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Rand will be stronger if SA Reserve Bank resists the urge to hike rates

Sep 20 2018 14:37

The South African Reserve Bank's Monetary Policy Committee is unlikely to hike the repo rate at its policy meeting despite the sharply weaker rand and rising interest rate expectations, according to to Overberg Asset Management.

Unfortunately, the SARB has little influence on the rand.

In its weekly economic and market overview, OAM noted that any attempt to shore-up the rand by hiking interest rates would probably backfire, leading instead to a weakening in the currency.

"In the week after South Africa officially entered into recession with the release of second quarter (Q2) GDP figures, the rand lost almost 4% against a basket of emerging market currencies.

According to the analysts at OAM the consensus view is that a rate hike would add further pressure on GDP growth, leading to even more rand weakness, and therefore additional rather than less inflationary pressure.

"The SARB, by hiking the repo rate, would undermine household spending, which is particularly vulnerable to rising interest rates and contributes over 60% to South Africa’s GDP."

South Africa economic review

• The BER Business Confidence Index (BER BCI), which has a direct lagged relationship with gross fixed capital formation, fell from 39 in the second quarter (Q2) to 38 in Q3, having been as high as 45 in Q1, inspired by the inauguration of Cyril Ramaphosa as president. The index remains well below the 50-level, which marks the threshold between net positive and net negative confidence, suggesting investment levels are likely to remain depressed over the next 6-9 months.

A turnaround in confidence levels likely depends on greater policy certainty over land reform, mining legislation, and a more efficient public sector. Among the BER BCI sub-categories, confidence levels fell further for manufacturers, wholesalers and retailers but increased marginally for new vehicle dealers and building contractors.

• The Sacci Business Confidence Index (Sacci BCI), after rising modestly in July from 93.7 to 94.7, slumped in August to 90.5 its weakest since August 2017. Of the 13 sub-components, the biggest negative drivers were a fall in exports, a weaker rand, and higher inflation, while there was a marked improvement in import volumes, construction activity, vehicle sales and real financing costs. The Sacci BCI indicates a lack of economic momentum and jobs growth in the months ahead.

Potential catalysts for a change in business sentiment include the decision by the Constitutional Review Committee at the end of September on whether the constitution needs to change to better facilitate land expropriation without compensation. Other potential catalysts in October include upcoming jobs and investment summits and the Medium-Term Budget Policy Statement, which will be closely scrutinised for any slippage in fiscal prudence.

• Retail sales volumes grew in July by a stronger than expected 1.3% month-on-month more than reversing the 1.1% decline in June and well ahead of the 0.3% consensus forecast. On a year-on-year basis, retail sales increased in July by 1.3% while June’s figure was revised substantially upwards from 0.7% to 1.8%. The data bodes well for a return to GDP growth in the third quarter (Q3). Among the retail sectors, textiles, clothing, footwear and leather goods grew 3.0% on the year up from 1.0% in June.

Household furniture, appliances and equipment grew 6.9%, pharmaceuticals and medical goods, cosmetics and toiletries grew 2.1%, while hardware, paint and glass contracted 5.1% the sixth straight year-on-year decline. Retail sales should maintain a modest uptrend over Q3 helped by the public wage settlement and rising household credit extension.

• Manufacturing production volumes increased in July by a stronger than expected 2.9% year-on-year, up from 0.6% in June. Although the figures may have been flattered by there being one more working day in July 2018 than in July 2017, the month-on-month increase of 1.6% was also encouraging, compared with just 0.2% in June. Among the manufacturing sectors, motor vehicles, parts, accessories and other transport equipment increased by a solid 8.3% on the year after contracting 2.8% in June.

Food and beverages production, which contributes 25.8% of total manufacturing production, was also strong with growth of 5.8% on the year accelerating from 4.1% in June. Although showing an encouraging start to the third quarter (Q3), manufacturing production is unlikely to maintain momentum over the remainder of Q3 according to survey data.

The BER manufacturing confidence index fell in Q3 from 27 to 21 well below the neutral 50-level while the BER manufacturing purchasing managers’ index slumped in August from 51.5 to 43.4 its lowest since August 2017, also well below the key 50-level.

• Spoiling an otherwise strong start to the third quarter (Q3) from both retail and manufacturing sectors, mining production slumped in July by 8.6% month-on-month more than reversing June’s 5.0% increase. On a year-on-year basis production contracted by 5.2% following an increase of 3.7% in June. The decline was broad-based.

Production of copper, nickel, iron ore, gold and building materials fell year-on-year by 42.0%, 22.7%, 17.4%, 15.0% and 9.3%, respectively. Although notoriously volatile, mining production, after contributing positively in Q2, may detract from GDP growth in Q3. The sector continues to perform below potential due to lingering uncertainty over mining legislation.

The week ahead

• Consumer price inflation: Stats SA announced that annual consumer inflation for August was marginally lower than analysts had expected. 

The CPI rate (for all urban areas) was 4.9% compared with July's 5.1% print. The consensus was for CPI to accelerate to 5.2%.

• SARB Monetary Policy Committee meeting: No change in interest rates is expected although the South African Reserve Bank Monetary Policy Committee meeting is likely issue a more “hawkish” statement outlining the growing risk of inflation stemming from the sharply weaker rand. 

Technical analysis 

• The rand has retraced 50% of its 2016 to 2017 appreciation against the US dollar, indicating that the spike in the rand/dollar rate to R15.50/$ in the first week of September may mark the peak in the currency’s recent decline.  

• The rally in the US dollar index has reached its medium-term goal suggesting a correction from current levels. The dollar remains below a major 30-year resistance line suggesting the bull run in the dollar may be over.

• The British pound has broken back below key resistance at £1.35/$ suggesting a trading range of £1.30/$ to £1.35/$. The £1.28/$ level is expected to provide strong resistance.

• The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.

• The US 10-year Treasury yield is struggling to break decisively above key resistance at 3.0%. However, a break above this level is expected and would open the next target of 3.6%.

• The benchmark R186 2025 SA Gilt yield has retraced earlier weakness and fallen back below the key 9.0% level. A trading range of 8.4% to 9.0% is expected over the foreseeable future.

• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.  

• The Brent oil price has struggled to break above key resistance at $75 per barrel, indicating a likely trading range of $65 to $75 per barrel. The outlook for base metals prices is less certain after the copper price retreated sharply from the key $7 000 per ton level. A decisive break below $6 000 per ton would herald a bear market in copper and base metals’ prices.

• Gold has developed an inverse "head and shoulders" pattern, which indicates a price recovery and a test of the $1 400 target level.

• Despite the consolidation since the start of the year the break in the JSE All Share index above the key resistance level of 60 000 in December signals the early stages of a new bull market.

Bottom line 

• The South African Reserve Bank (SARB) Monetary Policy Committee is unlikely to hike the repo rate at its policy meeting on Thursday despite the sharply weaker rand and rising interest rate expectations.

The rand has depreciation 11% versus the US dollar since the beginning of August. Over this time, the Forward Rate Agreement (FRA) Market has re-priced the interest rate outlook, now discounting a 75 basis-points increase in the repo rate over the next nine months.

• Emerging market central banks have been hiking interest rates to shore-up their currencies. Since August, Argentina and Turkey, home to the worst affected emerging market currencies, have hiked their prescribed short-term interest rates from 40% to 60% and from 17.75% to 24%, respectively. India and Indonesia, have been steadily hiking interest rates since the start of the year.

• According to the SARB the rand poses the biggest upside risk to the inflation outlook, particularly if recent rand weakness is sustained. Last month headline consumer price inflation (CPI) accelerated from 4.6% to 5.1% although the biggest culprit was the higher fuel price. Core CPI, which excludes food and energy prices due to their volatility, picked-up more modestly from 4.2% to 4.3%.

The August CPI numbers, Stats SA on Wednesday announced that annual consumer inflation for August was marginally lower than analysts had expected. 

The CPI rate (for all urban areas) was 4.9% compared with July's 5.1% print. The consensus was for CPI to accelerate to 5.2%.

•  Unfortunately, the SARB has little influence on the rand. Any attempt to shore-up the rand by hiking interest rates would probably backfire, leading instead to a weakening in the currency. The more significant determinant of rand strength is GDP growth.

In the week after South Africa officially entered into recession with the release of second quarter (Q2) GDP figures, the rand lost almost 4% against a basket of emerging market currencies. Slow GDP growth means reduced tax revenue, greater stress on the budget deficit and a more imminent danger of further credit rating downgrades.

• The SARB, by hiking the repo rate, would undermine household disposable income, add further pressure on GDP growth, leading to even more rand weakness, and therefore additional rather than less inflationary pressure. Household spending, which is particularly vulnerable to rising interest rates, contributes over 60% to South Africa’s GDP.

• Counter-intuitively, the SARB would be rewarded with a stronger rand if it resisted the temptation to hike the repo rate on Thursday. Lower interest rates will lead to stronger GDP growth and stronger capital inflows.

• The SARB traditionally errs on the side of caution, far slower to react than most emerging market central banks to changing external conditions. This is borne out by far fewer interest rate changes. Just as the SARB was slow to respond to the 9% appreciation in the R/$ exchange rate in the month following last December’s ANC elective conference, the response to the current rand slump is likely to be equally measured.

The SARB will most likely adjust its accompanying policy statement to reflect a more hawkish tone, cautioning against the increased risks of higher inflation. However, a rate increase is extremely unlikely especially with the country in recession.

For the full report, including a look at international markets, click here.

* 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.

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. 

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