Turkey's Cooking: A Case of Intentional Overheating

Turkey is seen as one of the weakest links in emerging markets, with the Turkish Lira (TRY) falling substantially against the U.S. dollar, an impressive feat in itself given how the U.S. dollar has weakened substantially year-to-date as well. This post will review the foundation of how Turkey appears to be at risk of over-heating, and how this seems to be intentional at the hand of President Recep Tayyip Erdogan.

Source: Federal Reserve Bank of St. Louis

The Turkish Lira has followed up on a weak performance in 2017 with new record highs against the dollar in 2018, hitting 4.195 lira per US$ at its peak on April 11 of this year. The currency's decline has since taken a breather, and as of this posting it sits at roughly 4.06 lira per dollar, still down nearly 7.3% on the dollar year-to-date.

The rapid depreciation of the lira stems from growing anxieties over the state of Turkey, particularly with the increasing likelihood that the country's economy is being deliberately set to overheat.

Source: Federal Reserve Bank of St. Louis

Shown above is the consumer price index for Turkey, percent change from a year ago. After hitting nearly 13% in November 2017, the annual rate of inflation has slowed to "only" 10.2% in March 2018. At face value, one might be inclined to believe that inflation may finally be contained, and that the depreciating lira may not have as strong an effect as it's been made out to be.
However, the lower inflation rate looks to be a consequence of the base effect.

Source: Federal Reserve Bank of St. Louis

Indexed to October 1955, Turkey's CPI showed an acceleration around this time in 2017, as highlighted in the image above. Note, however, that the CPI seemed to then decelerate substantially for May through September 2017. In other words, what the base effect gives, the base effect may very well take away. The lira's depreciation that really kicked off in October 2016 (see top image) is already feeding through into the CPI, given the leg up in the index seen beginning around January 2017.

Continued depreciation of the lira since then, combined with the base effect reversing in 2018 Q2 and Q3, should result in upside surprises to Turkish inflation figures in the coming months, potentially intensifying the lira's depreciation and maybe even disrupting capital inflows to the country, though that may be more a consequence of global monetary policy tightening throughout the year, if it does happen.

Source: Federal Reserve Bank of St. Louis

This inflation surge has been accompanied by a surging economy, as Turkey's gross domestic product spiked to nearly 7.5% in 2017, about double the growth rate seen in 2016 and the highest print since 2013. The combination of surging economic output and inflation is what's leading to the fears of an overheating economy, fears that will only intensify if 2018 Q2 - Q3 inflation figures do accelerate again and/or the lira continues to depreciate.

Interestingly enough, the overheating economy has been not only welcomed but instigated by the administration of Turkey's President Recep Tayyip Erdogan. Erdogan has announced snap elections for June 24, well ahead of the expected dates of late 2019. It's believed the elections may be to capitalize on the current strength of the economy, rather than waiting until 2019 when the overheating may take its toll and hurt Erdogan's chances at re-election. Whether Erdogan allows the economy to return to a more normal state after elections (assuming he does win) remains to be seen, although the announcement of a $30+ billion investment project to create jobs and further boost the economy makes that possibility seem rather remote.

The economy will likely be left to overheat, particularly given the lowered credibility and independence of the Turkish central bank. Although the central bank raised its late-liquidity lending window lending rate by 75 basis points this week, President Erdogan has repeatedly called for interest rates to be lowered, holding the view that lower interest rates will lower inflation. Current economic theory states that lower interest rates increase the availability of credit and money, increasing spending and boosting inflation. The interest rate increase this week is a sign that the central bank is at least attempting to retain some independence and credibility in preventing the economy from truly going off the rails, but so long as President Erdogan continues attacking the central bank for not cutting interest rates and the fiscal policy side remains extremely stimulative, the central bank's policy will likely have only minimal effects.

The country of Turkey looks to be enticing a textbook case of an overheating economy, with high inflation poised to jump higher in coming months, a currency continuing to depreciate, and economic output still growing strongly. The country's heavy reliance on capital inflows makes it a candidate for an economic crisis (whether FX-based or current-account based), although for now this remains only a possibility, not a certainty. What is certain, though, is Turkey is heading down an unsustainable economic path, and if concerted efforts aren't made to guide the economy back towards a more stable level, things could end quite badly, for the country and perhaps emerging markets in a broader sense.

Andrew

Economic Synopsis - March 2018

Note: All indexes and indicators shown here are experimental in nature and are not to be used for decision-making purposes. As the saying goes, 'beware of geeks bearing formulas'.

Overall, economic activity was seen somewhat weaker in the first quarter of 2018 compared to the previous quarter, as had been expected. Economic activity is expected to become more robust once again moving into the second and third quarters of 2018, however.

Current Conditions Index

Note: The CCI depicts the magnitude of the current stage of the business cycle. In other words, the high positive values seen in 2013 are indicative of the presence of an expansion with little likelihood for a recession, while current lower values are indicative of a later-stage expansion.

The Current Conditions Index showed a downshift in economic strength in the first quarter of 2018 compared to the last quarter of 2017, with the March 2018 value coming in roughly one unit lower than that seen in December. This fits with the narrative of the U.S. being in the late stage of this current economic expansion, as monetary policy begins to meaningfully tighten and the above-potential growth seen for much of 2017 moderates some.

Weighted Economic Leading Indicator

The Weighted Economic Leading Indicator, which aims to depict economic conditions with a roughly six month lead time, anticipated the current slow-down back in the second half of 2017. Since then, the indicator has ramped back up again, now substantially higher than lows recorded last year. This signals the likelihood of a rebound in economic strength in the second and third quarters of 2018, likely extending into Q4 (as it appears right now). However, the current values remain substantially below those seen from 2010-2013, indicating that this expansion is indeed nearing its end. Thus, while a rebound in economic activity is expected in 2018 Q2 and Q3, the risk of contractionary conditions will increase if this rebound cannot sustain itself.

New Housing Activity Index

The New Housing Activity Index confirms what the industry appears to be reporting amidst the current housing shortage- that housing activity is merely moving along, and is not at a robust level. As such, a continuation of the housing supply shortage is expected for the remainder of 2013. The index could move lower still if mortgage rates continue to rise, potentially turning away buyers already afflicted by rising home prices. Through 2018 Q3, however, the housing market looks to be stable.

Excess in Stock Markets Indicator

After peaking at nearly 20.00 in early 2018, the stock market gyrations in February sent the Excess in Stock Markets Indicator back on the decline. Despite this, the metric remains elevated, and still not far from the 30.00 watermark, historically a level reached when "excess" in stock markets was significant (i.e. the 1987 stock market crash). Given the spread between the red and blue lines, as well as the still-elevated nature of the metric, stock markets still look to have areas of excess present. Further volatility throughout 2018 can be expected, particularly against a backdrop of tightening monetary policy by global central banks and a late-stage expansion in the U.S.

Derived Recession Probabilities

Lastly, the two gauges of recession probabilities I maintain continue to stay well below the 50% mark. The primary Derived Probability gauge held steady month-over-month at ~27%, while the experimental companion to that gauge (the gray line) fell further to a more-than-two year low of ~20%. This fits in with the indicators reviewed above, highlighting the expectation of continued benign economic conditions through 2018 Q2 and Q3, potentially Q4 as well. This could certainly change with the advent of a U.S./China trade war, aggressive tightening of global monetary policy, or a sustained slowdown in the European Union and/or China.

Andrew