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Turkey Navigates the Straits of a Crisis (Part II)

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In an earlier article, we discussed the strength and attractiveness of the Turkish economy. In part II of Worldview: Turkey, we will look at the currency, fixed income, and equity markets. In brief, Turkey has many attractive emerging market characteristics, but its risk-adjusted performance as an equity investment, while positive, has not been as outstanding as its economic performance would suggest it could be.

There are two ways of interpreting this discrepancy. One is that investors in Turkey are overly skittish and that Turkey will start to outperform markedly as investors become more familiar, knowledgeable, and comfortable with the country. This line essentially amounts to arguing that Turkey is undervalued because it is perceived as riskier than it really is. The other is that investor skittishness is justified by risks that are not picked up by simple examination and extrapolation of economic trends.




As mentioned in the previous article, Turkey has had chronic difficulties with inflation, which has only recently come under control. In 1980, $1 USD bought approximately 90 (old) Turkish lira (TRL). By 2001 the lira had devalued so far that more than 1.65 million were required to purchase $1 USD. Turkey introduced the New Turkish Lira (TRY) in 2005, which, at a value of 1 TRY = 1,000,000 TRL, simply dropped six zeros off of the previous lira. The two currencies briefly circulated together while the old lira notes were gradually removed from circulation, and the “new” prefix from the new lira was dropped in 2009; the international currency code for the Turkish Lira, however, remains TRY.

Figure 3: Currency Chart

Value of (New) Turkish Lira in USD and EUR
Source: Bloomberg (accessed June 22, 2010).

Rapid depreciation of the old lira had largely ended by 2001, about four years before the new lira. Figure 4 shows the value of the lira in dollars (blue) and euros (red) from July 2001 to June 2010, with old lira exchange rates restated in terms of their new lira equivalents. The figure shows that over this period, Turkey’s lira has tended to weaken at a pace of roughly 2.4% annually versus the US dollar and about 6.3% versus the euro (both with approximately 20% annualized volatility). These effects are largely attributable to Turkey’s improved-but-still-moderately-high inflation differential and to the strengthening of the euro over much of the period.

Foreign investors in Turkey need to remember that they are swimming against the trend of a declining currency, which will diminish the value of Turkey’s otherwise impressive local market returns when repatriated. Although Turkey has largely put its economic house in order, inflation is still elevated relative to core developed countries, and will likely continue for the foreseeable future. Despite the weakening trend, however, the currency is substantially more stable and predictable when compared to previous decades.




Turkey’s inflation history has made it problematic for the government to issue long-term debt, but this situation has improved markedly in recent years. Figure 4 shows OECD data on long-term government bond rates for the 2000–2010 period. As inflation has come under control, local-currency lending rates have dropped markedly and demand for sovereign notes has surged.

Figure 4: Turkish Long-Term Government Debt (OECD)
Long-Term Interest Rate on Turkish Government Bonds (OECD)
Source: Bloomberg (accessed June 27, 2010).

In December 2009, Fitch Ratings upgraded Turkey’s sovereign debt from BB- to BB+, just two notches below investment grade. Moody’s followed suit in January 2010 (to Ba2) and S&P in February (to BB). Despite rating agencies’ ranking of Turkey as still speculative-grade, Bloomberg reports (Bloomberg: June 24, 2010) that Turkey’s sovereign credit default swaps are trading at spreads characteristic of investment grade bonds. The article reports that five-year insurance for Turkish sovereigns runs at approximately 190 bps over US Treasurys. This is comparable to Russia, which is rated investment grade (BBB) and lower (i.e., better) than Spain, which is rated AA and has spreads of 266 bps.




The Istanbul Stock Exchange (ISE) was chartered in its modern form in 1985 and today has a daily volume of roughly $1 billion spread over more than 300 companies. Figure 5, below, shows the weekly total return performance of the MSCI Turkey total return index from January 1, 1999, to June 18, 2010, measured in USD.

Figure 5: Stock Index Performance Chart
MSCI Total REturn Indexes (Gross in USD)
Source: Bloomberg (accessed June 22, 2010).

The figure is indexed to a value of 100 on 4 January 2004, which is the first January week’s-end data point in which the BRIC index is available. It shows that Turkey’s stock market has performed in line with many other emerging markets, and has also recovered well from the worldwide crash of 2008–9. There have been several large drawdowns over this time frame, however: 2000, 2006, 2008, and 2009. Clearly Turkey is not a low-risk country from an investment standpoint.

Barclays’ Turkey iShares ETF (TUR) is designed to track the MSCIs Turkey Total Return index. Examining the underlying basket shows that the index is heavily weighted to financials (52.2%), with the next largest segments being Industrials (11.5%) and Telecommunications (10.2%). Together these three sectors account for over 75% of the index. The strong presence of banking may explain the very high beta we observe later.

Figure 6: Risk-Return Chart Risk Return Chart for MSCI TR Indexes (USD) Source: Bloomberg (accessed June 22, 2010). Dates: November 14, 2003–June 18, 2010.

Figure 6 shows Turkey’s position on a risk-return chart along with a sample of comparable MSCI total return indexes. These are based on weekly returns data from 2003-2010 and constitute approximately one business cycle. The chart shows that Turkish equities have delivered high rates of return over the period (20.6% annually), but are also highly volatile (56.4% annualized standard deviation).

The chart indicates that Turkish equities are indeed attractive investments, but only for investors who are prepared to stomach the high volatility. Investors overly focused on the high returns and attractive economic growth story may find themselves shaken out and unable to hold on during volatile times.

Table 2 offers a quantitative returns analysis comparing Turkey’s total return performance versus competitors (Poland) and other broad MSCI Indexes relevant to an emerging markets analysis. The returns were based on an index model using the MSCI All-Capitalization World Index as a benchmark and uses weekly returns from 14 November 2003 to 18 June 2010. The start date reflected the availability of total return levels for the BRIC index.

Table 2: Quantitative Returns Analysis Using ACWI Index model

The table’s top section shows that the BRIC index and the broad MSCI emerging market index had the highest Sharpe ratios (assuming an average risk-free rate of 2%) over the period by a substantial margin. Turkey’s Sharpe ratio ranked third in the list at 0.374, and it has outperformed its region, frontier markets, the US, and the ACWI, but has been less spectacular when compared to other emerging market indexes.

Using the MSCI ACWI index as a benchmark (center section of Table 2), we find that Turkey is still the most volatile index in the group. It has the highest beta to the ACWI, indicating substantial degrees of systematic risk, but there is also a large amount of residual country-specific risk. With a correlation of approximately +0.7 to ACWI returns, Turkey is less correlated to the world index than other indexes, with the exception of frontier markets, which is substantially less correlated than anything else. Turkey thus offers some, but not enormous diversification advantages compared to other emerging markets.

Turkey does offer a large Jensen Alpha (11.5%), which makes it attractive, but, because the country-specific risk is so large (32.1%), accessing it is less appealing than it would at first appear. From a portfolio construction perspective, many investors might prefer to use the MSCI BRIC or MSCI EM index, which are able to achieve similar levels of alpha with less idiosyncratic risk.

If we regress Turkey’s returns versus other emerging market benchmarks (bottom section of Table 2), we again find that Turkey does not add value to a diversified EM or BRIC portfolio—the alpha to the BRIC benchmarks is even negative—but it does appear to improve a cap-weighted world portfolio, a US-only portfolio, and even a frontier markets portfolio (although Turkey is really rather advanced to be considered a “frontier market”).

The Turkish economy has an excellent growth story surrounding it, and its public and private achievements in the areas of economic development, banking regulation, and the control of inflation are worthy of admiration. There is every reason to believe that Turkey’s fundamental performance will continue to impress, even in a troubled world.

As good as the growth story is, however, the volatility of its equities market would seem to require even higher rates of return to justify substantial exposure, and attractive-sounding local market returns need to be tempered by the knowledge that the currency is still on course for gradual weakening. In the fixed income space, arriving at the doorstep of investment grade is a bright spot for the country, and may be the way for investors to buy in to the improved fundamentals with less volatility.

Nonetheless, there is no reason to assume that the large volatility will continue forever. It is certainly possible that as investors become more familiar with Turkey country-specific volatility will decline, in which case Turkey may prove to be as appealing a place for one’s investment as it is for one’s holiday.




Sezer, Seda, and Michael Patterson. “Turkey trading like investment grade as default swaps top emerging Europe.” Bloomberg (June 24, 2010).

Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Global Research and Consulting, an independent consulting firm specializing in macro strategy, including quantitative, emerging market, and SRI research.

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Dear Mitch. Thank you for your detailed and thoughtful review.

You write: "Turkey is undervalued because it is perceived as riskier than it really is." May be market discounts the factors that you dismiss as inessential? Among these are terrible relationships with all countries in its immediate vicinity, except, surprisingly, its historical foe, Russia. Not all of these conflicts are of Turkey's own making as it is seen from a current rout with Netanyahu Cabinet in Israel, but bad international relations are not healthy for the Turkish economic and trade relations. Second, current situation is characterized by a conflict between largely secularist military and the Islamist political establishment. Third, the current Islamic political elite is rather moderate in its views. However, the sole factor of its reliance on the electoral support by the most backward strata in Turkish society does not preclude its evolution into more fundamentalist stance, if only to placate its voters.

Peter Lerner, PhD is semi-retired and teaches one business course on Manhattan. He has also contributed to the recent book:
"Emerging markets: performance, analysis and innovation," Taylor & Francis, 2009.

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