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Robust rand defies the odds

Sep 27 2016 23:35

Cape Town - The rand's current stellar performance seems inexplicable, given the absence of growth in the domestic economy, rising political and regulatory uncertainty, and the real threat of losing our investment grade rating.

However, the unit’s relative strength is attributed to two key factors: AB InBev’s takeover of SABMiller and the global search for income yield. Unfortunately, the first is once-off and the second is living on borrowed time, says Overberg Asset Management in its weekly overview of the South African economic and investment landscape.

"It is rumoured that AB InBev has been accumulating rand in order to pay SABMiller’s South African shareholders. They make up around 9.5% of SABMiller’s shareholder register and will need to receive around R120bn from AB InBev."

READ: 3 reasons why the rand is rallying against the dollar

OAM says further that the rand may be cheap versus its theoretical “purchasing power parity” (PPP) level but not by much. According to the PPP model the rand is only 6% cheaper than its fair value of R12.80/$.

Following the “Nenegate” debacle last December the rand was 25% undervalued.

"Admittedly the rand has at times overshot its fair value. For instance, in mid-2010 (during the Fifa World Cup) the rand was 15% above fair value. However, given the threat of a sovereign credit rating downgrade to sub-investment grade, and an economy teetering on the edge of recession it seems unlikely that the rand should be anywhere close to its PPP fair value."

OAM says given the extent to which the rand has closed-in on its theoretical fair value in spite of the near-recessionary economy, looming credit rating downgrade and rising political uncertainty, the current rand strength offers an excellent opportunity to diversify into offshore markets.

South Africa economic review

• At its policy meeting the SA Reserve Bank (Sarb) decided by unanimous vote to keep its benchmark repo interest rate unchanged at 7.0%.

Sarb governor Lesetja Kganyago adopted decidedly more “dovish” language in his policy statement describing the upside risk to the inflation outlook as having “moderated somewhat”. Kganyago said that provided the currency and inflation forecasts materialise the Sarb “may be close to the end of the tightening cycle”.

The Sarb forecasts headline consumer price inflation (CPI) will peak in the fourth quarter (Q4) at 6.7%, down from a previous 7.1% and will return to the 3% to 6% target range in Q2 2017, earlier than its previous forecast of Q3 2017.

READ: Rates unchanged as Sarb lifts growth forecast

The policy statement projected improved rand levels although cautioned that the rand “remains vulnerable to future changes in the US monetary policy stance, domestic political developments as well as to a risk of a possible ratings downgrade later in the year”. 

• Consumer price inflation (CPI) moderated from 6.0% year-on-year in July to 5.9% in August in line with consensus forecast and back within the SA Reserve Bank’s 3-6% target range.

CPI is unlikely to remain within the Sarb’s target range for long due to unfavourable base effects, the diminishing impact of lower fuel prices and the continued acceleration of drought-induced food price increases.

Food price inflation remained unchanged at 11.3% but likely to rise beyond 12% over coming months as meat prices respond to a rebuilding of livestock herds. The fuel price fell in August by 7.6% month-on-month subtracting 0.4 percentage points from CPI inflation, a tailwind which is likely to fade amid expected fuel price increases in the latter part of the year.

• In its quarterly update on SA’s sovereign credit rating outlook Moody’s rating agency analyst Zuzana Brixiova said “we have a negative outlook which means the risks (to the rating) are tilted to the downside”.

However, she added that “fundamentally we expect that the probability of a downgrade is less than 50%, it’s about one-third.”

Moody’s, which rates SA two notches above “junk” status and one notch above fellow rating agencies Standard & Poor’s and Fitch, will announce its rating decision on 25 November. Moody’s rating decision is likely to hinge on the pace of economic growth during the second half of the year, the level of fiscal prudence displayed at the Medium-Term Budget Policy Statement in October and the financial burden of state-owned enterprises.

In addition, Brixiova stated that Moody’s would pay close attention to political developments, which it cited as a major source of credit weakness.

READ: Despite political noise, SA institutions remain strong - Moody's

• Amid growing concerns over the financial burden of state-owned enterprises (SOEs), PetroSA announced that it faced an R8.8bn funding gap relating to the decommissioning of its gas-to-liquid refinery and offshore structures in Mossel Bay.

PetroSA has only provided for R1.9bn of the R10.7bn estimated cost, which the Auditor General expects will increase further following a full technical assessment. In addition, PatroSA’s proven and probable reserves have shrunk from 97.6 billion cubic feet in 2015 to 75.8 billion in 2016, threatening the long-term financial stability of the SOE.

• The Bureau of Economic Research (BER) manufacturing business confidence index increased from 23 in the second quarter (Q2) to 30 in Q2, which although encouraging still indicates that 70% of survey respondents consider business conditions unsatisfactory. Meanwhile, the SA Reserve Bank leading indicator fell in July by 1.1% month-on-month more than reversing its 1% increase in June.

Only three of the 10 index components increased, including the commodity price index, the BER index and the leading business cycle indicator for SA’s major trading partners. The largest detractors were the decline in number of building plans approved and a flattening in the interest rate yield curve.

The week ahead

• Quarterly employment report: Due on Tuesday, 27 September, has been rescheduled for publication to 7 October. Despite the recovery in GDP growth during the second quarter (Q2), depressed business confidence is likely to keep a lid on employment gains, with further job losses predicted in the formal sector of the economy during Q2.

• Private sector credit extension: Due on Thursday, 29 September. Private sector credit extension growth is expected to moderate further from 6.8% year-on-year in July to 6.7% in August according to consensus forecast, pinned down by a combination of tightening lending standards and weak household credit demand.

• Producer price inflation (PPI): Due on Thursday ,29 September. Despite recent fuel price cuts the year-on-year increase in PPI is projected to rise slightly from 7.4% in July to 7.5% in August, according to consensus forecast, due to a continuation of drought induced food price increases.

• Trade balance: Due on Friday, 30 September. The trade surplus is expected to reduce from R5.2bn in July to R3.2bn in August, according to consensus forecast, in line with the recent loss in momentum in manufacturing and mining output.

Technical analysis

• While the rand has broken below key resistance levels versus the dollar at R14.20/$ and R13.80/$ the strengthening trend is not confirmed by momentum indicators, signalling that the currency is overbought.

• 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.

• Following the Brexit vote the British pound hit its weakest level against the US dollar since 1985. The £1.30/$ level provides key support, which if broken would open up a Fibonacci projected target of £1.20-1.24/$.

• 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 below key resistance levels of 1.6% confirming that the major bull trend in US bonds is likely to continue as the deleveraging phase is still in its early stages.

• The benchmark R186 SA Gilt yield has compressed to its lowest level since “Nenegate” last year, falling below key resistance at 9.0%. The yield is now testing the bottom of the current consolidation channel at 8.5%, which if broken will target a yield of 8.0%.

• The MSCI World Equity index has broken downward from a rising trend-line 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 between mid-2016 and mid-2017.

• The S&P 500 index has broken to new record highs but the rally is not being confirmed by momentum indicators, which suggests the market is overbought and in danger of correction. A further negative signal is that the Dow Jones Transport Index, traditionally a lead indicator for the broader market, is underperforming the broader index.

• Despite this year’s 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 developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1 400 target level.

• 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 50 900, in turn opening a downside target of 45 000. A break above 54 200 on the JSE All Share index would project an upward move to 60 000, marking a new high for the JSE.

The bottom line

• On Wednesday, 21 September the rand was the strongest performing currency worldwide, strengthening 2.42% against the US dollar in a single day.

In the year-to-date the rand has gained 14.0% versus the dollar, one of the strongest performing currencies worldwide. It seems inexplicable, given the absence of growth in the domestic economy, rising political and regulatory uncertainty, and the real threat of losing our investment grade rating.

• Years of quantitative easing and zero interest rate policy by the world’s major central banks has caused yields of many bonds to drop below 0%. In July a record amount, in excess of $12trn worth of bonds, was in negative yield territory.

The search for positive yields prompted unprecedented portfolio inflows into high yielding emerging market (EM) bonds.

• Global bond yields have already started rising, a trend which will tarnish the allure of emerging market bonds. German 10-year bund yields moved back into positive territory on 9 September. The US 10-year Treasury yield has risen steadily over the past six weeks from a low of 1.36% in July to over 1.70%.

A resumption of the Fed rate hiking cycle will encourage further increases in bond yields. While the Fed refrained from hiking interest rates at its September policy meeting the probability of a rate hike in December has risen since the policy meeting from 50% to 65%.

With the JSE ALSI 40 index now deriving over 70% of its earnings from offshore, an absence of rand hedge shares in an investment portfolio would put it at considerable risk of underperforming the market benchmark.

• Given the extent to which the rand has closed-in on its theoretical fair value in spite of the near-recessionary economy, looming credit rating downgrade and rising political uncertainty, the current rand strength offers an excellent opportunity to diversify into offshore markets.

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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