Turkish Referendum Full Preview

This Sunday, Turkey will vote in a hotly contested referendum on the presidential
system, whose outcome could place sweeping new powers in the
hands of President Tayyip Erdogan and herald the most radical change to
the country’s political system in its modern history.

The package of 18 amendments would abolish the office of prime minister and give the president the authority to draft the budget, declare a state of emergency and issue decrees overseeing ministries without parliamentary approval.

Opinion polls have given a narrow lead for a “Yes” vote, which would replace Turkey’s parliamentary democracy with an all-powerful presidency and may see Erdogan in office until at least 2029.  The outcome will also shape Turkey’s strained relations with the European Union. The NATO member state has curbed the flow of migrants – mainly refugees from wars in Syria and Iraq – into the bloc but Erdogan says he may review the deal after the vote. Some 55 million people are eligible to vote at 167,140 polling stations across the nation, which open at 7.00 am (0400 GMT) in the east of the country and close at 5 pm (1400 GMT). Turkish voters abroad have already cast their ballots.

The referendum has bitterly divided a nation which has already seen extensive political fracture over the past year, including one “failed coup” attempt last summer. Erdogan and his supporters say the changes are needed to amend the current constitution, written by generals following a 1980 military coup, confront the security and political challenges Turkey faces, and avoid the fragile coalition governments of the past. Opponents say it is a step towards greater authoritarianism in a country where around 40,000 people have been arrested and 120,000 sacked or suspended from their jobs in a crackdown following last July’s failed coup, drawing criticism from Turkey’s Western allies and rights groups, and resulting in the worst diplomatic relations between Turkey and Europe in recent history. Relations between Turkey and Europe hit a low during the referendum campaign when EU countries, including Germany and the Netherlands, barred Turkish ministers from holding rallies in support of the changes. Erdogan called the moves “Nazi acts” and said Turkey could reconsider ties with the European Union after many years of seeking EU membership.

On the eve of the vote, Erdogan held four separate rallies in Istanbul, urging supporters to turn out in large numbers. “April 16 will be a turning point for Turkey’s political history… Every vote you cast tomorrow will be a cornerstone of our revival,” he told a crowd of flag-waving supporters. “There are only hours left now. Call all your friends, family members, acquaintances, and head to the polls,” he said.

Erdogan and the ruling AK Party, led by Prime Minister Binali Yildirim, have enjoyed a disproportionate share of media coverage in the buildup to the vote, overshadowing the secular main opposition Republican People’s Party (CHP) and pro-Kurdish People’s Democratic Party (HDP). Erdogan has sought to ridicule CHP leader Kemal Kilicdaroglu, playing videos of his gaffes during rallies, and has associated the “No” vote with support for terrorism.

Kilicdaroglu has accused Erdogan of seeking a “one-man regime”, and said the proposed changes would put the country in danger. “This is not about right or left… this is a national issue… We will make our choices with our children and future in mind,” he said during his final rally in the capital Ankara.

The government says Turkey, faced with conflict to the south in Syria and Iraq, and a security threat from Islamic State and Kurdish PKK militants, needs strong and clear leadership to combat terrorism.

While recent polls suggest a pick-up in momentum for “yes”, they remain close, and the large share of “undecided” voters is adding to the uncertainty. According to Wall Street banks like Barclays, a “yes” outcome will likely result in a broad-based, yet potentially short-lived, relief rally driven by a reduction in near-term political uncertainty. In the event of a less-expected “no” outcome, Barclays expect a negative market reaction and positioning for this looks most attractive via FX options.

Below is a full preview of the Turkish referendum, whose outcome should be known sometime on Sunday night, courtesy of Barclays.

Referendum countdown

Turkey is heading for a public referendum on the presidential system on 16 April, this Sunday. The recent polls suggest a pick-up in momentum in favor of “yes” (Figure 1) and this is also evident in the latest surveys of pollsters such as Metropoll and Gezici, which show “yes” at around 53% as opposed to earlier surveys of below 50%. The “yes” and “no” outcomes still appear to be close on average, however, and the associated margin of error (2-3% according to pollsters) along with the large share of “undecided” voters underscores the binary nature of the referendum outcome.

Achieving 50%+ support for the “yes” campaign (AKP-MHP) might look relatively straightforward at first sight, given a combined voter base of 61% (November 2015 election results) and the almost perfectly aligned rhetoric and policies of the parties. Recall that the transformation of the political landscape before and in the aftermath of the November 2015 elections led to a firm macro-level consolidation of Turkish politics along two lines: the “nationalist front” (mostly AKP and MHP voters) and the “social democrat front” (mostly CHP and HDP voters).

However, polls suggest a less comfortable race for the “yes” campaign: i) a large number of MHP voters seem to still be unconvinced by the “yes” campaign, and ii) the true color of the “undecided voters” is hard to decipher: pollsters say voters are increasingly refraining from revealing their preference due to the mood created by the extraordinary state of affairs, and “undecided” voters could be skewed towards “no”. Metropoll argued that more than 75% of undecided need to vote “no” for it to win; while historically, undecided voters have tended to either vote for the status quo or not participate in elections. The low polling response rate due various factors (such as peer pressure in the South East and the Black Sea regions according to some pollsters) is yet another complication that could potentially be distorting the poll results.

Nevertheless, momentum has picked up in favor of “yes” based on the most recent polls, and this has also been echoed by the political expert media commentary. Among the key catalysts, experts note the following.

  1. The effectiveness of President Erdogan’s campaign to push the “yes” votes of the AKP electorate higher (from the 80% level to the 90% level), as well as its impact on convincing more of the MHP electorate to vote “yes”.
  2. The tailwind provided by escalating tensions with the Netherlands and the EU, which is likely to help consolidate the nationalist vote.
  3. The positive impact of the improving economic sentiment recently on the “yes” campaign (Figures 2 and 3).
  4. The tactical missteps of the main opposition party CHP (i.e. comments by party officials) influencing undecided AKP voters in favor of “yes”.

Overall, it is hard to simplify the referendum to a probability exercise of an early election under yes/no outcomes, given that it is far more complex and the implications are unclear (both scenarios entail an early election possibility, in our view). While markets will likely perceive near-term political risks (i.e. an early election) to be lower in the scenario of a “yes” outcome, medium-term concerns about policy uncertainty and institutional strength are likely to remain; the Venice Commission opined that constitutional changes will remove checks and balances, leading to weaker institutions. The influence of presidential advisors on policymaking and the transformation to a “new economic model” would likely be solidified under a presidential system accompanied by an accommodative monetary policy bias, a potentially looser fiscal stance and an increase in quasi-fiscal spending focused on infrastructure projects via the sovereign wealth fund (SWF). We believe that, even in the event of a “yes” outcome, the likelihood of an early election in Q4 2017/Q1 2018 is still non-negligible as President Erdogan may choose to bring forward presidential elections (from August 2019).

* * *

Market implications for FX, local rates and sovereign credit

The market appears largely positioned for an outcome consistent with polls that suggest a “yes” result is most likely. In FX option markets, for example, the volatility-adjusted premium for USDTRY calls versus puts has recently dropped to multi-year lows and below-average kurtosis suggests little demand for negative tail-event protection (Figure 4). In bonds, TurkGB risk premia remain extremely low and currently offer less return than USTs on a hedged basis (Figure 5). Finally, in EM credit, Turkey YTD has outperformed the broader Bloomberg Barclays USD EM sovereign index, partially reversing the c.10% underperformance in 2016 (in total return terms).

YES: A “yes” outcome would likely result in a broad-based, yet potentially short-lived, relief rally

Despite the market’s anticipation of a “yes” outcome, we think the associated reduction in near-term political uncertainty would likely still deliver some relief rally, allowing a temporary reprieve for the TRY and a steeper curve in anticipation of a “gradual” unwinding of tight liquidity policy.

In FX, still-large TRY political risk premia and undervaluation suggest room for appreciation following a “yes” outcome. While our estimate of the lira’s political risk premia has reduced from 15pp at the end of January, it remains relatively large at 8pp (Figure 6). Furthermore, our short-term Financial Fair Value (FFV) model suggests a 4% undervalued TRY against the USD (Figure 7).

We believe risk-reward argues for being long TRYZAR targeting January highs of 3.90 with a stop-loss at 3.67 for a reward to risk ratio of 3:1 (spot reference: 3.73). We prefer this to short USDTRY as South Africa’s similarly low risk-adjusted real interest rate differentials and heightened political risk should provide a degree of protection in the event of a “no” outcome. The trade also remains positive carry.

In rates, very low bond risk premia suggest a rates rally following a “yes” is likely to be concentrated at the front end of the yield curve as market participants will likely price a gradual unwinding of the CBT’s liquidity tightening measures. As such, we reiterate our existing trade recommendation of paying the 1s5s TRY cross-currency swap spread targeting -30bp with a stop-loss of -100bp.

For Turkey sovereign credit, we maintain our Market Weight rating. This balances our concerns about a likely medium-term deterioration of Turkey’s credit metrics in a presidential system on the one hand with relatively attractive valuations and likely reduced near-term political uncertainty in a “yes” vote on the other hand. In the near term, we see potential for further spread compression of Turkey against South Africa, especially in the 5y sector of the curve (Turkey ‘22s vs SOAF ‘22s), with South Africa remaining vulnerable to adverse developments.

In the corporate credit space, we also have a Market Weight rating on Turkish banks and corporates. In the case of a “yes” vote, we would expect bank seniors to benefit more than corporates given the more significant spread pick-up relative to the sovereign. Higher beta seniors trading at a discount of over 100bp to the sovereign as well as new-style Tier 2s yielding over 7% are likely best positioned to benefit, in our opinion, although this could be met with more Tier 2 supply. We would expect the opposite reaction to a “no” vote, with IG-rated corporates and more expensive bank seniors as well as old-style Tier 2s to be less vulnerable in any sell-off.

NO: Positioning for a “no” outcome looks most compelling via FX options

The less-expected “no” outcome will likely result in larger market movements as a higher risk of an early election would increase risk premia in the local bond curve, weigh on the lira and increase FX implied volatility, in our view.

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