Markets are all about the mighty US dollar at the moment – weakness rather than strength is the hope for the SA economy. But rand strength could follow the right SA responses to our impaired credit rating
The markets this year have been most concerned about the danger of the Fed raising interest rates as US growth prospects were deteriorating. A strong US dollar, in such circumstances, posed a particular threat to emerging market currency, bond and equity markets. The presumed greater risk of a global recession was increasingly reflected by significantly lower commodity prices and the shares of the companies that produce them. Emerging market equities, bonds and currencies markets all revealed these increasingly risk averse sentiments.
The highly correlated and not co-incidental weakness in commodity and emerging markets continued until the last week in January as we show below. The Commodity Research Bureau Index (CRB) shown below includes about a 27% weighting in oil. A further figure compares the prices of particular metals to the emerging market (EM) equity index (MSCI EM). Price weakness until late January 2016 and a recovery since is revealed in the figures below.
The previously strong US dollar however weakened this week, as the danger of higher interest rates in the US faded away. Dovish interest rate comments by the Chairman of the New York Fed led the dollar lower. It was a spark that lit up the shares of the mining companies. The shares of leading mining companies listed on the JSE responded dramatically to a weaker US dollar. As at Friday afternoon 5 January, Anglo leads the pack and is up about 36% since the Monday close on 1 February.
The rand and the JSE as a whole responded as it usually does to the global forces that move EM markets. SA had earlier revealed particular dangers to its policy settings that led to a significantly weaker rand and higher risk spreads, compared to its EM peers. But these SA-specific risks were a December event, though the EM influence is apparent throughout the extended December to February period with a degree of extra SA risk revealed in December.
The striking impact of the stronger rand on the long end of the RSA bond market is shown below. The rand – as influenced by global forces, as it usually does – overwhelmed the impact of higher short term rates on the bond and equity markets, as imposed by the MPC of the Reserve Bank on Thursday 28 January.
In the figure below we compare alternative measures of SA risk that reveal a very similar pattern of SA risk aversion. The difference between RSA and USA bond yields compensates investors for the expected weakness of the USD/ZAR exchange rate. This risk premium jumped up sharply on 10 December 2015 when Finance Minister Nene lost his job. The risk premium has since declined, helped by the stronger rand and lower interest rates since. Yet the SA risks priced into the markets remain highly elevated as is shown by the wider five year CDS spread, both absolutely and relative to the spread on equivalent Turkish dollar-denominated debt. This spread, equivalent to the difference between the running yield on RSA US dollar denominated debt and its US equivalent, represents the cost of insuring against RSA debt default.
The SA economy is growing very slowly. The decision by the Reserve Bank to further increase its repo rate will add to the contractionary pressures acting on the economy. Fiscal austerity seems very likely to be introduced in the 2016-17 Budget to be presented later this month. The hope must be that the painful demonstration of fiscal conservatism will lower the risk premium attached to SA debt and equities, so attracting more capital to SA and so add to the value of the rand.
Only a stronger rand, bringing lower than expected inflation and lower interest rates, can reverse the cyclical direction of the economy. A weaker dollar and stronger flows into EMs will be a great help to the rand. But it will take more than a credible commitment to fiscal conservatism to reduce the SA-specific risks holding back the rand and the economy. A recognition by the government that the partial privatisation of underperforming state-owned enterprises would improve the performance of the economy and the quality of the RSA balance sheet, is essential to reducing the risk premium added to the returns of investments in SA.