US momentum hurts undervalued Rand; expect a rally soon – Jammine

JOHANNESBURG — The movement of the South African Rand is a lot like the cork floating in the ocean. As much as the cork has intrinsic value to someone, it’s direction is largely determined by the circumstances around it. It’s the same analogy as when America sneezes the rest of the world catches a cold, sometimes it’s just out of your hands. And the analysis from respected economist Azar Jammine paints such a picture, as certain data points to a stronger Dollar while the Rand and other emerging market currencies sell off. The one bright spot; he agrees with President Cyril Ramaphosa in that the Rand is undervalued, and would not be surprised to see the currency rally over the next few months. – Stuart Lowman 

By Azar Jammine*

Key points:
  • The Rand has suddenly lost about 4% of its value vis-à-vis the Dollar in the past few days on the back of data suggesting that the US economy, far from slowing, is gathering further momentum. In turn, this is generating fears of a faster pace of US interest rate increases.
  • The rise in the US 10-year Treasury bond yield to over 3.2% has taken this key bond interest rate to its highest level in seven years, attracting funds into the Dollar away from other currencies.
  • In the case of the Rand, it has also been bracketed in the same category as the Argentinian Peso and Turkish Lira, as well as many other Asian currencies, whose economies are seen to be vulnerable to large current account deficits on account of their dependence on imported oil at a time when oil prices are surging.
  • Despite the recent sell-off in the Rand on the back of the above-mentioned factors, there are those who believe that emerging market assets and bonds are offering attractive returns. Over and above this, one must bear in mind that the US budget and current account deficits are extremely high relative to those of Europe and several other economies. Furthermore, there is no guarantee that oil prices will continue surging ahead. On the contrary, there are reasons for believing they could fall back significantly in due course. Consequently, one should not expect the Rand to continue weakening other than possibly in the very short term.
  • We continue to believe that the South African currency may well rally to between R13.50 and R14.00 in coming months.  Even at this level, some will see it as undervalued.
Strong US data sparked fears of higher US rates, causing Dollar to soar

The past few days have seen the Rand retracing around 4% of its gains against the US Dollar seen in preceding weeks, with the currency depreciating from highs close to R14.00, to levels around R14.85 at present. However, one needs to acknowledge upfront that most of the reason for this depreciation relates to renewed strength in the US Dollar once again; the Rand’s depreciation has been somewhat greater than that of most other currencies, especially those of emerging markets, but by no means has it been in isolation.

A collection of mixed denomination South African rand banknotes sit in an arranged photo in Johannesburg. Photographer: Waldo Swiegers/Bloomberg

The South African currency clearly is being used once again as a proxy for emerging market currencies and for the desire of international investors to exit these currencies in order to reinvest those funds into US Dollar assets which are increasingly being seen to be offering more attractive returns as prospects for US interest rate hikes increase. The past few days have seen the release of a host of real economic data suggesting that the US economy, far from losing momentum, is gathering still more strength on the back of the corporate tax cuts announced last year by President Trump.

Firstly, the US Institute of Supply Management (ISM) data on the services sector in the world’s largest economy, showed an increase in this index to 61.0 in September, from 58.5 in August, when an outcome of 58.0 had been anticipated. This suggests that the services sector in the US is pumping strongly. Secondly, on the manufacturing side, US factory orders rose by 2.3% m-o-m in August, the largest improvement in 11 months.

Furthermore, the figures for July were revised to show a decline of just -0.5% m-o-m, less than the original -0.8% figure reported. More importantly, in the first eight months of this year, factory orders are up 8.6% on the same period of 2017.

Thirdly, US private sector employment increased by 230,000 jobs in September, well ahead of market expectations for a 185,000 increase. This suggests that the overall non-farm payrolls data (due to be published later today) are also going to be better than anticipated.

The conclusion drawn by the markets of these data, coming on the back of an upwardly revised 4.2% GDP growth rate for the 2nd qtr in the US, which is actually higher than the 3.9% unemployment rate, is that the US Federal Reserve Board may well increase US interest rates by more than had been anticipated over the next 15 months.

Many are now starting to factor in the possibility that US interest rates may well increase not only in December this year but four more times during the course of 2019. In response to this expectation, US long-term interest rates have soared to their highest levels in seven years, with the 10-year Treasury bond now trading at over 3.2%. It is therefore starting to become increasingly attractive for investors to deposit their funds into such bonds and not to endure the risks associated with investment in other assets or even bonds of other countries.

Emerging Market currencies also depressed by surging oil prices

In respect of emerging market currencies specifically, there is an additional reason why some of them have lost so much ground in recent days. The surge in international oil prices to their highest levels in more than four years and to levels well in excess of most expectations, has contributed to anxiety regarding the potential increase in the current account deficits of countries who are dependent on importing crude oil. Included in this category are the three currencies which have been most vulnerable to sell-off in recent months at times when risk aversion towards emerging markets has increased, viz. the Argentinian Peso, Turkish Lira and South African Rand.

This time round Asian currencies have also softened given the dependence of most of these economies on imported crude oil.

However, some beginning to find Emerging Market assets relatively attractive

The key question arising from these developments is how far the sell-off in emerging market currencies will continue. In this regard it is interesting to note that some key finance houses are beginning to view the opportunities available in capitalising on cheap emerging market assets as being quite attractive.

For example, there are some leading houses that suggest that one could get a return of 15% by investing in emerging market bonds over the coming year, through a combination of both currency appreciation and high yield. These views also don’t incorporate the possibility that the potential gains in the Dollar might be limited bearing in mind that the US is running a current account deficit of -$465bn as well as a large budget deficit approaching 5% of GDP.

Under the circumstances, we believe it is misleading to expect the Rand to continue losing ground on a sustained basis from current levels. At these levels the Rand is arguably around 10% to 15% below the average level at which it has traded in real terms over the past two decades. Admittedly, there are important reasons why one could argue that the currency deserves to be cheap, including the fact that economic growth is extremely weak, policy uncertainty is likely to continue until general elections are out of the way next year and credit ratings agencies could still downgrade credit ratings further.

We would not be surprised to see the Rand rallying at some stage in the next few months to levels below R14.00 and to average an exchange rate of between R14.00 and R14.50 over the coming year. Even at these levels, many would see the currency has been “undervalued”. For what it is worth, President Cyril Ramaphosa suggested this was the case earlier this week.

  • Azar Jammine is the chief economist at Econometrix.