LONDON High yields and a benign global backdrop are keeping many investors engaged with Turkish bonds and stocks ahead of a crucial referendum, but the outlook is glum for this once favored emerging economy.
Sunday's referendum will ask Turks if they want an executive presidency, which would grant President Tayyip Erdogan wide-ranging powers and bring about one of the biggest changes in its system of governance since the modern republic was founded almost a century ago.
Many investors are nervous about the hotly contested vote which polls indicate may be too close to call. But they are more concerned about Turkey's economic outlook, dimmed by stalled reforms and armed conflicts along its southern borders.
Most are also skeptical about the government's view that a yes vote in the referendum will give Ankara a freer rein to implement reform
But they are reluctant to throw the towel in just yet.
Paul Greer, senior emerging market debt trader at Fidelity International in London, is one of those with a tactical overweight on Turkey, arguing that Turkish securities already implement many of the risks in their price.
The lira is one of the few emerging currencies to have weakened against the dollar this year:
Greer said a yes vote would spark at least a brief rally.
"I don't think the market is heavily positioned in Turkish assets at the moment, which will be reflected in the market reaction," he said, adding that chances of a new election being called would rekindle uncertainty once the referendum is past.
"Then the market will start to refocus on Turkey's challenged fundamentals."
Turkey's sizeable bond market has long made it a major destination for emerging debt investors, while its well-managed companies and buoyant consumer demand lured equity funds. But asset allocation data is indicative of growing jitters in the run-up to the vote.
According to fund tracker EPFR, emerging debt funds had added exposure to Turkey by 0.2 percent since November, but were still underweight on aggregate.
JPMorgan's monthly client survey too showed investors underweight Turkish local debt in March. Foreigners held 16.7 percent of the market versus 17.7 percent a year ago and around 10 percentage points down from early-2013.
One such fund is Ashmore which has been bearish Turkey for a couple of years, though Jan Dehn, its head of research, says the asset manager continues to trade the debt "actively".
"Erdogan will win the referendum and markets will like that because otherwise there is massive uncertainty," Dehn said. "But the way we approach Turkey is from an underweight position."
Equity investors were overweight Turkey as of February, according to Bank of America Merrill Lynch. This may be down to the boost exporters will receive from lira weakness, and share valuations, which according to BAML, are 20 percent cheaper than historical averages.
But the overall overweight position is smaller than it was before a failed coup last July, BAML added.
Keeping foreign investors sweet is crucial to plug Turkey's wide current account deficit which amounts to roughly $30 billion a year and is one of the largest in emerging markets: tmsnrt.rs/2fM78iH
Currently a quarter of that gap is filled by long-term bricks-and-mortar foreign direct investment, according to UBS estimates, compared to 80 percent a decade back.
One powerful catalyst that spurred reform and attracted investment in past years was the prospect that Turkey could some day join the European Union.
But relations have worsened and rhetoric terse since a crackdown following the failed coup last July. Erdogan has also mooted a referendum on the death penalty, which could effectively end Ankara's membership bid.
Second, any post-referendum relief rally may be short lived as concerns resurface about the greater rein Erdogan will have over institutions such as the judiciary, media and central bank.
But Aaron Grehan, Aviva Investors' deputy head of emerging market debt, says what happens to the dollar, Treasury yields and U.S. monetary policy will determine whether post-referendum Turkey continues to enjoy investor attention.
Yet these positions are likely to be tactical and short-term rather than conviction-based.
"There is no clear catalyst for positive economic development, so you have to make the distinction between an investment and a trade rationale," Grehan added.
(Additional reporting by Sujata Rao; Editing by Tom Heneghan)