Reading the markets – a spring update

September 5th, 2017 by Brian Kantor

These are very good times for emerging market (EM) equities and currencies. The MSCI EM equity index continues to power ahead and has gained over 25% this year. This may be compared to a gain of about 10% for the S&P 500 and the average European equity. The JSE All Share Index has also had a good year and is up by about 16% in US dollars (see figure 1).

A degree of perspective on these recently favourable equity trends is called for. As we show in figure 2 this EM outperformance has come after years of underperformance between 2011 and 2016, as is shown in figure 2. The EM comeback is still very much a partial one that dates from the first quarter of last year. Perhaps some encouragement can be taken from this perspective.

The EM equity comeback (measured in US dollars) can be attributed partly to a weaker US dollar and stronger EM exchange rates. In figure 3 below, we compare the performance of the US dollar vs other developed market exchange rates – mostly vs the euro. The US dollar has weakened significantly since January 2017, by about 8% according to the trade weighted (DXY) index, while the index of EM currencies vs the US dollar has shown a similar degree of strength. The EM Currency Index calculated by JP Morgan (JPMEMX) includes a small weight in the rand. The rand/US dollar exchange rate has performed in line with the average EM exchange rate. Note higher numbers in these figures indicate a more favourabe rate of exchange.

This strongly negative correlation between US dollar weakness vs its peers and EM currency strength vs the US dollar is of long standing, as we show in figure 4 below. The correlation coefficient is of the order of a negative (-0.83) using daily data.

Thus much of the recent strength in EM currencies, including the rand, reflects US dollar weakness vs its peers. As we will demonstrate further below, the recent strength of the rand is much more a tale of the US economy vs its developed market peers than of political and economic developments in SA. The rand has performed very much in line with its own EM peers against the USD,

EM economies and their equity and currency markets have clearly benefitted from a recovery in metal and commodity prices that are dependent on global demands. The global economy has grown faster and in a highly synchronised way in recent months. This news about the state of the global economy has become more encouraging for metal producers. The underperformance of EM currencies and equities since 2011 and their recent recovery is closely associated with the recovery in metal prices, as we show in figure 5 below. Metal prices bottomed out in mid-2016 and have enjoyed a strong move higher since mid-2017, as we show in figure 6.

As with the recovery in EM equity markets, the recovery in metal prices should also be understood as a still partial recovery from the heights of the super-cycle and one that has come after an extended period of lower prices.

The strength in the rand and in metal prices bodes well for the SA economy. It implies more valuable exports and more importantly raises the prospects of lower interest rates – essential if the economy is to enjoy something of a cyclical recovery. The market place appears to have recognised some of the better news about the global economy. The RSA sovereign risk spreads have receded, as we show in figures 8 and 9. The yield on RSA five year dollar denominated debt has fallen sharply from the yields and spreads demanded when President Zuma first intervened in the SA Treasury in December 2015. The cost of issuing RSA dollar-denominated debt has fallen significantly, despite the downgrading of the debt rating agencies.

What has not changed much in recent months has been the spread between rand-denominated RSA bond yields and their US equivalents. For 10 year bonds, the yield spread remains well over 6% p.a. indicating that the rand, despite its recent strength, is still expected to lose its USD exchange value at an average rate of more than 6%. Consistent with this view of persistent rand weakness, is that inflation compensation in the bond market, calculated as the difference between a 10 year vanilla bond yield and its inflation protected equivalent, also remains well above 6%. Inflation expectations or the outlook for the rand have not (yet) responded to the strength of the rand. 5 September 2017