How Multicultural Dreams Of A Liberal Islamist ‘Turkish Model’ Turned Into Nightmares

Posted: Jul 11, 2018 8:35 AM
How Multicultural Dreams Of A Liberal Islamist ‘Turkish Model’ Turned Into Nightmares

Turkish equity and currency have performed abysmally, arguably the worst in the world so far this year depending on which index you use. At least two indices have the nation's equity markets down by roughly 30% since the end of January (which I use as a starting point because the indices I help design and update rebalance at that time).

(Turkey in blue; emerging markets in orange. Article courtesy of TradingView.)

(Turkey in blue; global DOW in orange. Article courtesy of TradingView.)

The issue seems to be focused on political risk - this has been an election year and headlines from the global press have played up the possibility of the opposition finally making some headway. The election just occurred in June, and Erdogan prevailed in the Presidential election -- though by a narrow margin (final win was 52%) -- and it appears that although the ruling party retained control of the parliament, it does so with thinner margins than before. Given the strongman politics of a nation like Turkey, elections are risky things because strongmen do not reliably relinquish power in response to the electorate.

Now, in healthy nations, the mere act of holding an election is not a major market risk event. But some nations are brittle. I helped develop an index which assesses the brittleness of a nation's markets and economy in contrast with their resiliency. If a bad thing happens to a highly resilient nation, its markets tend to go down less, maybe 10% rather than 30%. And a resilient nation tends to bounce back faster.

What makes a nation resilient? A number of factors. For example, is there a lot of technical knowledge and capacity in the business sector? A country with power outages and limited computer infrastructure and knowledge can have trouble responding to adverse events. If the lights go out, or the one guy who knows how to run the network can't make it to work due to riots, systems just stop working.

Rule of law is important to resiliency. A country with weak rule of law is more liable to break the law because the law is not respected. Corruption is a constant headwind, but can make things much worse during risk spikes when people are forced to bribe their way through tough times.

A very important factor for a country like Turkey is its supply of foreign reserves. During the Asian contagion in the late ‘90s, countries which otherwise had good prospects for long-term growth basically ran out of money to pay their debts. The debts weren't that high, but they simply ran out of cash. Turkey's crisis seems to have a huge dollop of that kind of risk right now. Its currency, the Turkish Lira, has plummeted in value, which means it has to pay a lot more of those much-less-valuable-than-they-used-to-be Lira to keep current on foreign debt obligations.

As you can see below, Turkey is only above average in two categories of resiliency, and one of them is demographic strength which tends to be higher in non-developed countries in which other risk factors are lower.

The factors which tend to put the lights out in underdeveloped countries, good rule of law and monetary discipline (especially the foreign reserves that I talk about above), are extremely weak in Turkey -- about 0.2 on a scale of 0 to 1, nearly worst in class.

The international index that I helped develop and still work on, Vident International Equity Index (VEIQX), cut back on its allocation to Turkey at the end of January. In retrospect, that was a wise decision given the major sell-off which followed. But in due candor, I have to point out that we still had an overweight on Turkey compared with a cap-weighted approach. So, compared to what our portfolio would have been without cutting back on exposure to Turkey's market -- the move helped. But compared to a cap-weighted approach, our weighting to Turkey hurt.

There is a real tight rope in trying to minimize the possibility of catastrophic loss, for example losses of 30% or more on the one hand, and pursuing strong gains on the other. The fact is that nations which are more likely to give outsized losses are also more likely to give outsized gains. They are simply more volatile in their markets, more variable in returns. Turning the weighting down to a near zero level, which is what cap-weighting does, also means missing out on the possibility of very large gains as well. Including resiliency as a filter minimizes the big losses, but it also minimizes the big gains. On balance, a portfolio does better by including both resiliency and opportunity and balancing them against one another. In the long run, the historical evidence shows that this maximizes the probability of making a good absolute real return, even if it means living through some periods of draw-down.

For a deeper dive on which countries we're betting on (and against) and why, download the free country scorecard.