The past week or two of exceptional market volatility was not so much a case of China sneezing and the world catching cold – but the sense that China may have little idea of how to cope with a cold. Its feverish interventions in the Shanghai stock market and perhaps also the currency market did not make a good impression. Surely the advice – starve a fever but feed a cold – holds everywhere.
Clearly there is much room for further slips before China becomes more of a fully market and service-driven economy – policy errors that will continue to complicate the calculation of market values in and outside of the Middle Kingdom. Fortunately, the US economy, despite some doubts about possible China contagion, remains well set on its recovery path. A major upward revision of US Q2 GDP growth rates released yesterday would have served as a helpful vapor rub for unnecessarily troubled breasts.
It remains for the Fed to get its long heralded first interest rate hike out of the way – to help confirm that the US economy has normalised, even when accompanied by below normal inflation rates. Our sense is that the markets will be reassured rather than troubled buy a 25bp increase in the Federal Funds rate, while giving the Fed ample time to consider its next move on the path to normality.
It is emerging market (EM) equities that have lagged far behind the progress made in developed equity markets since 2011. They have most to gain from a US recovery that can be expected to promote faster growth everywhere. EM equities and currencies, South Africa naturally included, lost relatively most in the recent turmoil. It is encouraging to observe that EM equities (priced in US dollars) have recovered as much as (or more) than the US market in recent days.
Also coming back with the recovery in equity markets was the volatility indicator for the S&P 500 (the VIX) and the risk premium for SA and the rand – indicated by the spread between RSA and US bond yields. There is clearly scope for further declines in these risk indicators and if they do decline to anything like normal levels, we will see further strength in the S&P 500 – and also in the rand.
What also may have been noticed in all the turbulence and rand weakness was that there was only one place to hide in the equity markets from rand weakness – in gold shares. In other words, there were no rand hedges, other than the gold shares. The rand value of even the most globally exposed counters, the global consumer plays and their like, declined with the cost of a US dollar.
There is an important difference between equities that can be regarded as rand hedges (rand values that rise with rand weakness\) and SA economy hedges. When the rand weakens for global reasons the dollar and the rand value of most equities and bonds will decline, as recent trends confirm. Hence there are no rand hedges outside the gold mines when the global risk outlook deteriorates. When the rand declines for South African specific reasons – those companies on the JSE with a largely global footprint – will see the US dollar value of their activities largely unaffected; hence rand weakness for SA reasons can then translate into higher rand values.
Gold is different. Its price and the value of gold mines, in US dollars, tends to rise in troubled times. Hence the extreme behaviour of JSE-listed gold mines in August. Between 17 August and 24 August, the JSE mold miners gained 27.8%. This was while the USD/ZAR exchange rate moved from R12.90 to R13.21 – down some 2.3%. Over the same few days of rand weakness the All Share Index went from 50751 to 47631, a decline of 6.3%. Over the next three days the Gold Mine Index gave up 19.25% of its rand value at the close on the 24 August as the All Share Index added 3.1% and the rand stabilised.
Clearly, SA gold shares can protect portfolios meaningfully against global risk aversion, even though they have proved to be a very expensive form of portfolio insurance over the longer run. The SA gold mines have suffered from not only higher costs of production and declining grades of ore mined, they have also proved vulnerable to SA events (strikes and the like) that limit production. Investors in SA mines should wish for a weaker rand in response to additional global risk aversion, unaccompanied by greater SA risks to their production.
South African shareholders should therefore wish for rand strength – not for rand weakness – unless they have an unhealthy weight in gold shares. But they should wish even more for rand strength that might follow a reduction in SA specific risks. If perceptions of SA risk, currently reflected in a high discount rate used to value company profits realised from SA activities, were to decline in response to better economic governance, the US dollar value of the rand would rise and the rand and the US dollar value of SA securities would rise. And most important, SA would be able to attract more foreign capital of all kinds on improved terms to help realise faster growth.