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Hermes: Turkey’s election: a case for cautious optimism?

Turkish parliamentary and presidential elections will take place this Sunday amid a febrile political and economic climate. In recent months, the country has been grappling with double-digit inflation, a pressured lira and fears over the independence of its central bank. As voters prepare to go to the polls, Andrey Kuznetsov, Portfolio Manager at Hermes Investment Management, assesses the investment landscape in Turkey.

 Turkey is no stranger to political instability. On Sunday, Turks will go to the polls for the sixth time in four years, and for the second time under emergency law after President Recep Tayyip Erdogan brought forward the election by 18 months[1]. The move, Erdogan said, reflects the country’s need to “overcome uncertainty”[2], but critics argue he wants to push through the vote before the country’s economic woes get materially worse.

While Erogan looks like he will win the presidential race, the parliamentary election, looks too close to call. There is a risk that Erdogan’s ruling AK Party and the nationalist MHP party will not retain a parliamentary majority after Sunday’s vote.

Economic concerns worry voters

Voters have already been spooked by the country’s flailing economy: the lira has depreciated by about 25% against the US dollar so far this year, hurt by domestic politics and global monetary policy. A series of tirades by Erdogan against high interest rates have sparked concerns about central bank independence and inflation is stuck in double-digit territory.

First-quarter economic growth was strong at 7.4%. However, it is widely expected that the Turkish economy will have slowed sharply in the second quarter due to recent lira weakness and a trio of interest-rate hikes totalling 500 basis points (bps) since April.

Opportunities

At present, there is a significant premium priced in to Turkish sovereign bonds. For example, the 6% Turkish sovereign bond maturing in 2027 is trading 450bps over US Treasuries, and it has widened by about 200bps so far this year. This has created opportunities for investors to gain exposure to companies with robust levers that can withstand the current macro environment, such as exporters and well-capitalised, domestically focused businesses. One such example is current holding Turk Telekom.

 Figure 1: The spread of Turkish sovereign bonds over US Treasuries has widened this year

Source: Bloomberg as at 20 June 2018
Source: Bloomberg as at 20 June 2018

Turk Telekom: emitting good signals?

The incumbent integrated telecommunications giant Turk Telekom provides local, national, international and mobile telecommunication services, internet products and services.

In the first quarter, Turk Telekom reported strong earnings, with revenue aligned with inflation. It also generated decent subscriber growth during this period. Consolidated revenues increased 8.8% year-on-year to 4.7bn lira, while EBITDA grew by 29% year-on-year to 2bn lira[3].

Despite a strong start to the year, the recent lira weakness will have an impact on the company’s credit profile. Nevertheless, there are several mitigating factors. Turk Telekom’s ability to partly pass on inflation to consumers should help ease the adverse impact of the sharp lira depreciation on its group revenue and margin. Moreover, its large share of hard currency debt will have a smaller impact than in the past as the company has been steadily increasing its hedging of this exposure.

Balancing stakeholder interests

The most notable mitigating factor, however, was Turk Telekom’s decision not to pay a dividend during 2018[4]. The impact of the ongoing depreciation of the lira against the US dollar and the euro led to an increase in the group’s interest-bearing liabilities. Based on our conversations with the company, this prudent decision serves to highlight the company’s desire to delever its balance sheet – and thereby, de-risk the business – during a period of heightened uncertainty. Furthermore, the board’s sensible focus on managing financial risk during this period of volatility reflects its aim to balance the interests of all stakeholders, and is good corporate governance, in our view.

Turkey: a good call?

The uncertainty of any major presidential and parliamentary election is always likely to pose some risk. However, despite a fragmented political landscape and economic concerns, there are good investment opportunities in Turkey – and we believe Turk Telekom is one credit issuer that has positioned itself well in the current market environment.