Rand Risks Remain High as SARB Cuts Rates

new south africaThe South African Reserve Bank meets Thursday and is expected to cut rates 25 bp to 5.5%.  Political risk remains high, as does downgrade risk and so we remain negative on the rand.

POLITICAL OUTLOOK

President Zuma survived the no confidence vote and seems likely to serve out his full term until the 2019 elections.  This is hardly good news for the investment outlook, as this probably means it’s business as usual with regards to policy.  We believe Zuma and Finance Minister Gigaba will continue to pursue expansive fiscal policies ahead of the elections.

Political risk also remains high due to the ANC leadership vote this year.  It’s held every five years and it is scheduled for December 16020 in Johannesburg.  Party delegates will elect the ANC President as well as Deputy President, other senior posts, and 80 members of the National Executive Committee.  The next ANC President will go on to become the nation’s President is the ANC wins the 2019 elections.

The ruling ANC is at the crossroads, having seen its share of the popular vote fall in every election since the end of apartheid.  This includes last year municipal elections, when it won only 54% vs. 62% at the last national election in 2014.  A sub-50% showing in 2019 would be a disaster for the ANC, to state the obvious.  Yet given how toxic Zuma has become, we think markets would welcome an opposition win in 2019.  There is no date in set yet, but national elections have been held in April (1994, 2004, and 2009), May (2014), and June (1999).

The question of succession remains an important one for the longer-term outlook.  Zuma is now fighting for his post-presidency survival.  He needs to make sure that the next leader won’t go after him and put him in jail, and so Zuma is intent on having an ally as his successor.  Will the ANC go with Zuma’s ex-wife, Nkosazana Dlamini-Zuma?  That would signal a triumph of the Zuma wing and a continuation of current ANC policies.  Or does the ANC go with Deputy President Cyril Ramaphosa?  This would signal a triumph of the reformist wing.

Corruption remains an issue for the country.  South Africa scores fairly low in the World Bank’s Ease of Doing Business rankings (74 out of 190 and down from 72 in 2016).  Its best components are protecting minority investors and resolving insolvency, while the worst are trading across borders and starting a business.  South Africa also scores low in Transparency International’s Corruption Perceptions Index (64 out of 176 and tied with Montenegro, Oman, Senegal, and Suriname).

ECONOMIC OUTLOOK

The economy is still sluggish from several past rounds of monetary and fiscal tightening.  Those measures are now being unwound, and GDP growth is forecast by the IMF to accelerate modestly to 1.0% in 2017 from 0.3% in 2016 before picking up to 1.2% in 2018.  GDP rose 1.1% y/y in Q2, stronger than expected but hardly budging from 1.0% in Q1.  Monthly data so far in Q3 suggest some modest slowing, which warns of some downside risks to the growth forecasts.

Price pressures bear watching, as CPI accelerated to 4.8% y/y in August from 4.6% in July.  It’s worth noting that most in EM saw faster inflation in August, but that does not mean the disinflation trend is over.  Inflation remains well within the 3-6% target range.  Also, PPI inflation continues to fall.  At 3.6% y/y in July, it’s the lowest since September 2015 and suggests little in the way of pipeline price pressures.

This supports the case for lower rates, and we believe SARB will cut 25 bp again to 5.5% when it meets Thursday.  The bank started the easing cycle with a 25 bp cut at its last meeting in July, and we see no reason why it should pause now.  The rand is about 3% weaker since that last cut, but it remains firmer than it was a year ago.  We also expect a 25 bp cut at the November meeting, and we believe that lower rates will continue to erode the rand’s attractiveness.

Fiscal policy has deteriorated.  Revenues remain sluggish, but expenditures have risen sharply in the last two months.  At his last budget presentation in February, Gordhan targeted a budget deficit of -ZAR149 bln (-3.1% of GDP) for FY2017/18.  The 12-month total was -ZAR196 bln in July and growing, and so Gigaba would do well to announce some tightening measures in his mid-term speech next month.  However, we expect to be underwhelmed.

The external accounts are worsening.  Low commodity prices have hurt exports, but the sluggish economy have helped reduce imports.  As a result, the current account deficit was only -1.7% of GDP in 2016.  It is expected by the IMF to widen to -3.4% in 2017 and -3.6% in 2018.  However, the gap will likely be covered largely by so-called hot money, as FDI inflows remain weak.

Foreign reserves remain steady.  At $47 bln in August, they cover nearly 5 months of import but barely cover the stock of short-term external debt.  This is another sign of the nation’s external vulnerability.

INVESTMENT OUTLOOK

The rand is underperforming after a stellar 2016.  In 2016, ZAR rose 13% vs. USD and was behind only the best performers BRL (22%) and RUB (20%).  So far in 2017, ZAR is up 3.6% YTD and is ahead of only the worst EM performers COP (3.5%), PEN (3.4%), IDR (+1.4%), TRY (+1.3%), PHP (-2.5%), and ARS (-7%).  Our EM FX model shows the rand to have WEAK fundamentals, and so this year’s underperformance is likely to continue.

Since April, USD/ZAR has traded for the most part in the 12.50-13.50 range.  Now, the pair is poised to test the August high near 13.5365 and the July high near 13.6280.  After that, the April high near 13.96 comes into focus.  Again, we think further SARB easing will weigh on the rand, as relatively high carry is the only thing supporting the currency.

South African equities are underperforming EM for another year.  In 2016, MSCI South Africa rose 1% vs. 7% for MSCI EM.  So far this year, MSCI South Africa is up 10% YTD and compares to 29.6% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has South Africa at a VERY UNDERWEIGHT position.

South African bonds have outperformed this year.  The yield on 10-year local currency government bonds is about -52 bp YTD.  This is compares to the best performers Brazil (-167 bp), Indonesia (-147 bp), Peru (-109 bp), Russia (-81 bp), and Mexico (-59 bp).  With inflation likely to remain low and the central bank likely to ease further, we think South African bonds can continue outperforming.

However, the big danger to bonds comes from the ratings side.  South Africa’s inclusion in Citibank’s World Government Bond Index (WGBI) hinges on retaining investment grade local currency ratings from both S&P and Moody’s.  Moody’s has a Baa3 rating on both its local and foreign currency ratings, while S&P has a BB+ foreign currency rating along with a BBB- local currency rating.

According to Bloomberg, both S&P and Moody’s are scheduled to issue ratings decisions on November 24.  We have always believed that local and foreign currency ratings should be equal.  Our own sovereign ratings model showed South Africa’s implied rating steady at BB/Ba2/BB this quarter, which supports our view that at least one of these two agencies will cut South Africa again.  If so, it would be ejected from WGBI and this would likely lead to some forced selling.