Although local political events do affect the rand, as we have seen recently, it’s the global factors that have a longer-term influence.
Amid much fanfare, the rand broke through to R12 to the US dollar for the first time since May 2015. At first glance it appears to be a continuation of the “Ramaphosa rally” as investors price in improved prospects for economic reform, policy certainty and corruption fighting. However, as is mostly the case, the global backdrop is crucial. After all, the rand has strengthened 4% against the US dollar this year, but is flat against the euro and weaker against the pound. In other words, this is a weak dollar story, though the new positive sentiment towards South Africa certainly helps. Other emerging markets have also seen their currencies rally against the dollar.
Rand versus major currencies
*Rebased to 100
Greenback back to earth
The dollar surged from 2011, as the US economy grew much faster than its peers and markets anticipated interest rates rising from near-zero levels. The first of these hikes by the US Federal Reserve came in December 2015. This was a few days after markets and politics collided forcefully in South Africa when finance minister Nene was fired out of the blue, at the worst possible time in terms of global risk appetite. But since the Fed has started hiking (with five in total, taking the funds rate to 1.50%) the dollar has declined, apart from a brief spike following the election of Donald Trump as US president. The sell-off has accelerated since the start of the year.
Why is the dollar sinking, given that a country with strong economic growth and rising interest rates normally sees its currency appreciate? Moreover, the other central banks – the European Central Bank (ECB) and the Bank of Japan – still have an extremely accommodative policy stance with negative interest rates, which both reiterated last week. The Bank of Japan last week held steady on interest rates (-0.1%) and its policy of buying bonds to keep the 10-year government bond yield close to 0%.
The ECB kept interest rates on hold and its bond-buying programme will remain in place until at least September with the aim of getting Eurozone inflation higher. A strong euro – it hit $1.25 for the first time since December 2014 – works against the ECB’s aims by putting downward pressure on inflation and hurting the revenues from the Eurozone export machine.
The explanation probably lies in the fact that it is expectations that mostly drive currency markets, not necessarily current interest rate differentials (which are still massively in favour of the dollar). The market priced in higher US rates long before they arrived (starting in 2011 already). In other words, even though the ECB and Bank of Japan are currently accommodative, their next move is expected to be a tightening of monetary policy.
It also doesn’t help that there is an element of dysfunction in US politics, as last week’s brief government shutdown showed. In contrast, when the dollar was surging, the dysfunction was in Europe (which was struggling to cobble together a solution to the Greece crisis) and places like Brazil. Last week Trump’s Treasury Secretary Steven Mnuchin said that a weak dollar would be good for America to close its trade deficit (he is not wrong, but his predecessors usually held the line that a strong dollar was nevertheless preferable). But he was quickly contradicted by his boss.
Finally, global investor risk appetite is high, as surging equity markets illustrate. When investors are fearful, they tend to look for safety in the US (the dollar surged during the global financial crisis). However, when fear recedes, they look for opportunities outside the US. There is an element of feedback, since a weak dollar is also beneficial to the giant multinationals listed in New York.
Can the dollar weakness (and hence rand strength) persist? From a valuation point of view, the trade-weighted dollar is still above its long-term average and therefore still has room to decline. Bullish investor sentiment towards emerging markets is another support for the local currency. If new leadership in government can follow through with some quick-win reforms, the rand could hold its own. It is probably not overvalued against the dollar yet, and has a history of overshooting on the up (as it did on the way down).
Trade-weighted US dollar index
Improved inflation outlook
What does the stronger rand mean for South Africa? For one thing, it lowers the cost of imported items priced in dollars (less so for items priced in euro, see chart 2). Therefore, it softens the blow of the higher oil price. After December’s petrol price jump, January saw a cut and February is on track for another reduction based on the current average over-recovery of 30 cents per litre.
Consumer inflation in December rose slightly to 4.7% due to the petrol price hike. December petrol inflation was 14%, but should decline in the coming months. Food inflation declined to 4.8%, while it was running as high as 11% at the start of the year. This is particularly helpful for poor households, which spend most of their income on food. The inflation rate for the poorest 10% of the population declined to 1.6%. Wealthier households spend the largest part of their incomes on services. The inflation rate for the highest earning 10% was 4.9% in December. Insurance (including medical aid, short-term and life cover) is a big driver of overall inflation. It has a 10% weight in the CPI basket and increased by 8% year-on-year. The biggest item in the basket – actual and implied rent – saw lower inflation rates in December, indicative of a weak housing market.
Core inflation – excluding volatile food and fuel prices – fell to 4.2%, the lowest level since December 2011. The evidence of the strengthening rand since early 2016 is visible in low inflation rates for clothing, household appliances and new vehicles.
Producer inflation ticked up to 5.2% due to higher petroleum prices. Producer inflation was only 3.9%, excluding petroleum products, showing that there is limited upward pressure in the inflation pipeline.
This means that the Reserve Bank could cut rates once or twice, once the risk of the February Budget and Moody’s subsequent ratings decision has passed. If the Budget delivers tax hikes as expected, it strengthens the case for the Reserve Bank to lower interest rates to ease the pressure on consumers. However, the Reserve Bank’s insistence on maintaining relatively high real interest rates (around 2%) means deep cuts are unlikely. It is also increasingly focused on getting inflation to the mid-point of the 3% to 6% target range, rather than just below the upper-end.
South African inflation
A stronger rand is obviously negative for export earnings. Every dollar earned abroad is now worth less. Fortunately, the prices of commodities – accounting for about half of export revenues – have been relatively buoyant, reaching new cycle highs.
Portfolio impact of the rand movements
The stronger rand is clearly good for interest rate-sensitive assets, and bonds have rallied 2.2% this month already. However, longer-dated bond yields are still attractively high, above the average of the past decade and well above inflation, offering prospects for decent real returns.
The impact on equities and property is likely to be mixed. At an index level, a strong rand is negative as the main indices (All Share, SWIX, Top 40) are dominated by rand hedges. But the rand is obviously not the only factor driving the local equity market. The prices of the big non-resource rand hedges on the JSE will take their cue from global equity markets, while mining companies will be influenced by commodity prices. Domestically-focused shares should benefit from the improved interest rate outlook as well as the moderate economic recovery.
At an index level, listed property on the JSE has seen a substantially increased exposure to offshore earnings over ten years, from virtually nothing to 40% (mostly in Europe). Three of the largest offshore property companies (soon to be two, after a merger between Intu and Hammerson) on the JSE are not in the benchmark index. They are, however, in the investible universe of property fund managers and therefore most likely in many investors’ portfolios. This pushes the total offshore exposure to beyond 50%. Listed property had a torrid start to the year as the Resilient stable of companies came under pressure.
Currency appreciation will reduce the rand value of dollar assets, such as the 25% offshore exposure most balanced funds hold. But the dollar values of these assets are still increasing and the rand will one day depreciate again, we just don’t know when. Therefore, now as ever, investors need to be patient. In the same way that overreacting when the rand crashed was a bad idea, they need to avoid a knee-jerk response to the currency’s newfound strength. It is important to remember that local political developments cause short-term moves in the rand, while global factors will shape its longer-term trajectory.
Source: Moneyweb report by Dave Mohr and Izak Odendaal at Old Mutual Multi-Managers.