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EEMEA: long Turkey credit Turkey has been one of the big underperformers among the major EM lately, and now valuations are the most attractive in a long time. Sovereign credit spreads are down to BB- levels even though the country is still rated as a BB+ credit (Chart 50). The lira which our Compass model has shown as overvalued for many years is now finally in line with the equilibrium of about 3.30 vs USD. The REER is almost down to the lows reached during the 2013 taper tantrum and 2015 China devaluation. In equities the discount vs GEM is at historical highs (Chart 51). So contrarians should get interested. To be clear, we have been warning for a long time that the leverage and stimulus driven growth model was weakening and needed a boost through supply side reforms. And obviously political events have been manifold. But as we are talking about year-ahead trades rather than the near-term ideas, we believe it is worth noting that Turkish markets have a habit of alternating between bad and good years: 2010, ‘12, ‘14 good; 2011, ’13 and ’15 bad. After another bad year in 2016, one could consider a possible rebound in 2017. Not a short-term trade This is not a 1-month but rather a 3-6 months trade, where Q1 will likely be critical. In the short term, US rates volatility is harmful for countries like Turkey that have funded large current account deficits with short-term debt. This interacts with the local sentiment weakness that has lately resulted in rising deposit dollarization. An acceleration of this trend would now be the biggest risk to asset prices, in our view. Before entering the trade we should see dollarization stabilize. Lately households have been net buyers of dollars for the first time since the coup attempt. We should see a couple of weeks of dollar selling to confirm that this potential risk is dissipating. The trigger for a rebound from low valuations likely lies in a stabilization of sentiment which could occur during the first half of next year. Currently the state of emergency is scheduled to end in January, and the news flow suggests a referendum by April/May. In a positive scenario, politics calm down by the referendum which may also reduce the need for further stimulus through fiscal, monetary policy or moral suasion of the banks. Among asset classes, we think Eurobonds provide the best risk/reward as the rating is a natural valuation “magnet”, and the credit remains a solid BB+ fundamentally, in our view. Our preferred bonds would be the 26s (current: 5% for October 26s) on the 10y tenor and 45s (current 6.5%) on the long end. However, a rebound would also favor equities and local spreads. FX is least compelling as TRY has been asymmetric in recent years: big sell-offs and small recoveries. We think the reason is high inflation and a policy bias for a weaker exchange rate. In FX a positive view would be best expressed by selling the USD/TRY risk-reversal which is currently at around 5.0 and could target 4.0 in a scenario where the sovereign rallies back to BB+. Chart 50: Turkey sovereign priced too cheaply at implied BB- rating Chart 51: Real effective TRY and Turkey equities near the 5-year lows BBB 55 ——Real Effective Exchange Rate for TRY 2 Implied rating for 10y Turkey ——Turkey-GEM P/E gap, ths = Actual rating - Turkey 0 BBB- 50 -2 BB+ 45 -4 Be 40 6 BB- Seoeeoe ts eoeeaeegeeseoecaegese = = I ala a wo © © FRU Gygqgqqqqgqqqgqqgqqqgg y FF a a a = ua Z a S2SS7FSSSRSPSPSSLZESS 5S 8 g = 8 & & & Source: BofA Merrill Lynch Global Research, Bloomberg, Source: BofA Merrill Lynch Global Research, Bloomberg, Haver, EPFR Bankof America Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 27 Merrill Lynch HOUSE_OVERSIGHT_014757