Rand vulnerable beyond Sarb’s forecasts

Cape Town - Despite the SA Reserve Bank’s increased optimism towards the rand, the currency provides the greatest risk to the inflation outlook and interest rate trajectory, cautions Overberg Asset Management in its weekly overview of the economic and political landscape in South Africa.

Although undervalued on a purchasing power parity level, the rand is vulnerable to further depreciation potentially far beyond the SARB’s forecasts of relatively modest declines.

Beyond the obvious domestic detractors to the rand’s stability such as political uncertainty and the key credit rating decision by Standard & Poor’s, global influences will cause the rand, among other emerging market currencies, to decline during the second half of the year.

South Africa economic review

• Despite assurances from the National Prosecution Authority that it would not be placing finance minister Pravin Gordhan under arrest, the rand fell heavily against major currencies. Versus the dollar, pound and euro the rand fell from R/$15.30 to 15.71, from R/£21.95 to 22.80, and from R/€17.28 to 17.61 respectively. In the past week the rand also declined against emerging market currencies, versus the Argentinian peso, Indian rupee, Malaysian ringgit, and Thai baht by 5.0%, 3.2%, 3.1%, and 3.7% respectively. The yield on the R186 ten-year bond also spiked sharply higher from 9.20% to 9.45%.

• As expected the SA Reserve Bank (SARB) kept the repo rate unchanged at 7.0% although one of the six members of the monetary policy committee voted for a further 25 basis point increase. Governor Lesetja Kganyago cited better than expected inflation data. The SARB stuck to its forecast that consumer price inflation (CPI) would peak at 7.3% in the final quarter of 2016 before easing to an average 5.4% in 2018. However, it projected that CPI would return to its 3-6% target range by the third quarter (Q3) 2017 sooner than its earlier forecast of Q4. While encouraging, the SARB cautioned against the risk to inflation from food prices and exchange rate volatility. (See Bottom Line for more detailed analysis).

• Consumer price inflation (CPI) moderated from 6.3% year-on-year in March to 6.2% in April in line with consensus forecast. However, the underlying data is concerning. Fuel prices increased 7.5% month-on-month and will drive annual CPI readings sharply higher once the base effect of year-ago comparative data falls away. Food price inflation was also high rising 1.9% on the month and 11.0% on the year. 3-month-on-3-month seasonally adjusted annualised food price inflation is approaching 24% and will remain elevated once meat prices begin rising. Meat prices are expected to soar in response to farmers rebuilding herds which were decimated during the drought. Unfortunately, there are also signs that the rand’s depreciation is finally showing-up in inflation readings with substantial price increases in vehicles, equipment and appliances.

• Retail sales growth slowed sharply from 4.0% year-on-year in February to 2.8% in March the weakest growth since May 2015 and well below the 3.8% consensus forecast. The slowdown was especially evident in the hardware & paint and household furniture sectors which contracted -5.1% and -1.9% on the year. Overall retail sales grew in the first quarter (Q1) by just 0.6% quarter-on-quarter annualised a substantial drop on the 4.1% growth recorded in Q4 last year. Combined with the decline in mining and manufacturing production during Q1 the weak retail data points to a likely GDP contraction in Q1 of around -0.5% quarter-on-quarter annualised.

The week ahead

• Producer price inflation (PPI): Due Thursday 26th May. PPI is expected to edge slightly higher from 7.1% year-on-year in March to 7.2% in April according to consensus forecast, due to the lagged effects of rand depreciation, and increase in food and commodity prices.

Technical analysis

• The rand remains below successive support levels suggesting a continuation in the rand’s depreciation.

• 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 JPMorgan 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 1.8% and 2.0%. 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 broke out of its long-term bull trend as a result of “Nenegate”. The new bear trend for the R186 is underpinned by resistance at 9.0% with a risk of further upside to 10.50%. While SA bond yields may fall in line with global bonds they are unlikely to return to the bull trend.

• The MSCI World Equity index has broken downward from a rising trendline which has been intact since the 2008/09 global financial crisis. Given the magnitude and duration of the 2009-2015 bull market the overall correction is likely to reach a downside target for the MSCI World Equity index of 1 400.

• 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 is likely to have just occurred. 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.

• The S&P 500 index has broken downward from a rising wedge pattern, which is traditionally a trend-changing pattern. The downward trend is likely to remain intact unless the index decisively regains the 2070 level. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, is leading the broader market lower on the downside.

• Despite the recent price rally Brent crude’s break below the key $30 support level in February suggests a continuation of the weakening long-term trend to a downside $25 target. Copper is regarded a reliable lead indicator for industrial commodity prices and barometer of global economic growth. Despite its recent rally the copper price broke below the key $4 500 support level in February suggesting further downside ahead.  

• Gold has broken its recent downtrend by rising decisively above the $1100 resistance level. An extended break above $1250 is needed to confirm the end of gold’s bear market.

• The JSE All Share index is testing an important resistance line but if this remains unbroken the index is likely to move back below the 24-month moving average at 50,700 in turn opening a downside target of 45 000 and an ultimate target of 43 000.

Bottom line

• As expected the SA Reserve Bank (SARB) left the repo interest rate unchanged at 7.0% citing an improvement in the inflation outlook. The SARB lowered its forecast for core consumer price inflation (CPI), its preferred inflation measure which excludes food and fuel prices. The SARB’s core CPI forecast for 2016 was lowered from a previous 6.2% to 5.9%, within the SARB’s 3-6% inflation target.

• The SARB attributed its improved inflation outlook to the effect of higher interest rates, a wider output gap between full and actual capacity utilisation, a lower than expected increase in electricity tariffs, and a moderation in the rand’s depreciation.

• The SARB expects the rand’s real effective exchange rate will depreciate -7.6% in 2016 better than its earlier forecast of -11% depreciation. Moreover, in 2017 the SARB forecasts the real effective exchange rate of the rand will appreciate by +1.4% better than the earlier forecast for no change.

• Despite the SARB’s increased optimism towards the rand, the currency provides the greatest risk to the inflation outlook and interest rate trajectory. Although undervalued on a purchasing power parity level, the rand is vulnerable to further depreciation potentially far beyond the SARB’s forecasts of relatively modest declines.

• Beyond the obvious domestic detractors to the rand’s stability such as political uncertainty and the key credit rating decision by Standard & Poor’s, global influences will cause the rand, among other emerging market currencies, to decline during the second half of the year. China’s commodity-driven economic recovery since the start of the year, is based on added leverage in an already over-leveraged property sector, and is likely to be short-lived. The Federal Reserve is paving the way for an interest rate hike in June and a second hike before year-end. The dollar will strengthen leading to a resumption of heavy declines in emerging market currencies.

• In its decision to pause the SARB cited weak economic growth as well as improved inflation. Its forecast for GDP growth in 2016 was lowered from a previous 0.8% to 0.6% and for 2017 from 1.4% to 1.3%. However, the SARB’s primary mandate is to maintain price stability. Regardless of the economy’s anemic state the SARB will likely resume its interest rate hiking cycle at the next policy meeting, given the likelihood of upsets to its rand depreciation forecasts. A further two 25 basis point rate hikes are expected before year-end.

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* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

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