Taper the fearing. Don’t fear the tapering.

A hectic month for markets; but correction in the cards in the short term -- Benchmark and 10-year TRL-denominated bond yields have jumped almost 300bp from their historic lows of 4.61% and 5.97%, respectively, as of the date of Turkey’s sovereign rating upgrade to investment grade (IG). In the meantime, the TRL has weakened 8% and Turkey’s CDS premium has almost doubled to 230bp, while the stock market has shed 24% from its peak. Though profit taking was not quite unexpected for Turkish assets after the upgrade to IG by Moody’s, its magnitude has exceeded our projections, driven by uncertainties posed by FED tapering. On the other hand, TRL assets have underperformed EM peers to some extent, probably related to re-pricing of political risks after incidents during Gezi Park protests, though an optimist may also perceive this as a correction after the significant outperformance preceding the IG upgrade. Whatever the reason, the damage is done… Yet, it is still not clear whether the Fed’s base case scenario (The Federal Reserve may “moderate” its pace of bond purchases later this year and may end them around mid-2014) will pan out, as this seems contingent on sustained improvements in non-farm payroll and economic activity. Therefore, we deem Fed fears overblown and perceive the 100bp spike in US10YT in such a short period of time exaggerated. From a different perspective, however, pricing in of tapering fears sooner rather than later may bode well for risk sentiment, going forward. On the other hand, even though tapering off of QE on a flow basis seems quite imminent in a likely scenario, monetary tightening i.e. Fed funds rate hike, potentially lies further ahead and seems unlikely before 2015. 

Sell in May… Well, if not, in June… The timing of the significant capital outflows from EMs and Turkey is quite consistent with the seasonality of global fund flows, reminiscent of the old adage “Sell in May and Go Away”… But the sell-off has intensified and continued after the June FOMC meeting, which may rekindle “sudden stop” concerns. We think, however, that drawing definitive inferences would be premature at this stage, and further observations seem necessary. Investors might recall that cumulative capital outflows in May via different channels reached US$7.9bn -- mainly through swap transactions (US$6.6bn) -- while the bulk of the outflows occurred prior to the domestic disturbances. However, US$2.7bn had already returned in the first two weeks of June. As usual, the shift in the direction of capital flows triggered an immediate change in the CBT’s monetary stance, from easing to tightening, albeit in gradual steps. Apart from that, we believe an improving outlook for economic activity and a likely deterioration in inflation due to exchange rate pass-through also underpin the case for a tighter stance. Considering that the CBT’s recent policy framework is focussed entirely on weakening the tight link between capital flows and domestic economic indicators such as loans and the current account deficit, we might assume that the direction of capital flows will also be vital for monetary policy decisions, going forward.

Global and local growth on the right track, if you are looking backwards... Taking a glance at the current state of affairs, the slide in PMI indices since February -- the most widely followed leading indicators of global economic activity -- has ceased in May, possibly signalling an end to loss of momentum in global recovery. In the case of Turkey, GDP growth beat expectations with 3% yoy increase in 1Q13, and latest IP data, as well as other leading indicators including capacity utilisation and real sector confidence indices, suggest a further acceleration in economic activity in 2Q13. While these had initially raised the odds for the achievement of our 4% 2013 GDP growth forecast, the turmoil in global markets and on-going re-pricing of domestic political risks ahead of the heavy election agenda have jeopardised our GDP growth forecast via hurting consumer confidence; prompting monetary tightening; and entailing tighter financial conditions. Nevertheless, the fact that such developments impact growth expectations for the year 2013 only to a limited degree is apparent from the minor retreat in average growth expectations -- from 4.1% to 3.9%, at least for the time being. On the other hand, despite the significant rise in the trade deficit in April -- and probably in May -- due to surprisingly high gold imports, downside risks to growth in second half and the continuation of the downward trend in prices of commodities, most notably oil, may suffice to infer that the deterioration anticipated in the current account balance in 2013 should be contained. Meanwhile, year-end inflation expectations have deteriorated slightly in June survey to marginally above 6.5%, while 12- and 24-month forward looking inflation expectations have remained close to 6% levels. However, considering a probable jump in annual CPI in June due to unprocessed food prices and the likely FX pass-through (10-15%) to prices if the 8% weakening of the TRL is sustained, not to mention administrative price increases, the extent of the deterioration in inflation expectations would be the most important factor to be monitored by the CBT regarding monetary policy decisions. All in all, considering all the factors mentioned above, we have made some revisions to our macro and financial forecasts, which are provided in this report.

Last but not least, we believe the fate of Turkish assets is closely tied to global risk appetite i.e. fluctuations in US Treasury yields, in the very short term. Following drastic price gyrations, we would expect domestic markets to meander in consolidation ranges in the short term, with intermittent relief rallies. Technically speaking, the stock market may settle in a range of 70,000-78,000 if the BIST holds above the 73,000 level. Regarding the secondary bond market, where the “Great Bond Massacre” took place, we still attach less likelihood to interest rates closing the year above current levels. On the FX front, it is clear that the TRL will remain under pressure amid capital outflows. If this is not idiosyncratic, the CBT may only smooth the process with the tools at its disposal and try to eliminate the underperformance against the EM average, which is exactly what it has been doing. During such periods, it is hard to draw a line in the sand, i.e. defend a certain level with full force. It seems sensible, rather, to try to avert any excessive depreciation pressure on the domestic currency, via orderly FX selling auctions. In our view, the CBT, mindful of the inflationary risks posed by the recent depreciation of the currency, may take measures including an interest rate corridor hike, if need be, in order to bring the TRL against the FX basket within the implicit comfort zone (2.05 - 2.20) for 2013.