Turkey and Islamic State

Turkey and Islamic State
David R. Kotok
September 20, 2014

While we watch the war unfolding against the Islamic State (IS) in Syria and Iraq, it is critical to keep an eye on neighboring Turkey. There is a lot at stake; Turkey holds a key position. The news reports today are replete with commentary about Turkey as it takes a very soft role in fighting IS. Turkey was worried about 49 Turkish diplomats and their families. They were hostages of IS. Their rescue or release or escape is being reported this morning.  There are also accounts of 31 Turkish truck drivers taken hostage by IS. Their whereabouts are still unknown.  Reports of the Turkish hostage takings started this month.

Turkey’s government is trying to walk a fine line between (1) not alienating IS to the point where Turks have to witness the beheading of a Turkish citizen on the one hand and (2) maintaining some forms of security internally and with its NATO alliance on the other. Meanwhile Turkey has a high-risk, porous border with Syria and Iraq. In other words, Turkish leaders are trying to walk a line between two difficult masters. Turkish internal politics and demographics make this a very risky venture.

It is important to note that Turkey is a NATO member with a strong military. It has the largest Air Force among the NATO countries with the exception of the United States. That air force has not been reported to be engaged in airstrikes.  Perhaps the IS holding of hostages restrained the Turkish government.  We have no way to know about these internal Turkish decisions.

Turkey is looking to upgrade its Air Force from F-16 fighters to newer versions. Further, according to Capital Alpha briefing report, a “senior commander of the Turkish Air Force” has confirmed in a presentation that Turkey “is developing its own precision-guided weapons as well as satellites.”

Meanwhile, Turkey’s largest export customer is Germany, a country that is dealing with its own energy supply problems caused by the Russia-Ukraine tensions. Turkey’s second largest export market is Iraq. That country is in a downward spiral.

Turkey’s credit ratings are falling. Fitch has taken Turkey to a BBB-, which is the lowest level of investment grade. Other rating models point to downgrades. The Turkish president, Recep Tayyip Erdoğan, has threatened to cut ties with the rating agencies. The president may not like what the rating agencies say, but Turkey has a current account deficit of over 6% of GDP and growing. The country’s debts are rising, and its foreign exchange reserves are under pressure. Its currency is falling against the US dollar.

The complexity of its situation is exacerbated by reports of internal IS recruitment. There are reports that discuss IS offices in Turkish cities. There has been a German report that IS has made Turkey an official recruiting location. That report also notes that prospective IS fighters from poorer neighborhoods in Turkey can find their way to an office in Istanbul. There are other reports of “Jihadist gift shops” and IS branded T-shirts. Newsweek reporters Alev Scott and Alexander Christie-Miller have described IS recruitments of young men from Sunni Muslim districts “plagued by poverty and drug addiction.” Some Turkish officials have estimated that more than 1,000 Turkish citizens are fighting for IS.

At Cumberland Advisors, we do not own any Turkish investment exposure with the exception of a broad-based exchange-traded fund (ETF) that has a very small Turkish component (0.7%) as part of the full index. We avoid risks associated with this deteriorating situation on the Turkish border with Syria and Iraq. We think risks are rising in the neighborhood. American policy against IS has only limited chances of success if Turkey is passive.

Our investment position is to manage risks where we can assess them. The risk in this region is impossible to measure. It is driven by news flow that rapidly impacts risk premia. In some cases, one can identify risks such as oil flows through Turkey, Turkish debts and stocks, or other types of risks such as the Mosul Dam. In other cases, there are secondary effects that are difficult to measure. In any event, we avoid Turkey. And to counter risk, we have a cash reserve in most of our separately managed ETF accounts.

We follow reports as closely as we can. Turkey belongs on everyone’s radar.

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David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors