Turkish President Recep Tayyip Erdogan gave investors a taste of just how quickly local politics can undo their investment strategies.
In three days this week, the lira wiped out almost all of the gains achieved in the past two months as markets reacted to a deepening rift between Erdogan and Prime Minister Ahmet Davutoglu that’s set to end with the premier leaving his job later this month. Government bonds plunged and the nation’s main stock index has suffered the worst losses worldwide.
The latest political convulsions have reignited concern that Turkey’s democratic institutions lack the power to resist Erdogan’s bid to expand his powers, which subsided after elections last year gave the AK Party from which he hailed a smaller majority than he would need to change the constitution. Burak Demircioglu at Istanbul-based Burgan Yatirim Menkul Degerler said further political upsets threaten to set off “very harsh” market reaction.
“I think spasms like that will become more frequent,” Luis Costa, Citigroup Inc.’s London-based chief strategist for eastern Europe, the Middle East and Africa, said in comments before the conclusion of a meeting between the two leaders late on Wednesday. “It is going to be a hot summer in Turkey.”
Costa said if the lira drops toward 3 per dollar, this may trigger a selloff in shorter-dated Turkish debt, though he retains a position in two-year bonds. The currency slid 3.3 percent to 2.9469 per dollar by 10:22 p.m. in Istanbul, extending losses after a person familiar with the matter said the AK Party will hold a leadership contest within 15 days, and the premier won’t be a candidate.
The political row revolves around efforts by Erdogan, who previously served as prime minister for more than a decade until 2014, to transform the once largely ceremonial post of national president to a position with real executive clout. Davutoglu has been caught in increasingly frequent clashes with Erdogan to assert his authority, and last week was stripped by the AK Party of the power to name local branch heads.
“It’s a very tenuous situation under Erdogan, given his much more authoritarian style,” said Sacha Tihanyi, a senior emerging-market strategist at TD Securities in New York. Market volatility on Wednesday “shows just how vulnerable positioning is,” he said.
Rising domestic tensions are exerting pressure on Turkish markets just as bearishness toward developing nations mounts as investors brace for tighter U.S. monetary policy. Two Federal Reserve policy makers this week raised the possibility of an interest-rate hike at their meeting next month.
Wagers that the Fed would delay tightening were among the key drivers of a rally that sent the lira to an eight-month high and Turkish bond yields to an 11-month low last month. Rising U.S. borrowing costs imply better returns on dollar-denominated assets and temper the appeal of riskier developing nations.
While markets will open weaker on Thursday, “longer term, the consolidation of power could mean that things that needed to be done in Turkey and were not done before because of the power struggle will actually be done,” said Tim Ghriskey, who helps oversee $1.5 billion as managing director and chief investment officer at Solaris Asset Management. “I don’t expect a longer-term selloff.”
Even after the rout this week, Turkish local-currency bonds have handed investors returns of 11 percent in 2016 through Tuesday, more than double the average for a Bloomberg benchmark of emerging-market government bonds.
Turkey is particularly susceptible to swings in investor appetite because its current-account deficit, which economists project will widen to 4.5 percent of economic output this year, makes it reliant on capital inflows. The country was able to narrow the gap in the past two years as plunging oil prices reduced its import bill, although crude has recovered about 60 percent since touching a 12-year low in January.
The political strife is undermining confidence in Turkey’s $720 billion economy at a time when investors are also concerned by an escalating conflict with Kurdish rebels and attacks by Islamic State militants. This week’s selloff in Turkish bonds was the steepest among developing nations, with yields on 10-year securities rising 39 basis points to 9.63 percent.
“Real risks to stability” such as growing dissent within the ruling party or the prime minister stepping down may prompt a reaction that’s “a lot harsher than what we’ve seen so far,” according to Burgan Yatirim’s Demircioglu. “Up until now, the stability was seen as a given.”