It may sound strange to think of investing in two countries that are run by regimes that are not particularly business friendly, that are involved in military action on the hottest conflict theatre of the world today, that just went through a major currency crisis and that have been put under sanctions by the USA…
However, managing money is first and foremost about identifying investment opportunities, analyzing the risks and the potential rewards and determining the appropriate timing of the investments.
Crisis, be they political, military or economical also provide the best investment opportunities as fear takes over from the usual greed and valuations are pushed to extremes.
As always, our analytical framework is based on macro-economics, liquidity, valuation and technical analysis and is performed on totally factual and objective considerations beyond any political views or affinities,
We come to the conclusion that time may have come to DIP A TOE in the equity markets of the 12th and 15th largest economies of the world.
Russia and Turkey have great similarities even if the former declined from being one of the largest economies of the world 30 years ago to the 12th with a GDP of US$ 1.5 Trillion, just after Canada and before South Korea while the latter rose from the bottom of the economic ladder in the 1970s to becoming a member of the G20, just ahead of The Netherlands with a GDP of 851 US $ Bln.
Both countries are highly populated with respectively 147 and 80 Million citizens and both have large consumer markets and a strong industrial base.
Both are run by “democratically” elected leaders that have constantly reinforced their powers at the expense of freedom and democracy, and both are extremely active geo-politically on the Middle Eastern and Syrian scenes.
Both countries have a “rule of Law” culture and highly educated middle classes, but both have also drifted towards a more radical religious bias even if one is Christian and the other Muslim.
Both countries have strong national and singular identities, being at the cross-roads off the West and the East, very close to Europe without being part of it and close to Asia and the Middle East without truly being or wanting to be part of them.
As a result, historically, Russia has always been “against” the West while Turkey slowly but surely evolved from being an intrinsic part of the “Western Bloc” during the Cold War to becoming a stand alone nation with close ties and interests with Russia despite still being a member of NATO.
Finally, the two economies are highly dependent on the outside world. Russia is the world’s richest country in terms of resources and commodities and its economy is highly relient on Oil revenues which account for 42 % of the country’s GDP while Turkey’s economy is highly dependent on industrial exports and Tourism.
As such, their economies are highly geared towards the outside world. Trade balances, current account surpluses or deficits and foreign financing are key elements of their economic stability.
Which explains why they both suffered the same economic fate in the past few months as global liquidity started tightening and politically-driven US sanctions came into play.
In both cases, the events of the past two months sent their currencies tumbling and interest rates sky-rocketing, both short term and long term, another stock markets took a beating.
In both cases, the events of the past two months will have lasting consequences and most probably a sharp recession next year, as higher interest rates and devalued currencies force numerous businesses into bankruptcy.
However, history shows that recessions are actually periods of time where stock markets do rally as interest rates come down and liquidity flows the markets.
Moreover, high inflation and worries about currency fluctuations does push domestic savings into local stocks usually pushing valuations higher.
A quick look at the charts below sums up the current situation.
The sanctions ordered by Donald Trump against Russia in July 2018 following the Skripal affair sent the Russian currency 12 % lower until the Central bank decisively raised interest rates.
The chart below shows that the Russian Ruble has now found a solid floor 20 % lower than it was trading a in January 2018.
The interesting part is that Russia did not have to raise rates too much to stem the panic and that even if a cheaper currency has inflationary repercussions on the economy at large, it is actually a boon for an economy that derives 42 % of its resources form Oil and Gas sold in US dollar, giving substantial ammunition to the Government to implement supply-side growth policies.
Clearly, Russian inflation picked up sharply in August 2018, rising to 3.1 % form 2.5 % the month before, mainly due to higher food costs – Russia imports most of its wheat -, but inflation still remains extremely low when compared to history and with interest rates at 7.5 %, real rates are actually substantially positive.
Indeed, the impact of the devaluation on GDP growth will be negative in the short term, but will actually be beneficial for the country’s growth longer term as Russia exports most of its mineral resources in hard currency.
Strong Oil prices have been a boon for the world’s second largest producer and exporter of oil while lower commodity prices have had a marginally negative impact on its economy overall.
Russia has been actively managing oil supplies with its counterparts of OPEC since the December 2016 agreement, and until now, the trend in oil prices is still positive.
Russia benefits from a historically low unemployment rate, and its export-oriented industries should benefit from the recent devaluation more than anything, and wages are growing at 8 %, a much higher rate of growth than inflation, meaning that the Russian population at large is enjoying growth in their disposable income.
Finally, Russia enjoys a structural Trade surplus due to its large export industry, and that trade surplus should accelerate after an initial dip due to the currency devaluation.
Russia’s foreign debt decreased to 485.50 USD Billion in the second quarter of 2018 from 524.90 USD Billion in the first quarter of 2018, representing 33 % of Russia’s total debt.
Even more significant is the fact that Russia’s Debt to GDP ratio is actually THE LOWEST OF THE ENTIRE UNIVERSE of the 50 largest economies of the world at 12.6%.
In fact, in terms of public finances and external debt position, Russia is in an extremely healthy position that gives it the ammunitions to insulate itself form external shocks.
All this to say that the macro-economic picture and financial position of the Russian economy is solid and the recent events have more to do with politics than worrying fundamentals.
And indeed the Russian stock market barely budged.
In fact, what is most attractive is that RUSSIA is today the CHEAPEST STOCK MARKET of the entire universe, not only when looked a on a short term basis, but also when valuing them on a cyclically-adjusted basis.
Russia’s MICEX index of the 10 largest Russian companies trades on an extremely low 5.86 x earnings and a dividend yield of 5.39 %.
Very rarely in its history, has the Russian stock market traded that cheaply.
Even more interesting is the fact that when earnings are cyclically adjusted over a 10 year period, Russian stocks stand out as being the Cheapest in the entire universe with a CAPE ratio at 6.4 x, a discount of 10 % to book value and a discount to sales of 20 %
In fact, the recent devaluation of the Russian Ruble provides in our view a great opportunity to dip a toe in the cheapest equity market of the world, knowing that the currency will probably remain stable or even appreciate further.
Turkey’s situation is definitely less favorable and the Turkish financial markets were much more severely affected by the sanctions imposed by the USA on two Turkish ministers to get the release of an American Pastor arrested in June for espionnage.
Turkey’s economy hinges primarily on industrial exports and its main markets are in Europe and the Middle East.
As a result, job creation in Turkey is a direct function of investments and high rates of economic growth hinge on the ability of Turkish manufacturers to access cheap financing.
As is always the case, the proximity of Europe and its abnormally low interest rates and the fact that the Euro Zone is its main export market enticed Turkish corporations to borrow massively in EURO INSTEAD OF TURKISH LIRA so as to save the wide interest rate differential.
and indeed, and contrary to Russia, Turkey’s external debt stock stood at $466.67 billion, more than half of its gross domestic product (GDP) – 52.9 percent – at the end of March 2018, the private sector’s share in the country’s external debt stock was 69.7 percent.
With a negative trade balance, a current account deficit and a large stock of external debt, turkey’s position was extremely fragile already.
The simple announcement of limited sanctions was the trigger that caused a major economic collapse.
When sanctions hit Turkey, within a secular declining currency trend, corporations and individuals rushed to buy EUROs and Dollars and sell Turkish Lira to cover their foreign currency liabilities, sending the currency crashing from 3.98 to 7 at the peak, a 75 % devaluation in less than two months.
The courageous decision of the Governor of Turkey’s Central bank to raise rates massively, despite the ire of Recep Tayib Erdogan allowed the currency to stabilize and a significant bottom is probably in place.
Interest rates shot up from 6 % in May 2018 to 24 % currently, obviously taking a major toll on corporations and individuals alike.
Likewise, long term rates rose from 12 % in April 2018 to 17.9 % today, after a peak above 20 % at the time of the crisis.
As would be expected, Inflation shot up from 6.5 % in June 2016 to 17.9 % today, cutting massively into the Turkish people’s purchasing power.
As can be seen from the above, the Turkish crisis has been much more drastic than the Russian one and it has been so because the financial and economic position of Turkey was already weak and deteriorating.
It is yet too early to see the impact of the July events on the economic numbers of Turkey yet, but it is extremely likely that Turkey will go through a sharp economic contraction next year that some economist see as high as 20 %.
We doubt that the effect will be that large, as the sharp devaluation of the Turkish currency makes Turkish exports that much ore competitive, but the combined effects of high inflation and interest rates on consumption and the sizable amount fo bankruptcies that will take place will take a serious toll o. the Turkish economy in the short term
Unemployment rate is bound to shoot up in the coming months
The traded deficit is set to explode dur to the higher cost of imported goods and the current account deficit set to increase sharply as well.
Clearly, Turkey’s short term outlook is bleak and the only way out of its major 2018 shock is to raise rates sufficiently high to bring stability back, quash inflation and attract foreign capital again.
This may not be palatable to Recep Erdogan, but the social and political backlash of a major economic crisis are probably even worse in a country where the population is already deeply unhappy with the waves of arrests and sharp decrease in personal freedoms and the invasion of Syrian refugees.
We may be speculating here, but we doubt that Erdogan is in a political position to really cut the wings of te Central Bank and prevent it form doing its job.
On the positive side, the sharp devaluation of the Turkish Lira is a boon for its export industries and for Incoming tourism, the two major engines of growth of Turkey’s economy.
18 % of Turkey’s GDP comes from exports and 80 % of the vehicles produced in Turkey are sold outside of Turkey. The sharp depreciation of the Turkish cost of labor will certainly trigger investments in manufacturing capacity as well.
Tourism accounts for 10 % of Turkey’s GDP and tourism revenues were already growing at 20%+ in the first half of the year.
The recent devaluation will most probably make Turkey an extremely attractive tourist destination and bring in significant additional hard currency.
In other words, things will be tough in Turkey for the months to come, but we believes that the worst has passed in terms of the financial crisis.
The currency has made a significant bottom, higher interest rates will start attracting foreign capital again, the ensuing recession will ultimately reduce inflation once the base effect is passed, and monetary policy will become accommodative again.
Moreover, at times of inflation of even hyper-inflation, the stock market is the best refuge for savings, as testified by the stellar performance of Argentinian stocks in the past three years.
Turkish industrial concerns are extremely solid and well-managed enterprises and even if the country and the banking system may need help from the IMF at some point, we see them surviving to the current crisis.
The Turkish Titans 20 Index has found a bottom after having lost 30 % of its value and the long term chart is delivering a STRONG BUY signal.
Turkish equities are amongst the cheapest in the world with a P/E ratio of 6.35 x and a dividend yield of 4.90 %. while the 10 yer CAPE ratio is also amongst the most attractive at 8.7x. ( see table above in the Russia section)
All being said and told, it seems to us that The recent crisis and currency devaluations of Turkey and Russia offer an attractive entry point in these cheap equity markets for the long term.
The main short term risks are that both Turkey and Russia could be involved in a generalized conflict in Syria and the Middle East, a situation that could certainly cause volatility.
However, we do not see such a conflict causing any major or lasting damage to either countries’ infrastructure or economy, while an end of the Syrian conflict, either peacefully or militarily would position the two countries corporations as major beneficiaries of a global reconstruction plan for Syria.