Cape Town - The rand has been on a tear over the past week, rallying versus the pound and dollar from R13.63/$ to R13.18 and from R17.63/£ to R16.99.
Overberg Asset Management looks at the factors behind the robust rand in this week's overview of the economic landscape.
- Risk premiums across South African capital markets are narrowing, reflected in not just a stronger currency but also firmer bond yields and tighter credit default spreads. Despite the credit rating downgrade, net foreign inflows into South Africa’s bond markets remain positive to the tune of R2.4bn in the month-to-date and R40.62bn since the start of the year.
- The domestic economy is in the very early stages of a cyclical recovery. The cyclical economic rebound, fuelled by a recovery in mining and agriculture, has taken many by surprise. Mining production surged in the first quarter by 14.7% quarter-on-quarter annualised. The agricultural sector is also expected to rebound strongly.
- Amid rising international commodity prices and strengthening global trade South Africa’s trade balance has improved from a trade deficit of R6.6bn in the third quarter 2016 to a trade surplus of R55.7bn in the fourth quarter. Our current account deficit has narrowed steadily from -5.8% of GDP in 2013 to an impressive -1.7%, its lowest level since the second quarter of 2011.
- Inflation is expected to fall back within the Reserve Bank’s 3% to 6% target range in the next month and stay within this range over the medium-term, paving the way for interest rate cuts. While cautious in the face of political risk and associated rand fallout, the Reserve Bank is likely to embark on a rate cutting cycle following the ANC electoral conference in December.
- Historically, credit rating downgrades are followed by a period of currency strength. This unlikely effect is borne out by evidence among emerging markets such as Brazil, Turkey and Russia, which suffered similar downgrades. The effect on currency and other financial assets tends to be priced in before the event, with a reversal of those moves after the actual downgrade.
- Global appetite for emerging market (EM) assets generally has continued unabated. As one of the more liquid and better developed, South Africa’s financial markets provide easy access to global investors looking for a quick entry into the EM asset class. With key election-risk out of the way following the French polls, global market volatility is expected to remain low, fuelling continued emerging market demand.
- Boosted by positive global financial market dynamics and evidence of a domestic cyclical economic recovery, conjecture over a resolution to South Africa’s political woes, is also supporting the rand. President Zuma’s unwelcome changes to the Cabinet and the National Treasury have escalated the level of political uncertainty. However, there is growing hope that these seismic events will force an early and constructive shift in leadership in the ANC. A change in leadership could provide the catalyst for the structural reforms which are required to lift South Africa’s economy from a mere cyclical upturn to a prolonged secular recovery.
South Africa economic review
• Net foreign selling of South African equities reached R6.6bn in the past week, the highest weekly level since President Zuma’s ill-fated Cabinet reshuffle. By contrast however, foreign investors remained net buyers of bonds to the tune of R2.4bn.
Since the start of the year foreigners have sold a net R41.99bn of equities but bought R40.62bn of bonds. Despite the double credit rating downgrade foreign appetite for South African bonds remains undeterred. The clue may be in the sustained uptrend in global demand for emerging market assets generally and the potential for a cyclical upturn in South Africa’s economy.
• Manufacturing production fell in March by 0.6% month-on-month marking the third successive monthly decline. On a year-on-year basis production gained by a marginal 0.3%, better than the 3.7% contraction in February and the -2.4% consensus forecast.
The improvement is attributed to the “basic iron and steel, non-ferrous metals, metal products and machinery” category which grew 6% on the year, “glass and other non-metallic mineral products” up 10.5% and “motor vehicles, parts, accessories and other transport equipment” with a gain of 5.8%.
Although manufacturing contracted in the first quarter by 3.6% quarter-on-quarter annualised the downtrend appears to be bottoming-out. Manufacturing will exhibit a gradual cyclical upturn over the remainder of the year helped by the strong recovery in mining and agriculture and as improving global demand boosts export oriented industries.
• Mining production grew strongly in March by 3.7% month-on-month, the fourth straight monthly increase, and by 15.5% year-on-year, well above the 4.7% consensus forecast. The recovery was broad-based with 11 of the 12 major categories showing positive month-on-month growth, with building materials the only exception.
The biggest contributors were platinum group metals and iron ore which grew by 30% and 24.4% on the year. Mining production grew in the first quarter (Q1) by 14.7% quarter-on-quarter annualised, making a robust contribution to Q1 GDP growth.
Mining production is expected to maintain its recovery over the course of the year, helped by a synchronised global economic recovery and rising international commodity prices.
• Solid Q1 mining production figures more than compensate for the continued, albeit slowing, contraction in manufacturing production.
Although Q1 retail sales are likely to be disappointing amid weak consumer confidence, agriculture will likely post an additional upside surprise. Based on existing mining and manufacturing data out so far, Q1 GDP growth is likely to show quarter-on-quarter annualised growth of around 1.5% to 2.0% in Q1, a substantial improvement on the -0.3% growth recorded in Q4.
The week ahead
• Retail sales: Due on Wednesday, 17 May. Following negative year-on-year readings for January and February, retail sales are expected to post another contraction in March. Easter fell in March last year versus April this year, creating a high comparative base, while household spending remains constrained by high unemployment, poor credit extension and weak consumer confidence.
• Wholesale trade figures: Due on Thursday, 18 May. Wholesale trade figures have been hampered by poor consumer demand. However, after falling in February by a substantial 8.7% year-on-year, the biggest drop since January 2010, some respite is expected in March.
• The rand is trading in a range between R13.00 and R13.50 to the US dollar. A break below R13.50/$ is required to pave the way for further depreciation to the R14.50 /$ 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.
• Following the announcement of the snap election, the British pound has broken above key resistance at £1.25/$ which has now become a key support level and should promote further near-term currency gains. Recent strong gains have diminished prospects for a £1.18-1.22/$ target.
• 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 has broken back above the key support level of 2.0%, endangering the multi-year bull trend in US bonds.
• The benchmark R186 2025 SA Gilt yield is trading in a tight trading range of 8.5% to 9.0%. A break above 9.0% is required for the yield to move decisively higher towards the 10.5% target level.
• 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.
• Despite failing to hold above the $55 level the Brent crude price is well supported at $50 a barrel. Base metal prices are in a bull trend, confirmed by copper’s increase above key resistance at $5 500 per ton.
• Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1 400/oz target level.
• 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.
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