Ignore politics at your own peril

One of the occupational hazards of being a professional economist is that our forecasts are sometimes wrong. Real world situations are usually very complex, non-linear and therefore difficult to predict. In order to simplify complicated real world problems, we make assumptions.

Obviously, a change in the underlying assumptions can send a whole forecast in an opposite direction. This makes it easy to understand John Maynard Keynes, a great British economist, who is reported to have said “When the facts change, I change my mind.”

In early February this year, I presented Merrill Lynch’s 2007 Year Ahead Report to local investors in İstanbul. The presentation, which included an overview of key global economic trends and investments themes, was also focused on Turkey’s political outlook because both presidential and parliamentary elections were scheduled for this year. With the usual caveats about the difficulties of making point forecasts, I painted a reasonably constructive scenario for both the global economy -- strong growth and plenty of liquidity -- and domestic Turkish politics -- plenty of noise, but a benign outcome in both the presidential and parliamentary elections. Noting that the ruling party had a significant majority in the parliament, I argued that presidential elections would be smooth. I’ve also noted that opinion polls were suggesting that the governing Justice and Development Party (AK Party) would most likely win a second term either as a single-party government or be the lead coalition member. Our base case scenario for Turkish politics was implicitly based on a working assumption that Turkey, as an EU accession candidate, had implemented political reforms, enhancing its democracy.

Global backdrop has so far remained supportive of emerging markets in general and Turkey in particular. Despite the economic slowdown in the US, global growth is still strong and liquidity is ample. However, I got it wrong on domestic politics. Turkey’s presidential elections were far from being smooth. Why?

Well, I simply failed to anticipate the extent of the opposition by Turkey’s secular and military establishment. Despite the compromise, the opposition parties have boycotted the presidential election, and appealed to the Constitutional Court for cancellation of the parliamentary ballot on the grounds that there was no two-third quorum. Only hours after the main opposition Republican People’s Party appealed to the Constitutional Court, the army stepped in with its own statement threatening the government with an intervention. The court ruled in favor of the opposition last week, effectively preventing the ruling AK Party from choosing Mr. Gül as the president. This was a highly controversial ruling because the Turkish constitution doesn’t have an explicit provision for a two-third quorum. In addition, such a quorum was not sought in the previous presidential elections. The latest news is that Gül has withdrawn his candidacy.

While the political turmoil has unsettled investors, the market reaction has been relatively modest. Turkish equities fell 7.3 percent in dollar terms, YTL weakened 1.1 percent, while the sovereign debt spreads widened by 10 base points. Despite last week’s losses, Turkey is one of the best performing emerging markets year-to-date. The stock market is up 20.4 percent, YTL is nearly 5 percent stronger against the dollar, and the Turkish external debt has generated year-to-date total return of 3.4 percent, slightly outperforming ML IGOV index. The market’s unemotional response to political crisis doesn’t seem to be unique to Turkey. Other emerging markets such as Israel, Ukraine, and Thailand have recently weathered political turmoil reasonably well.

Have investors become complacent about political risk in Turkey and around the world or are they simply demanding less compensation for holding risky assets because of improvements in the underlying macroeconomic fundamentals? We think it is a bit of both. Yes, there have been significant improvements in emerging markets macro fundamentals, making them more resilient to both internal and external shocks. For example, EM foreign currency reserves now amount to more than 70 percent of their external debt. More importantly, the global backdrop remains supportive of risk taking. The pace of global growth remains strong and inflationary pressures appear moderate. World economic growth in 2007 is expected to be around 5 percent for the third year in a row, making it the best growth cycle in three decades. Similarly, there is still ample liquidity. The year-on-year growth in the global dollar liquidity remains above 10 percent. However, past experience shows that sustained financial market upswings can also make investors complacent. Even though there have been significant interruptions in the current global bull market, the market corrections since October 2002 have been short-lived. Investors, who tend to have short memories, seem to be treating every market correction as a buying opportunity.

Looking at Turkey specific factors, investors seem to think that the constitutional court decision, which paves the way for elections, will help defuse political tensions between the government and the establishment. Markets also seem to think that the ruling AK Party will do well in early elections.

In short, the court ruling is a significant development. Early parliamentary elections, scheduled for July 22nd, should provide some clarity on politics. With the governing AK Party pushing for the president to be elected directly by the Turkish people, despite the wishes of the establishment, there appears to be more questions than answers about presidential elections. It is also worth noting that sometimes political shocks take time to work their way through the system. Investors should ask themselves, ‘Do these events fundamentally change the economic landscape?’ In other words, will the parliamentary elections generate a strong, stable and reformist government?

* Chief Emerging EMEA Economist & Strategist, Merrill Lynch