Turkey falls out of favour

Turkish stocks have tumbled from their May highs as investors give Turkey the cold shoulder.

"The days when Turkey was considered a market darling are over," says Mert Yildiz of Burgan Bank. The Turkish stock market has slumped by a third from its record peak in May. And the Turkish lira has fallen to a record low against the dollar.

So what's gone wrong? Investors are taking a closer look at Turkey's vulnerabilities because the global backdrop has become less favourable. Once the Federal Reserve signalled in spring that there would be less money printing and, eventually, higher interest rates in the US, risky assets such as emerging markets looked less attractive. They seemed especially unappealing if they had relied to a large extent on foreign cash to underpin growth.

Enter Turkey, which The Economist reckons is the emerging market most vulnerable to a freeze in capital inflows. For starters, it has a whopping current account deficit (or external deficit) of over 6% of GDP. So it is a net debtor to the rest of the world and needs foreign capital to plug the gap. India's external deficit is only around 4% of GDP.

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Meanwhile, Turkey has a high level of short-term foreign debt compared to its foreign-exchange reserves, which means it could struggle to tide borrowers through temporary difficulties. Foreign debt has tripled since 2002, and half of it must be repaid or rolled over within a year. And credit has grown faster in Turkey since 2009 than elsewhere in the emerging world.

Given all this, you can see why investors fear that Turkey's economy is in for "a sharp adjustment" now that liquidity is leaving emerging assets, as the International Monetary Fund warned recently. Declining foreign confidence is starting to affect the domestic economy, with consumer confidence falling at its fastest pace in six months.

The central bank faces the usual emerging-market balancing act in these situations: trying to keep interest rates high enough to deter foreign money from fleeing, yet not so high that growth will be choked off. The sharp fall in the lira also threatens to stoke inflation.

If worries over Turkey's finances mount, the lira fall could quicken, making all these problems worse. Even without a "pronounced crisis", reckons Yildiz, Turkey faces "years of slow growth that will feel like a recession". Gold has fallen back from its three-month high of around $1,400 an ounce, with hopes that military action in Syria could be averted causing the latest price drop. But other factors influencing gold also point to a subdued performance over the next few months, reckons Fxpro.com's Simon Smith.

For starters, real interest rates have been rising globally over the past six months. Investors will be more reluctant to hold gold, which pays no interest, if they can get a real return on other assets. Higher interest rates are also a sign of a gradual return to economic normality, which is not good news for an asset that thrives in bad times.

There is another headwind for gold: dwindling inflation. Inflation in the OECD area as a whole is at a four-and-a-half-year low. Meanwhile, solid emerging-market demand for gold 50% of consumer demand stems from China and India looks set to be undermined by the slide in the Indian rupee, making gold more expensive to consumers. All told, says Smith, gold could see its first down year in 13 years. But we'd still hold on to the yellow metal.

We'd be surprised if we've really heard the last of inflation, and given the scope for instability as interest rates normalise or the euro crisis returns, holding some gold as portfolio insurance could well prove a canny move.