The Talented Mr Erdogan

This week we bargain-hunt in the aftermath of Turkey’s currency plunge. Several Turkish equities offer compelling bargains.

Turkey’s currency collapsed on August 4 and 5, due to the cumulative impact of negative real Turkish interest rates, the nearly complete shutdown of Turkey’s tourist business, and a shrinking economy.

The Turkish central bank lost a third of its foreign exchange reserves this year, despite heavy foreign-currency borrowings from Turkish banks to artificially boost reserve numbers.

Earlier this week it squeezed money-market liquidity in Turkish currency to make it hard for short-sellers to find TRY to sell. On Wednesday it gave up and let TRY plunge from 6.94 to the dollar on Tuesday to 7.22 on Tuesday.

In Euro terms, the Turkish stock market is trading at its lowest level since 2004.

That is not quite as catastrophic as it appears for Turkey’s economy. The market capitalization of the Istanbul 100 Index is only $35 billion, about the same as the Sands casino empire.

By contrast, the value of Turkey’s housing stock is by our back-of-the-envelope reckoning about $700 billion, or 20 times higher. Turkey’s housing sector has performed well this year, as Turkish citizens as well as foreigners poured money into the only asset that appreciated during the year to date.

The country’s home price index has gained 23% over the past year, well above 12% annual gain in the consumer price index.

The clever Mr Erdogan, who has denounced high-interest rates and let TRY depreciate in order to keep rates low, understands that currency depreciation is an instrument of income redistribution.

Two-thirds of Turkish households own their own home, and Turkey’s Gulf State neighbors hunt for bargains in Turkish real estate after devaluations. The low-interest-rate policy that the Turkish Central Bank adopted in 2019 succeeded in lifting home prices after several years of negative real returns.

The losers were Turkey’s corporate sector, which owes about $400 billion to foreigners (of which over $100 billion is short-term debt). For Turkish companies with large foreign-currency liabilities and domestic earnings, the cost of debt service has roughly doubled since the debt was contracted in 2014-2018.

Erdogan’s low-interest policy and its result, the further devaluation of the lira, thus constitutes a transfer of wealth from Turkish corporations to Turkish households. Something like this occurred during the stagflation of the 1970s in the United States, when negative real yields in the context of high inflation led to negative returns for stocks and bonds, while investment in homes had positive returns.

Turkey will not collapse after the fashion of Argentina. Geopolitically, it is too important for its allies to fail to act. Erdogan is negotiating between East and West.

In June, Turkey’s central bank activated its $400 million swap line with the People’s Bank of China, and for the first time ever Turkish importers paid for Chinese goods in RMB. Turkey sold a 48% stake in its Kumport container terminal to a Chinese enterprise.

Turkey also sold the Yavuz Sultan Selim Bridge, originally build with Chinese loans, to a Chinese syndicate for $688 million. China is prepared (at the right price) to purchase other Turkish assets that support the “middle corridor” of its Belt-and-Road Initiative.

Alibaba paid $750 million in 2018 for a minority stake in the Turkish e-commerce startup Trendyol, and Huawei has a number of joint ventures with Turkcell.

The threat of a major Turkish turn to China will force Washington and Brussels to consider alternative means of propping up the Turkish economy.

In the short term, Turkey almost certainly will raise interest rates in order to take the pressure off TRY. The market has already tightened medium-term interest rates in anticipation; the five-year local currency bond yield has risen by two percentage points in the past two months.

Stabilizing the lira today is much easier than it has been in the past because Turkey’s current account is in the black. It improved from -6% of GDP in 2018 to a slight positive during 2020. A shift to positive real interest rates and some additional financing should stabilize TRY around its present levels.

That leaves foreign investors with the chance to buy profitable Turkish companies at a fraction of their 2019 prices. Although the Turkish corporate sector carries a heavy debt burden, there are a number of large Turkish companies with very little debt, modest import requirements, and strong domestic markets. Below are a few names that meet these criteria.

Bim Birlesik Magazalar is Turkey’s largest consumer staples producer, with a return on equity of 36%, virtually no debt, and a history of outperforming the broad Turkish market. It is pricey at a P/E of 30, but remains the market leader.

Our top pick in the group is Turkcell, the dominant mobile phone provider in a country with an extremely high rate of smartphone penetration. It is selling at 11 times earnings, has little debt, and an ROE of 16% (projected to rise to 21% next year).

Koza Altin is a gold miner selling at seven times earnings. It has a strong earnings track record and is a net creditor.

For investors able to execute options, our favorite trade is to sell an at-the-money straddle on USD/TRY. Implied volatility on the currency pair is at 24%, equal to the March peak.

Beware of bargains in Chinese banks

Chinese regulators are pressing banks to reserve more for loan losses. That is the main (but not the only) reason for the underperformance of banks in this year’s China stock rally. Reserves have been rising, and for the most-affected institution, Citic Bank, now amount to more than 30% of net interest income.

We observe a close relationship between bank valuation and the extent of loan loss reserves. The chart below compares the price-earnings ratio for this group of banks to the ratio of loan loss reserves to net interest income. Each data point is shown as a bubble; the size of the bubble represents each bank’s dependence on foreign deposits.

The large bubble belongs to the Bank of China, which takes 20% of its deposits outside of China. The other banks have negligible foreign exposure. Bank of China sought to become more of a global investment bank, and the market has penalized it for its ambitions.

Early in July the Trump Administration began threatening sanctions against Chinese banks which might cut off their sources of dollar funding, and Secretary of State Michael Pompeo reiterated this threat on a Fox News interview on August 2.

The People’s Bank of China has more than adequate reserves to provide dollar financing to Chinese banks, and the enactment of “nuclear-option” sanctions is unlikely in any event. But the threat of US action helps explain why Bank of China is trading cheap to the trend line.

We prefer quality in Chinese banks and would stick with China Construction Bank, with a loss reserve-to-net-interest-income ratio of just 17% and virtually no foreign exposure. We reiterated last week’s recommendation of Ping An Insurance and China Life Insurance.