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Cape Town - South Africa has been named among the 'threatened three' emerging markets together with Brazil and Turkey, displaying the weakest currency fundamentals, says Overberg Asset Management in its weekly overview of the SA market landscape.
"SA had the dubious honour of being counted among the 'Fragile Five' during the emerging market currency sell-off in 2013 when the Fed first alluded to a 'tapering' of its quantitative easing programme," says OAM.
"Since then the group of vulnerable countries has declined but SA remains part of the club, signalling further rand weakness in spite of the almost 9.0% decline in the rand versus the dollar since the start of the year," according to OAM.
Market overview
SA economic review
• SA Reserve Bank (SARB) Governor Lesetja Kganyago, speaking at the World Economic Forum conference in Cape Town cited concerns over how firmly inflation expectations are anchored at 6%, the upper limit of the SARB’s 3-6% target range. Kganyago said the SARB would have to hike rates if it believed there would be a persistent breach of the inflation target.
Recent rand weakness and the application by Eskom for additional electricity tariff increases raise the likelihood that the inflation breach will be worse than the current SARB forecast. In its latest quarterly forecast the SARB forecasts a temporary breach in the first quarter (Q1) 2016 due to base effects which will unwind by Q2 next year.
However, analysts are tending towards the view that the inflation breach will begin in Q4 this year and remain more persistent. The deteriorating inflation outlook has caused the Forward Rate Agreement market to price in 170 basis points of rate hikes over the next 21 months.
• The level of gross reserves fell from $47.043bn in April to $46.446bn in May, a month-on-month decline of -1.3%. The decline is attributed to a weakening in foreign exchange reserves as a result of the strengthening US dollar.
The level of gross reserves is likely to remain volatile in coming months. Although SA’s relatively high interest rates should continue to attract short-term foreign capital inflows the appetite of foreign investors may dwindle when the Federal Reserve starts to raise interest rates.
Foreigners were net sellers of SA financial assets in May totaling –R1.8bn led by net sales of SA bonds amounting to –R3.1bn.
• Fitch credit rating agency maintained SA’s credit rating at BBB but kept the negative outlook. Fitch cited concern over the country’s weak economic potential due primarily to power constraints and a lack of appropriate economic reform. The rating agency also cited the large current account deficit and fiscal deficits as well as high levels of government indebtedness and contingent government liabilities. Fitch concluded that an upgrade in the country’s credit rating is unlikely in the near future.
SA political review
• The government announced that public sector wages would increase this year by 6.4%, lower than the 7% increase recently agreed upon between government and public sector unions. The 2012 wage agreement which based wage increases on consumer price inflation (CPI) stipulates that if actual CPI is lower than the projected average, the difference will be deducted from wages in the following year.
In 2014 public sector wages were calculated according to a projected CPI of 6.2% whereas actual CPI came in at 5.6%. As expected the reaction by public sector unions has been negative as the downward adjustment was not flagged prior to wage negotiations and may in the worst case scenario lead to a cancellation of the three year wage agreement signed last month.
• State-owned enterprise Transnet signed a R30bn loan facility agreement with China Development Bank (CDB) to fund the purchase of 591 locomotives to be manufactured by China South Rail and China North Rail. The deal forms part of Transnet Freight Rail’s recapitalisation programme which comprises the purchase of a total 1 064 locomotives.
The loans amount to 60% of the total R50bn requirement, carry a four-year grace period and have a maturity of 15 years.
Public Enterprises Minister Lynne Browne, who announced the funding and trade agreement said: “This transaction is expected to yield local job creation opportunities, increase South African rail manufacturing capacity and drive skills development as the contracted original-equipment manufacturers are expected to adhere to stringent localization and supplier development targets.”
• Transnet agreed to a three year wage settlement with the SA Transport and Allied Workers’ Union (Satawu). Although the duration of the wage agreement is positive the wage increases of 7% in year one followed by 7.5% and 8.25% in years two and three is well above the inflation rate and the recently agreed public sector wage deal. When taking into account the additional increases to housing allowances and medical aid subsidies the overall wage agreement will fuel concerns over SA’s rising budget deficit and inflation expectations.
The week ahead
• Standard & Poor’s credit rating review: Due Friday, 12 June. The Standard & Poor’s (S&P) credit rating agency will release its review of SA’s credit rating. S&P is widely expected to maintain its current credit rating of BBB- which is just one level above speculative grade or “junk” status. S&P’s current outlook is “stable” which means a downgrade is not imminent. A downgrade is traditionally preceded by a change in outlook from “stable” to “negative”.
• April manufacturing production: Due Thursday, 11 June. Manufacturing production is expected to show a softening bias following the robust increase in March of 1.2% month-on-month and 3.8% year-on-year.
Recent purchasing managers’ index (PMI) data suggests the manufacturing sector shrank in April by around -1.5% on the year hampered by public holidays and load shedding. There is unlikely to be any rebound during the second quarter as demand conditions also remain weak in the mining sector as well as from consumers.
• April mining production: Due Thursday, 11 June. Like the manufacturing sector mining output is expected to show a contraction on a month-on-month basis in April due to load shedding and the number of public holidays. On a year-on-year basis mining output is likely to show an increase of 5% according to consensus forecast due to favourable base effects although below the 18.8% increase recorded in March.
Technical analysis
• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation. A break above the key “Fibonacci” level of R12.15/$ signals further depreciation in the rand to the R13.00/$ level.
• The US dollar index is testing a major 30-year resistance line, which if broken will pave the way for further strong gains in the currency.
• Despite the recent uptick in bond yields the long-term JP Morgan global bond index bull trend remains intact, with the yield targeting a new low during the fifth and final wave.
• The US 10-year Treasury yield has broken above key resistance levels of 2.0% and 2.2%. However, there is unlikely to be a major bear trend in US bonds as the deleveraging phase is still in its early stages.
• The benchmark R186 SA Gilt yield is testing support at 8.15% and needs to break below resistance at 7.90% in order to resume its bull trend.
• The MSCI World Equity index is in the 5th and final wave of a rising-wedge formation. A rising-wedge formation is a typical trend-ending signal. European equities are set to outperform US markets. The Nikkei exhibits the most bullish pattern.
• Since the 1950s the Dow Jones and S&P 500 have displayed 7-year up-cycles and the top of the current US equity cycle can be expected in the next year. The next major wave down will complete the 16-17 year secular bear market that started in 2000. The secular bottom should occur around June 2016.
• In the meantime the S&P 500 is displaying a bullish short-term pattern. The index is moving into an advanced triangle pattern which normally signals the continuation of an upward trend. This view is corroborated by the “downward flag” of the Dow Jones index, which is also associated with an upward break-out.
• Although enjoying a temporary respite Brent crude’s previous break below key support levels at $60 and $50 suggesting a continuation of the weakening long-term trend. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. It has broken below the 2011 low of $6 500 suggesting a further downside move to $5 500.
• Despite recent advances gold is in a protracted bear market, signalled by rapid declines through successive support levels at $1 400, $1 300 and $1 250. Gold’s next target is $1 100 and is likely to breach $1 000 before the bear market ends.
• The All Share index has lost most of its gains since the start of the year. The All-share index bull market remains intact provided the index remains above 50 000.
Bottom line
• The emerging markets displaying the weakest currency fundamentals include Brazil, SA and Turkey, dubbed the “Threatened Three”. SA had the dubious honour of being counted among the “Fragile Five” during the emerging market currency sell-off in 2013 when the Fed first alluded to a “tapering” of its quantitative easing programme. Since then the group of vulnerable countries has declined but SA remains part of the club, signalling further rand weakness in spite of the almost 9.0% decline in the rand versus the dollar since the start of the year.
• Countries with high current account deficits are especially vulnerable. Among emerging markets SA has the largest deficit measuring 5.1% of GDP in the fourth quarter last year. Furthermore SA’s current account deficit has deteriorated when taking into account the near halving in the oil price over the past twelve months. Since SA imports 100% of its oil the current account deficit should have shown a significant improvement.
• There are two kinds of capital inflows into emerging markets, foreign direct investment which tends to be more stable and longer-term, and private portfolio flows, which correlate with the global liquidity cycle. The global liquidity cycle tends to be led by the US Federal Reserve Bank. On the last six occasions when the Fed started tightening interest rates, portfolio capital inflows into emerging markets either diminished or reversed. SA with its large current account deficit is especially dependent on portfolio capital inflows or so-called “hot money”.
• SA’s vulnerability is increased by the scale of foreign ownership of its financial assets. SA’s bond market has the highest level of foreign ownership out of all emerging markets with the sole exception of Indonesia. Over 40% of SA’s domestic bonds are owned by foreign investors, making the rand especially prone to any change in sentiment.
• The rand will gain little solace from a weakening economy beset by depressed consumer and business confidence, ongoing power outages, policy uncertainty, stifling bureaucracy, and inflexible labour markets.
• Furthermore, the brief respite shown in commodity markets, on which SA depends heavily for exports, is likely to be short-lived. The OECD has cut its forecast for global growth this year from a previous 3.8% to 3.1%, down from the 3.3% expansion last year and well below the average of 3.9% between 2002 and 2011. Commodity prices are unlikely to rally in a weak global growth environment.
The economy which can contribute the most to higher commodity prices is China but despite its monetary easing there is very little evidence that China’s economy is improving. Latest trade data shows China’s iron ore volume imports contracted in May by -8.4% year-on-year.
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Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.
