Turkish bonds sold off some 30bp on Friday after President Recep Erdogan’s crackdown on the country’s pro-Kurdish opposition escalated with the arrest of HDP leaders Selahattin Demirtas and Figen Yuksekdag. The lira weakened by nearly 2% on Friday and Turkish equities fell by more than 3%.
But this is nothing new. Despite the headline risk of escalating tensions with the EU, and Erdogan’s increasingly dictatorial leadership, investors have defended positions in Turkey by emphasising that the country’s economic outlook remains strong.
Politics, they said was one thing, but economics is another. And Turkey has a strong track record of willingness and ability to repay debt, as well as strong economic indicators and well capitalised, well managed banks. In addition, Turkey’s deputy prime minister, Mehmet Simsek - who is widely acknowledged as an “ally of the investment community” - remains in place. Political turbulence in Turkey is nothing new. But contracting growth and negative economic indicators are.
Figures published on Tuesday show that industrial production fell 3.1% year on year in September, which was far below the Bloomberg consensus forecast for growth of 2.5% year on year, and suggests that Turkish GDP contracted between Q2 and Q3, according to Capital Economics. In seasonally-adjusted terms, output declined by 3.8% over the month.
Market participants will be keenly watching for further indicators from Turkey’s current account balance, which will be published on November 11.
Turkish assets have underperformed the market over the last week. Though the lira has recovered some ground, it weakened to a high of 3.1860 to the dollar, from 3.15 on Monday. Turkey’s October 2026s opened on Tuesday at a Z-spread of 345bp from 340bp on Monday, and its 3045s opened on Tuesday at a Z-spread of 403bp from 387bp over the same time period. In mid-October, Turkey’s April 2026s were at a Z-spread of 306bp and were 330bp on Friday.
Investors have ridden out such sell-offs before, and more than once this year, and each time, spreads have stabilised and eventually tightened. After the attempted and failed coup on July 15, spreads widened out some 15bp-20bp, and then again when Moody’s slapped Turkey with a downgrade to Ba1 from BBB- in September.
By October, spreads had recovered enough to support the sovereign's $1.5bn tap of its 2026s, and three bank trades from Isbank, Turk Eximbank, Kuveyt Turk and Vakfibank shortly after. The sovereign even managed to print the tap at a spread that was tighter than before the Moody’s downgrade.
But it seems that politics are now translating into weaker economic growth and spreads are not expected to recover this year, meaning higher borrowing costs and very limited market access for Turkish names. How long is it before the market sees a Turkish default?
All three ratings agencies appear keen to stress that Turkeys’ strong institutions and commitment to reform temper any negative impacts of political tension.
Standard & Poor’s used this reasoning to justify its oddly timed decision — on the same day as the arrests —to boost Turkey’s long-term outlook to stable from negative.
S&P said that the “stable outlook reflects the balance between the resilience of the Turkish economy against lingering regional and domestic risks." It also noted that Turkey “continues to face large external vulnerabilities, especially if the Turkish lira depreciates sharply.”
But that report was published before the lira depreciated 2% against the dollar. And now investors are increasingly nervous. With year-end approaching, it is unlikely they will reintroduce additional Turkish risk to their portfolios. We may have to wait until the markets reopen in January to see how the investment community really feels about Turkey. A Clinton win tonight could prompt a rally, but that will not be credit specific.