have to move higher to attract LNG cargoes next winter from the US, if the pipeline is cancelled (Chart of the Week). Feature As major forecasting agencies continue to upgrade global growth prospects, expectations for industrial-commodity demand – energy, bulks, and base metals – also are moving higher. This week, the IMF raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021.1 This upgrade follows a similar move by the OECD last month.2 In the US, the EIA is expecting industrial demand for natural gas to rise 1.35 Bcf/d this year to 23.9 Bcf/d; versus 2019 levels, industrial demand will be 0.84 Bcf/d higher in 2021. For 2022, industrial demand is expected to be 24.2 Bcf/d. US industrial demand likely will recover faster than the EU's, given the expectation of a stronger recovery on the back of massive fiscal and monetary stimulus. Overall natgas demand in the US likely will move lower this year, given higher natgas prices expected this year and next will incentivize electricity generators to switch to coal at the margin, according to the EIA. Total demand is expected to be 82.9 Bcf/d in the US this year vs. 83.3 Bcf/d last year, owing to lower generator demand. Pipeline-quality gas output in the US – known as dry gas, since its liquids have been removed for other uses – is expected to average 91.4 Bcf/d this year, essentially unchanged. Lower consumption by the generators and flat production will allow US gas inventories to return to their five-year average levels of 3.7 Tcf by the end of October, in the EIA's estimation (Chart 2). Chart of the WeekUS-Russia Geopolitical Risk Underpriced US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 2US Natgas Inventories Return To Five-Year Average US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US Liquified Natural Gas (LNG) exports are likely to expand, as Asian and European demand grows (Chart 3). Prior to the boost in US LNG demand from colder weather, exports set monthly records of 9.4 Bcf/d and 9.8 Bcf/d in November and December of last year, respectively, with Asia accounting for the largest share of exports (Chart 4). This also marked the first time LNG exports exceeded US pipeline exports to Mexico and Canada. The EIA is forecasting US LNG exports will be 8.5 bcf/d and 9.2 Bcf/d this year and next, versus pipeline exports of 8.8 Bcf/d and 8.9 Bcf/d in 2021 and 2022, respectively. Chart 3US LNG Exports Continue Growing US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 4US LNG Exports Set Records In November And December 2020 US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher US LNG exports – and export potential given the size of the resource base at just over 500 Tcf – now are of a sufficient magnitude to be a formidable force in global markets, particularly in Europe. This puts it in direct conflict with Russia, which has targeted Europe as a key market for its pipeline natural gas exports. US-Russia Standoff Looming Over Nord Stream 2 Given the size and distribution of global oil and gas production and consumption, it comes as no surprise national interests can, at times, become as important to pricing these commodities as supply-demand fundamentals. This is particularly true in oil, and increasingly is becoming the case in natural gas. That the same dramatis personae – the US and Russia – should feature in geopolitical contests in oil and gas markets also should not come as a surprise. In an attempt to circumvent transporting its natural gas through Ukraine, Russia is building a 1,230 km underwater pipeline from Narva Bay in the Kingisepp district of the Leningrad region of Russia to Lubmin, near Greifswald, in Germany (Map 1). The Biden administration, like the Trump administration and US Congress, is officially attempting to halt the final leg of the pipeline from being built, although Biden has not yet put America’s full weight into stopping it. Biden claims it will be up to the Europeans to decide what to do. At the same time, any major Russian or Russian-backed military operation in Ukraine could trigger an American action to halt the pipeline in retaliation. Map 1Nord Stream 2 Route US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher In our estimation, there is a 50% chance that the Nord Stream 2 natural gas pipeline will not be completed this year or go into operation as planned given substantial geopolitical risks. The $11 billion pipeline would connect Russia directly to Germany with a capacity of about 55 billion cubic meters, which, combined with the existing Nord Stream One pipeline, would equal 110 BCM in offshore capacity, or 55% of Russia's natural gas exports to Europe in 2019. The pipeline’s construction is 94% complete, with the Russian ship Akademik Cherskiy entering Danish waters in late March to begin laying pipes to finish the final 138-kilometer stretch, according to Reuters. The pipeline could be finished in early August at the pace of 1 kilometer per day.3 The Russian and German governments are speeding up the project to finish it before US-Russia tensions, or the German elections in September, interrupt the construction process again. It is not too late for the US to try to halt the pipeline through sanctions. But for the Americans to succeed, the Biden administration would have to make an aggressive effort. Notably the Biden administration took office with a desire to sharpen US policy toward Russia.4 While Biden seeks Russian engagement on arms reduction treaties and the Iranian nuclear negotiations, he mainly aims to counter Russia, expand sanctions, provide weapons to Ukraine, and promote democracy in Russia’s sphere of influence. The result will almost inevitably be a new US-Russia confrontation, which is already taking shape over Russia’s buildup of troops on the border with Ukraine, where US and Russian meddling could cause civil war to reignite (Map 2). Map 2Russia’s Military Tensions With The West Escalate In Wake Of Biden’s Election And Ukraine’s Renewed Bid To Join NATO US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Tensions in Ukraine are directly tied to US military cooperation with Ukraine and any possibility that Ukraine will join the NATO military alliance, a red line for Putin. Nord Stream 2 is Russia’s way of bypassing Ukraine but a new US-Russia conflict, especially a Russian attack on Ukraine, would halt the pipeline. The pipeline’s completion would improve Russo-German strategic relations, undercut US liquefied natural gas exports to Germany and the EU, and reduce the US’s and eastern Europe’s leverage over Russia (and Germany). Biden says his administration is planning to impose new sanctions on firms that oversee, construct, or insure the pipeline, and such sanctions are required under American law.5 Yet Biden also wants a strong alliance with Germany, which favors the pipeline and does not want to escalate the conflict with Russia. The American laws against Nord Stream have big loopholes and give the president discretion regarding the use of sanctions, which means Biden would have to make a deliberate decision to override Germany and impose maximum sanctions if he truly wanted to halt construction.6 This would most likely occur if Russia committed a major new act of aggression in Ukraine or against other European democracies. The German policy, under the current ruling coalition led by Chancellor Angela Merkel’s Christian Democratic Union, is to finish the pipeline despite Russia’s conflicts with the West and political repression at home. Russia provides more than a third of Germany’s natural gas imports and this pipeline would bypass eastern Europe’s pipeline network and thus secure Germany’s (and Austria’s and the EU’s) natural gas supply whenever Russia cuts off the flow to Ukraine (through which roughly 40% of Russian natural gas still must pass to reach Europe). Germany's Election And Natgas Politics Germany wants to use natural gas as a bridge while it phases out nuclear energy and coal. Natural gas has grown 2.2 percentage points as a share of Germany’s total energy mix since the Fukushima disaster of 2011, and renewable energy has grown 7.7ppt, while coal has fallen 7.3ppt and nuclear has fallen 2.5ppt (Chart 5). The German federal election on September 26 complicates matters because Merkel and the Christian Democrats are likely to underperform their opinion polls and could even fall from power. They do not want to suffer a major foreign policy humiliation at the hands of the Americans or a strategic crisis with Russia right before the election. They will insist that Biden leave the pipeline alone and will offer other forms of cooperation against Russia in compensation. Therefore, the current German government could push through the pipeline and complete the project even in the face of US objections. But this outcome is not guaranteed. The German Greens are likely to gain influence in the Bundestag after the elections and could even lead the German government for the first time – and they are opposed to a new fossil fuel pipeline that increases Russia’s influence. Chart 5Germany Sees Nord Stream 2 Gas As Bridge To Low-Carbon Economy US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Hence there is a fair chance that the pipeline does not become operational: either Americans halt it out of strategic interest, or the German Greens halt it out of environmental and strategic interest, or both. True, there is a roughly equal chance that Merkel’s policy status quo survives in Germany, which would result in an operational pipeline. The best case for Germany might be that the current government completes the pipeline physically but the next government has optionality on whether to make it operational. But 50/50 odds of cancellation is a much higher risk than the consensus holds. The Russian policy is to finish Nord Stream 2 while also making an aggressive military stance against the West’s and NATO’s influence in Ukraine. This would expand Russian commodity and energy exports and undercut Ukraine’s natgas transit income. It would also increase Russian leverage over Germany – and it would divide Germany from the eastern Europeans and Americans. A preemptive American intervention would elicit Russian retaliation. The Russians could respond in the strategic sphere or the economic sphere. Economically they could react by cutting off natural gas to Europe, but that would undermine their diplomatic goals, so they would more likely respond by increasing production of natural gas or crude oil to steal American market share. In any scenario Russian retaliation would likely cause global price volatility in one or more energy markets, in addition to whatever volatility is induced by the cancellation of Nord Stream 2 itself. US-Russia tensions are likely to escalate but only Ukraine and Nord Stream 2, or the separate Iranian negotiations, have a direct impact on global energy supply. If Germany goes forward with the pipeline, then Russia would need to be countered by other means. The Americans, not the Germans, would provide these “other means,” such as military support to ensure the integrity of Ukraine and other nations’ borders. The Russians may gain a victory for their energy export strategy but they will never compromise on Ukraine and they will still need to focus on the broader global shift to renewable energy, which threatens their economic model and hence ultimately their regime stability. So, the risk of a market-moving US-Russia conflict can be delayed but probably not prevented (Chart 6). Chart 6US-Russia Conflit Likely US-Russia Conflit Likely US-Russia Conflit Likely Bottom Line: The Nord Stream 2 pipeline is not guaranteed to be completed this year as planned. The US is more likely to force a halt to the Nord Stream 2 pipeline than the consensus holds, especially if Russia attacks Ukraine. If the US fails to do so, then the German election will become the next signpost for whether the pipeline will become operational. If the Americans halt the pipeline, then US-Russian conflict either already erupted or will occur sooner rather than later and will likely impact global oil or natural gas prices. Investment Implications Our subjective assessment of 50% odds the US will succeed in halting completion of the final leg of Nord Stream 2 are higher than the consensus expectation. This translates directly into higher upside risk for natural gas prices in the US and Europe later this year and next. Given our view, we are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close. The probability of Nord Stream 2 cancellation is underpriced, which means the odds of higher prices in the LNG market are underpriced (Chart 7). The immediate implication of our view is European TTF prices will have to move higher to attract LNG cargoes next winter from the US, if the Nord Stream 2 pipeline's final leg is cancelled. This also would tighten the Asian markets, causing the JKM to move higher as well (Chart 8). Any indication of colder-than-normal weather in the US, Europe or Asian markets would mean a sharper move higher. Chart 7Natgas Tails Are Too Narrow For Next Winter US-Russia Pipeline Standoff Could Push LNG Prices Higher US-Russia Pipeline Standoff Could Push LNG Prices Higher Chart 8Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices Nord Stream 2 Cancellation Would Boost JKM Prices   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Commodities Round-Up Energy: Bullish The US and Iran began indirect talks earlier this week in Vienna aimed at restoring the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the "Iran nuclear deal." All of the other parties of the deal – Britain, China, France, Germany and Russia – are in favor of restoring the deal. BCA Research believes this is most likely to occur prior to the inauguration of a new president who is expected to be a hardliner willing to escalate Iran’s demands. US President Biden can unilaterally ease sanctions and bring the US into compliance with the deal, and Iran could then reciprocate. If a deal is not reached by August it could take years to resolve US-Iran tensions. China could offer to cooperate on sanctions and help to broker negotiations following the signing of its 25-year trade deal with Iran last week. Russia likely would demand the US not pressure its allies to cancel the Nord Stream 2 deal, in return for its assistance in brokering a deal. Base Metals: Bullish Iron ore prices continue to be supported by record steel prices in China, trading at more than $173/MT earlier this week. Even though steel production reportedly is falling in the top steel-producer in China, Tangshan, as a result of anti-pollution measures, for iron ore remains stout. As we have previously noted, we use steel prices as a leading indicator for copper prices. We remain long Dec21 copper and will be looking for a sell-off to get long Sep21 copper vs. short Sep21 copper if the market trades below $4/lb on the CME/COMEX futures market (Chart 9). Precious Metals: Bullish Gold held support ~ $1,680/oz at the end of March, following an earlier test in the month. We remain long the yellow metal, despite coming close to being stopped out last week (Chart 10). The earlier sell-off appeared to be caused by a need to raise liquidity to us. We continue to expect the Fed to hold firm to its stated intent to wait for actual inflation to become manifest before raising rates, and, therefore, continue to expect real rates to weaken. This will be supportive of gold and commodities generally (Chart 10). Ags/Softs: Neutral Corn continues to be well supported above $5.50/bu, following last week's USDA report showing farmers intend to increase acreage planted to just over 91mm acres, which is less than 1% above last year's level. Chart 9 Copper Prices Surge As Global Storage Draws Copper Prices Surge As Global Storage Draws Chart 10 Gold Disconnected From US Dollar And Rates Gold Disconnected From US Dollar And Rates       Footnotes 1     Please see the Fund's April 2021 forecast Managing Divergent Recoveries. 2     We noted last week these higher growth expectations generally are bullish for industrial commodities – energy, metals, and bulks.  Please see Fundamentals Support Oil, Bulks, And Metals, which we published 1 April 2021.  It is available at ces.bcaresearch.com. 3    For the rate of construction see Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Eurasia Daily Monitor 18: 17 (February 1, 2021), Jamestown Foundation, jamestown.org. For the current status, see Robin Emmott, “At NATO, Blinken warns Germany over Nord Stream 2 pipeline,” Reuters, March 23, 2021, reuters.com. 4    The Democratic Party blames Russia for what it sees as a campaign to undermine the democratic West and recreate the Soviet sphere of influence. See for example the 2008 invasion of Georgia, the failure of the Obama administration’s 2009-11 diplomatic “reset,” the Edward Snowden affair, the seizure of Crimea and civil war in Ukraine, the survival of Syria’s dictator, and Russian interference in US elections in 2016 and 2020. 5    The Countering Russian Influence in Europe and Eurasia Act of 2017, and the Protecting Europe’s Energy Security Act of 2019/2020, contain provisions requiring sanctions on firms that have contributed in any way a minimum of $1 million to the project, or provide pipe-laying services or insurance. There are exceptions for services provided by the governments of the EU member states, Norway, Switzerland, or the UK. The president has discretion over the implementation of sanctions as usual. 6    The German state of Mecklenburg-Vorpommern is creating a shell foundation to enable the completion of the pipeline. It can shield companies from American sanctions aimed at private companies, not sovereigns.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Chart 1Turkey: Deluge Of Money Turkey: Monetary Policy Orthodoxy Proved Short-Lived Turkey: Monetary Policy Orthodoxy Proved Short-Lived Turkish financial assets and specifically the lira will continue selling off because authorities have once again abandoned the tentative shift toward orthodox macro policies. Over the weekend, President Erdogan fired central bank governor Naci Ağbal, who raised interest rates by 200 basis points on Thursday – cumulating in 875 basis points of rate hikes since November 2020. His dismissal signals the limited tolerance President Erdogan has for high interest rates, as we argued in our latest report on Turkey. Indeed, President Erdogan cannot afford a relapse in domestic growth. The motive is that his popularity has been waning and support for the AKP has already been falling. Even though presidential elections are more than 24 months away, President Erdogan is very sensitive to any negative shock to the economy. The new central bank governor Sahap Kavcioglu is a fierce advocate for lower interest rates and will opt for an ultra-accommodative monetary policy stance. This, along with the fact that high inflation in Turkey remains a major structural problem and inflation expectations remain unanchored, means that real interest rates will become negative again. If the recent rate hikes are quickly reversed, the economy will resume overheating because: Broad money and loan growth remain very elevated (Chart 1). Domestic demand is robust, reflected in rising import volumes. Wages are growing at a 15% clip from a year ago (Chart 2). Notably, core consumer inflation tracks the exchange rate and its decline in the coming months will prove to be temporary as the lira’s strength was transitory (Chart 3). Chart 2Turkey: Wage-Inflation Spiral Is Alive Turkey: Monetary Policy Orthodoxy Proved Short-Lived Turkey: Monetary Policy Orthodoxy Proved Short-Lived Chart 3A Weaker Lira = Higher Inflation Turkey: Monetary Policy Orthodoxy Proved Short-Lived Turkey: Monetary Policy Orthodoxy Proved Short-Lived Chart 4Turkey: Foreign Capital Inflows Will Reverse Turkey: Monetary Policy Orthodoxy Proved Short-Lived Turkey: Monetary Policy Orthodoxy Proved Short-Lived Foreign investors have in recent months raised their holdings of Turkish stocks and local currency bonds (Chart 4). Now, they will likely be unwinding these positions. This will weigh on the currency. Finally, the central bank lacks the ability to defend the lira. Its net foreign exchange reserves have been completely depleted. In fact, it had borrowed foreign currency from commercial banks to defend the lira in the last few years. Thereby, the central bank’s own net foreign exchange reserves are actually negative. Bottom Line: The Turkish central bank will again fall behind the inflation curve. This is bearish for the lira and local currency bonds. Investors should consider shorting the lira versus the US dollar. Asset allocators should underweight both local currency government bonds and equities in their respective portfolios. Meanwhile, credit investors should be neutral on Turkish sovereign credit but underweight corporate credit within an EM credit portfolio. Andrija Vesic Associate Editor andrijav@bcaresearch.com

Chart 1Turkish Lira: A Long Lasting Breakout? Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Turkish financial markets are currently in a sweet spot, but a long-lasting rally in the Turkish lira is unlikely. In the near term, the nation’s financial markets will likely continue enjoying the following tailwinds (Chart 1): First, Turkey is benefiting from global liquidity overflows instigated by major DM central banks. The ultra-dovish stance of the Fed and the enormous fiscal largess of the new US administration and Congress have prompted a flight out of US dollars. Portfolio capital has rushed into EM, with Turkey benefiting only modestly from this. In fact, as illustrated in Chart 2, despite rising international investors’ holdings of Turkish bonds and equities, they remain low. Hence, more foreign portfolio inflows cannot be ruled out, especially if the global risk-on environment endures. Second, the lira’s recent appreciation will produce a moderation in inflation over the coming months. Historically, the inflation rate has lagged the exchange rate by around three months (Chart 3). This decline in inflation, albeit temporary in our opinion, could boost international investor confidence in Turkey’s macro policies and prompt more foreign capital inflows, thereby supporting the lira in the near run. Chart 2Will Foreigners Flock Into Turkish Assets? Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 3Currency Leads Inflation By Three Months Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Chart 4Turkey: Lending Rates Lead Growth By 6 Months Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Finally, given robust current economic conditions, President Erdogan will likely tolerate a few more months of high interest rates. However, presidential pressure on the central bank to reduce interest rates will mount as soon as economic growth relapses. Based on the previous relationship between interest rates, money growth and the business cycle, domestic demand will begin to slow in the second half of this year (Chart 4). Thus, beyond the next several months, Turkey’s financial markets will again be subject to the contradiction between the political desire to deliver strong growth and the need to contain inflation that has become structural in nature. In the second half of this year, the central bank will come under political pressure from President Erdogan to reduce interest rates considerably. This pressure will be especially strong if the pace of growth slows down, which is likely as per Chart 4 above. The central bank will have no choice but to capitulate to political pressure and start easing policy sooner than warranted. This will once again undermine the currency. Notably, January polls conducted by Metropoll suggest that the main opposition camp, the Nation Alliance, has surpassed the AKP governing coalition in popularity (Table 1). The trend will move further against the ruling party if the economy slows due to high borrowing costs. Table 1Which Alliance Are You Closer To? The Public Alliance Of The AK Party And MHP? The Nation Alliance Of The CHP And IYI Party? Turkey: Is The Sweet Spot Temporary? Turkey: Is The Sweet Spot Temporary? Inflation in Turkey has become an entrenched structural phenomenon. First, widening trade and current account deficits, even after excluding oil, are signs of structural inflation and excessive consumption (Chart 5). Second, the enormous money /credit overflows, including monetization of fiscal deficits by the central bank and commercial banks, has created a fertile ground for inflation. Money and credit growth are slowing but remain strong at a double-digit pace (Chart 6). Chart 5Current Account & Trade Deficits = Sign Of Excessive Demand Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 6Turkey: Money And Credit Growth At Double Digit! Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   In a nutshell, the central bank is still providing ample liquidity to commercial banks. This will allow the latter to maintain a rapid pace of asset expansion, i.e., loan origination and local currency government bonds purchases (Chart 7). Loose monetary settings are negative for the exchange rate. Finally, Turkish households and companies continue to convert their savings into foreign currency. Chart 8 demonstrates that despite the latest monetary tightening, residents continue to accumulate foreign currency deposits. This signals their inflation expectations remain high and distrust toward the lira has not diminished. Chart 7Turkey: CBRT Continues To Support Money Plethora Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 8Turkey: Households & Businesses Continue To Buy Foreign Currencies Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Therefore, without tight monetary and fiscal policies for an extended period of time, inflation will not fall durably. In short, the central bank’s 9.4% target for headline inflation for the end of 2021 and 7% at the end of 2022 will not be achieved. Importantly, authorities are imposing price controls on food items to grapple with rising prices. Such administrative measures might be effective in capping inflation in the short term. Yet, they will make inflation worse in the long run. Price controls will discourage investment and production resulting in future output falling short of demand. Bottom Line: For monetary policy to have a long-lasting stabilizing effect on the currency, real interest rates will have to rise considerably and stay high for some time to dampen money and credit growth as well as anchor inflation expectations. Due to the political imperative to deliver strong growth, the central bank will not be allowed to keep monetary policy tight for too long. This will begin to undermine the currency after a period of stability. Investment Recommendations Chart 9Remain Underweight Equities, But Tactically Upgrade Bonds To Neutral Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making The risk-reward of being short the lira in the next few months has deteriorated. We recommend investors close the short TRY versus an equal-weighted basket of EUR, JPY and CHF trade. This position has produced a 1.7% loss since its initiation on July 9, 2020. A better entry point will emerge over the coming months to re-instate shorts in the lira. Despite the possibility of near-term currency strength, we are reluctant to alter our structural underweight positions in Turkish equities within an EM equity portfolio (Chart 9, top panel). However, a period of stability in the currency could allow local currency bonds and sovereign credit to outperform their EM peers (Chart 9, middle and bottom panel). Hence, we are tactically upgrading the allocation of Turkish domestic and USD bonds from underweight to neutral within respective EM local bonds and sovereign credit portfolios. Andrija Vesic Associate Editor andrijav@bcaresearch.com

Chart 1Turkish Lira Versus US Dollar: Total Return Performance Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope? The firing of central bank governor Murat Uysal and the resignation of finance minister Berat Albayrak over the weekend has raised the issue as to whether Turkey is about to experience a major monetary policy reversal. A shift toward orthodox monetary policy is required to rebuild investor credibility and produce exchange rate stability (Chart 1). The root cause of the Turkish lira’s woes is well known: monetary policy has been ultra-loose with negative real interest rates, generating a boom in money and credit and a widening current account deficit. Hence, the central bank needs to hike interest rates substantially to stabilize the currency. Higher borrowing costs are needed to dampen bank lending and curtail domestic demand to narrow the current account deficit. Further, moderate fiscal tightening and, crucially, halting commercial banks from engaging in government debt monetization are also necessary. Chart 2Turkey: The Market Is Overly Optimistic On Rate Hikes Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope? The appointment of Naci Ağbal as the central bank (CBRT) governor could produce a temporary and moderate alteration in the monetary policy stance. Nevertheless, the appointment will not produce a permanent shift in monetary policy to tackle inflation, which is necessary to stabilize the Turkish lira on a sustainable basis. The reason is that given President Erdogan’s overreaching objective to deliver strong nominal growth, he cannot afford monetary and fiscal policies to be too tight for too long. Notably, the newly appointed central bank governor could hike rates by 200-300 basis points or so in the coming months. Yet, as soon as the currency stabilizes, the monetary tightening cycle will be halted, and it will not take too long for this stance to be reversed. The market is currently pricing more than 600 basis points in rate hikes over the next 3 months (Chart 2). Unless the lira plunges toward 10 TRY/USD, the CBRT is unlikely to hike rates that aggressively. Overall, President Erdogan de-facto runs monetary policy in Turkey and the CBRT is unlikely to adopt a sufficiently hawkish stance to curb inflation. Inflationary expectations remain high. Core inflation is at double digits and will continue rising (Chart 3). Service inflation is running at a rate of 11%. Wages are rising at close to 30% and the wage-inflation spiral continues to unravel (Chart 4). Chart 3Rising Inflation Is Structural In Turkey Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope? Chart 4Turkey: Wage-Inflation Spiral Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope?   The real policy rate deflated by PPI and real deposit rates deflated by core CPI are negative and low, respectively (Chart 5). Interbank rates have recently risen as the central bank has curtailed its funding to commercial banks (Chart 6). However, bank loan and broad money growth remain very high at 45% and 27%, respectively (Chart 7, top panel). Chart 5Turkey: Real (Inflation-Adjusted) Rates Are Negative Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope? Chart 6Turkey: TRY Stabilization Requires Reduced CBRT Funding To Banks Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope?   Furthermore, both central bank and commercial bank purchases of government bonds and bills continue mushrooming (Chart 7, bottom panel). These purchases create money supply out of thin air and, thereby, constitute monetization of public debt. The latter has allowed government spending to continue expanding at a double-digit rate. Importantly, import volume did not shrink during the pandemic — a sign of strong domestic demand — and the current account deficit is widening with and without oil (Chart 8). Chart 7Turkey: The Money/Credit Boom Is Ongoing Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope? Chart 8Retrenchment In Domestic Demand Is Needed To Narrow The Current Account Deficit Turkey: A Lasting Policy Reversal Or False Hope? Turkey: A Lasting Policy Reversal Or False Hope?   Lastly, President Erdogan will face a less sympathetic Washington in coming years with the inauguration of Joe Biden to the White House. In the coming year, rising political tensions between Washington and Ankara will weigh on Turkish financial markets. The sudden resignation of finance minister Berat Albayrak (President Erdogan’s son-in-law) Sunday suggests that the Turkish government is preparing for a less friendly US administration. It is alleged by US prosecutors that Berat Albayrak was connected to a US sanction-busting scheme for Iran led by state-owned Turkish bank Halkbank. Albayrak was CEO of Çalık Holding, a holding company used by the convicted Iranian-Turkish businessman Reza Zarrab to transact with the Iranian regime amid US sanctions. The scheme, related to a gold-to-oil swap between Turkish banks and Iranian officials, has been brought forth in US federal court and could potentially be used as a lever against President Erdogan. Bottom Line: Investors should remain short the lira versus a basket of the euro, CHF and JPY. A short TRY versus the USD trade is also justified as we expect the US dollar to firm in the coming months. In addition, continue underweighting Turkish equities and domestic currency bonds as well as sovereign and corporate credit relative to their respective EM benchmarks. We also reiterate our long Russian banks / Short Turkish banks trade. Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes