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Investing in Turkey in 2014: Storm clouds brewing

Turkey's messy 2013 and start to the year is worrying politicians and investors alike. As the war in neighboring Syria threatens to have knock-on effects and Prime Minister Recep Tayyip Erdogan struggles to contain an engulfing corruption probe, investors are thinking twice about the stability of the country. Known as the nation that bridges the gap between East and West, Turkey is also battling high inflation, low growth, and a weak stock market and lira.

Here's a look at what's worrying investors about Turkey.

Mustafa Ozer | AFP/Getty Images

Sectarian divides in Turkish politics

In its Top Risks 2014 report, risk consultancy Eurasia highlights Turkey as one of the Top 10 risks, and argues sectarian identities are playing a larger role in Turkish politics. The gap is widening between Sunni and Alevi communities. As Turkey continues to scale back support for militant Sunni groups, which increasingly are being run by extremists, Erdogan is set to strengthen his nationalist/conservative base up to the elections.

(Read more: Why this 'fragile five' currency is at record lows)

According to David Gordon, Chairman and Head of Research of Eurasia Group, after the violent Gezi Park protests last year, Erdogan has had to refocus his efforts on rebuilding confidence from within his own party, and he has therefore not had the capacity to reach out as much to the Kurds to continue the peace process talks with the Kurdistan Workers' Party (PKK).

Turkey worse in short term: Pro
Turkey worse in short term: Pro

Gordon says these talks now are on the verge of collapse, and he thinks the PKK ceasefire could completely break down after local elections in March. The Kurds have been the victim of Erdogan's political crisis and his response to it, according to Gordon, and he thinks Turkey's relationship with Iraq now will become even more complicated with a lot of regional spill-over effects. Gordon believes a consequence of the break-down in talks with the Kurds could be a reappearance of guerrilla activity.

No gullibility in Turkey as Gülen supports Gül

Erdogan's political focus at the moment is much more internal. There is a group within the Prime Minister's ruling Justice and Development Party (AKP), founded and run by Muhammed Fethullah Gülen. The Gülen Movement is seen as a seen as a mildly Islamist party within a party. It is pro-US and pro-Israel, heavily believes in education, interfaith dialogs and multi-party democracy. While Gülen himself lives in self-imposed exile in the US, his followers have acquired strong positions in the police and judiciary. It also has a very strong following (around 5 percent of the AKP vote).

(Read more: Turkey's Erdogan defiant as three ministers quit over scandal)

The Gülen Movement has been increasingly critical of Erdogan's behaviour and way of leading the country. Not only are they dissatisfied with his policy on Israel and the Kurds, but they also feel he hasn't appreciated how strong the Gülen Movement is -- and that they should have been given more political power.

While the Gülen Movement is not intent on destroying the AKP, it would like to see Turkey's current president, Abdullah Gül, become the new prime minister and run the AKP. Gül, who has a significantly different style from Erdogan, has not openly mounted a challenge for leadership of the party.The Gülen Movement, however, has tried to discredit Erdogan…possibly to the benefit of President Gül.

How to invest in Turkey
How to invest in Turkey

Erdogan under pressure

Against this backdrop, Eurasia Group's Gordon thinks there is a big risk that PM Erdogan could step up his divisive populist rhetoric. Gordon says that whereas Erdogan in the past had shown a more pragmatic view, party and political relations are already becoming strained thanks to the uncertainty about the role of the president versus prime minister. Erdogan will try everything to prevent President Gül from taking the chairmanship of AKP in September. While it is widely expected the AKP will win local and national elections this year, unpredictability within the party is set to continue.

Turkish stocks to continue lower

Christian Keller, Head of Emerging Market Research from Barclays, thinks Turkish equity markets could continue to move lower. With the Turkish lira having dropped substantially, Keller thinks the weaker currency will start to have an impact on the corporate sector. There is an argument that short-term Turkish interest rates should be 3-4 percentage points higher to counterbalance the weak lira. If the Turkish central bank were to hike rates to strengthen the lira, it would hurt stocks, and Keller says the financial sector in particular would be vulnerable. Keller also points out that around 60 percent of the main index in Istanbul is comprised precisely of financials.

(Read more: Emerging market stocks that could escape 'taper tantrums')

According to Barclays research, the recent emerging market outflow trend has shown retail investors exiting, while institutional investors to some extent have remained. Keller says activity in the first quarter will determine whether continued weak emerging market data could turn this into an extended move through 2014, or whether it was just a short-lived dip.

Institutional investors in developed markets have tiny amounts of money allocated to emerging markets at the moment. Keller highlights that this isn't reflective of the growing share of emerging market GDP in global GDP. According to Keller, over the next 5 years, strategic allocations should continue, and growth will becoming from emerging markets.

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