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Why investors will look past Turkey's authoritarian rule

The failed military coup and the Turkish government's sweeping crackdown makes Turkey a more difficult investment destination, but the global hunt for yield could lure investors who might otherwise have stayed away.

Turkish President Recep Tayyip Erdogan's government responded to Friday's attempted overthrow by arresting thousands in the military and judiciary. Nine thousand government employees were also fired from their jobs.

Turkish stocks plunged Monday, but the country's currency recovered some of the decline it saw during the short-lived coup effort Friday night. Turkish debt sold off, and its 10-year bond is yielding an attractive 9.5 percent, about 2.5 percentage points above U.S. high-yield debt.


People carry the coffin of a victim of the coup attempt at Kocatepe Mosque in Ankara, Turkey on July 18, 2016.
Dimitar Dilkoff | AFP | Getty Images
People carry the coffin of a victim of the coup attempt at Kocatepe Mosque in Ankara, Turkey on July 18, 2016.

"Right now if you're a businessman thinking about investing, you probably have to wait and see what Erdogan will do. All the assumptions are that he will tighten the grip. He had shown some authoritarian bent already. The coup may reinforce those trends. On the other hand, there's an off chance that reforms could be accelerated to try to offset some of the bad sentiment," said UBS Jorge Mariscal, emerging markets chief investment officer at UBS Wealth Management.

U.S. and European Union officials condemned the coup attempt and said they supported the democratically elected government. But on Monday EU foreign ministers warned Erdogan that his government needs to respect the law and any effort to reinstate the death penalty would end any chance the NATO country has of joining the EU.

"We've been negative on Turkey for quite some time and recent developments make us more concerned," said Gülen Tuncer, director, responsible for corporate and emerging markets bond research at Conning.

'Little bit of a negative shock'

While Erdogan's government is retaliating against those viewed as enemies, it has also been reassuring the global investment community that it would provide all the liquidity needed to keep markets and the economy functioning. The Turkish central bank meets Tuesday and could cut the overnight rate to 8.5 percent but would hold rates steady after that, according to UBS.

"So far, the reaction on the economy seems to be the right one. On the political front, it remains to be seen in his crackdown of the opposition," said Mariscal. "…This time around, he had a lot of popular support. The coup largely failed in part because people came out to the street in support of Erdogan."

Turkish stocks fell 7 percent, but the lira recovered some of the losses made Friday night. The ishares MSCI Turkey ETF TUR was down more than 6 percent, recovering several percentage points from its earlier losses in U.S. trading.

"The economy was in good shape coming into this, and it's going to have a little bit of a negative shock," Mariscal said. He expects the coup to impact the country's effort to regain tourism, which could in turn dent economic growth.

He expects GDP to grow 3.5 percent this year as a result of the coup, down from a previous forecast of 4 percent. Mariscal is also sticking with his call to overweight Turkish stocks, which are still up about 7 percent year to date.

Turkish bond yields spiked back to late June levels, and they had benefited less than some emerging markets from the global bond rally that sent U.S. yields to record lows this month. The reaction to the coup in Turkey initially spread to other emerging currencies late Friday, but that has reversed and Turkey is being treated as an isolated concern in emerging markets.

"Right now the concern is — and I think it's a valid concern — that all of this is creating an opportunity (for Erdogan) to consolidate power," said Tuncer. She said there's a risk that Erdogan will move the country toward a presidential system where he personally has a lot more control. "If that doesn't happen, it would be positive."

Tuncer said the performance of Turkey's economy belies one of its fundamental weaknesses – a dependence on foreign crude oil, which many energy analysts expect to get more expensive as the years goes on. "Our view is fundamentally, Turkey has not been doing so strongly, but with the low commodity prices, it has seen some improvement in its current account," she said.

But still while she views the Turkish bonds as an investment to avoid, they may attract some investors.

"Speaking form a fixed income investment standpoint, yield is so low … Emerging markets have been a good alternative. When we have a risk-on sentiment, complacency takes hold," she said, adding some investors overlook the risk. "I would expect investors to focus more after this weekend, and they'll start paying more attention but it's hard to tell. Investors have proven me wrong. Again, you're chasing yield. You're trying to put money to work."

Mariscal said Turkey had been mending relations with Russia, and that should have given it a tourism boost, with Russians returning to one of their favorite holiday destinations. "In the last couple of weeks, there were statements on both sides that were mending the rough patch. The coup came at a bad time, for things were about to recover in that industry," he said. Relations between Turkey and Russia became stressed after Turkey shot down a Russian war plane near the Syrian border last year.

"On the margin, the economy will suffer a little bit," he said. "When it comes to the market, the market was cheap already. We have Turkey as one of our most preferred equity markets. It was cheap. Earnings were recovering. It's getting a little cheaper today so we're monitoring the situation. For now, it's an overweight."

He said the stock market had been performing well over the last couple of weeks, and this may in fact be just a short-term headwind. "One important thing to remember is the AKP party, the government's party has been quite respective of the economy so given that there has been on the political front a move toward more authoritarianism, the basic economic tenets are to foster growth … The basic economic remains supportive of the market. Politics have been more volatile."

Mariscal said there could be a pause in investment in the country until it is clear what Erdogan will do. Erdogan has attempted to lead the country towards being a more Islamist state.

"The majority of the population is Islamic, so I would say he's quite popular for an Islamic leader. He's well received. I would say the majority of the population supports him. Turkish people value their political freedom and among Muslim states, it's the most open. If he threatens to undo that freedom, there's an important segment of the population that will come out in resistance to that. That's the uncertainty – how far he goes in his retaliation efforts," he said.

Turkey has been a critical player in the fight against ISIS, and as a result has suffered from ISIS-led attacks, including a major bombing at its airport. It has also been at the center of the Syrian refugee problem, which has divided Europe. The European Union has been discussing a deal that would grant the Turkish government aid for the refugees in its country, in exchange for stopping the flow of migrants crossing into Greece.

Fitch, in commenting on Turkey's sovereign debt Monday, pointed to concerns about the government crackdown and said the coup underlines the poltical risks to its credit profile. Turkey's debt is rated BBB-.

"Whether this translates into sovereign ratings pressure will depend on the extent to which the government's reaction deepens political divisions and weakens institutional independence. This could undermine policy coherence and heighten the risks that external financing stresses materialize," Fitch said.

Marc Chandler, chief currency strategist at Brown Brothers Harriman, said Turkey is not so important to the world's economic channels, as it is politically. He said Turkey is not attractive to many of his clients, who have viewed it as too risky. While many were shocked that the military attempted a coup, Chandler said the Turkish military has had a tradition of taking a stand against elected governments and that it views itself as a defender of secularism.

"Turkey was not a favorite even before this, partly because of the terrorism, and partly because people don't like Erdogan, and the encroachment on journalism and the judiciary branch," he said. But he too said some investors may look past those problems.