Amid a rapidly weakening currency and high inflation so far in 2018, all eyes were on the central bank of Turkey at its September meeting. And the central bank delivered with a rate hike of 6.25%, above the market consensus.
In our view this move not only makes the valuation case for the Turkish lira even more compelling (with interest rates now at 24%), but also instills faith that the central bank is willing and able to act appropriately on policy despite President Recep Tayyip Erdogan's desire to do otherwise.
We view the Turkish lira as deeply undervalued on a fundamental basis, a magnitude of undervaluation that is very compelling in isolation and that is also supported by significant forward carry (high interest rates compared with other currencies).
Lira Headwind: Erdogan
The primary headwind for the lira, if it were to be reduced to its most important element, has been the unusual reluctance of President Erdogan to sanction high interest rates to combat high inflation (most recently 18%).
To many, Erdogan appears highly in control of both the finance ministry and the central bank following his accumulation of executive powers in recent years.
As highlighted in a previous post, in late May, Turkey's central bank—despite Erdogan's declared reluctance—responded to earlier inflation reports by raising official interest rates by 5% in two closely aligned moves.
We had concluded at that time that the “game of chicken” had been conceded, and that orthodox inflation-combating policy was in evidence. This decision was negated in August as Erdogan returned to engage in a second game of chicken, with higher stakes than the first.
Lack of action by the central bank through August, despite a rapidly falling lira, produced a self-feeding currency crisis from which Turkey's leader did not readily back down. As a result, the lira undervaluation had become very large indeed. We concluded that the deeper undervaluation could compensate even for the sizable short-term negative influences.
Turkey's central bank increase of 6.25% last week is the biggest increase since Erdogan came to power in 2003.
This move, in the face of ongoing opposition from Erdogan himself, restores our relative conviction that monetary policy will be used sufficiently to attack inflation going forward, even as the president apparently wishes to distance himself from the stance.
It is a return to policy orthodoxy, about which severe doubts have been the most damaging influence on the lira during recent weeks.
The magnitude of the lira move in this short space of time is rare, but not unprecedented. We have seen, and responded to, similar fundamental value dislocations in the past in currencies such as the Indian rupee, Russian ruble, and Swiss franc.
These types of moves can initially create lumpy performance for investors on their way to becoming extremely attractive opportunities. Importantly, opportunities of this magnitude have the potential to be rewarded over time.
Although the “problem” with the lira has been a monetary stance judged inadequately tight by the market, the lira's positive carry, as mentioned above, is very high. Holding lira carry has not been sufficient to offset its depreciation in 2018, but could provide a substantial benefit going forward even if the lira does not fully re-appreciate.
Extreme Misvaluations Provide Opportunity
These types of opportunities—extreme misvaluations that are uncorrelated to the rest of the market—are exactly the opportunities that we seek to take advantage of in our portfolios and not just in small measure.
What is important about navigating these types of opportunities is to appropriately calibrate the exposure so that decision symmetry—the ability to increase, hold, or reduce the position—is available at any point. This has been and remains true today.
We are optimistic about the opportunity in front of us, and will continue to monitor developments as they arise.
Tom Clarke
Portfolio Manager
William Blair Investment Management
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