By: Andrea Cohen
This time we would like to examine the South African Rand for a directional trade idea. In recent months we see developments, both economic and political, that lead us to conclude that the ZAR is vulnerable at the moment and that a long USD-ZAR position should be considered.
The first thing we always look at when examining an economy is its interest rate policy. The rate in South Africa is determined by the South African Reserve Bank (SARB) and specifically, its Monetary Policy committee (MPC). The MPC convenes to discuss monetary policy which is mainly targeted at inflation. The SARB has an inflation target (3%-6%) and at the moment, inflation is very closer to the upper limit of that range.
The problem is that the MPC can’t use the rate as a weapon to fight inflation because higher rates depress economic activity. With domestic growth in South Africa in poor shape and outlook bleak, we don’t see a scenario in which the MPC will increase rates in the next year or so. Consensus is that GDP growth will remain subdued at below 3%, which is really an unimpressive rate for an emerging market.
It is important to understand that much of the change in the value of ZAR stems from demand for the currency for the purpose of buying local securities. Foreign investors’ appetite for South African bonds is, to a large extent, a function of other options they have. As rates in more established markets, namely in the US, are starting to go up, money will flow out of emerging markets in general and from South Africa in particular and back to safer American bonds. South Africa is less attractive now since, as discussed above, rates in South Africa are unlikely to go up anytime soon. Selloff of local securities and foreign investors converting proceeds into USD will negatively affect the ZAR. This sits well with chatter we hear on the street about EM portfolio managers reducing exposure to South Africa.
Another big theme for the ZAR is Gold. Within less than 5 months, Gold has fallen from close to $1,800 to below $1,600, or more than 11%. Gold (and other precious metals for that matter, re extremely important for the South African economy. Coupled with strikes and bloody union struggles that have occurred in the last year, this industry is hurting and that has huge consequences for the country. The general opinion on the street is that Gold is about to experience another drop in price. Some say to as low as $1,400. Although we don’t share the pessimism, we do agree that the risk in another drop in Gold is imminent and real. The effect on South Africa is dual: first, lower income from natural resources quickly translates to layoffs and political unrest. We have already seen young political players (such as Julius Malema) trying to leverage the labor struggles for political gain, and as unrest is brewing underneath the surface, there is no telling where an outburst will lead. Second is a more direct effect on the revenue column for the government. A quarter of South Africa’s exports are from metals and much of the tax revenue comes from mining corporations. Lower revenue means higher debt, which weakens the country and makes the ZAR even less attractive.
Reliance on precious metals, whose prices are erratic and lately dropping, sluggish growth, higher-than-expected inflation and shift in investment trend are the main reasons we predict a weakness in ZAR.
On a more opportunistic note, on Wednesday (February 27th), South African Finance Minister Gordhan will make a statement regarding the budget. In case Gordhan implies that growth will come in closer to the street’s expectations (rather to what the government had predicted back in October), then we can see a negative reaction in ZAR. In addition other economic data is due to be published this week (Trade Balance, GDP, Money Supply and Private Sector Credit), so there is a bunch or opportunities to be disappointed…
We suggest examining a medium-term long USD-ZAR position to capitalize on what we think will be an upcoming weakness in ZAR. Although USD-ZAR is on an up-trend lately, we think there is still room for it to go up.