Of Cyril, Emerging Markets and the Carry Trade
The South African Economic Climate in Context
From early December when Mr Ramaphosa became President, The markets as measured by the Alsi40 had a strong run from 50953 (on 14 December 2018) to 54576 (on 24 Jan 2018). This was the optimistic and euphoric 7% run that followed the ousting of Mr Zuma now referred to as Ramaphoria by the popular press. However, this was quickly followed by Ramaphobia when the market closed at 49544 on 12 February 2018, a drop of almost 10%.
The swing from Ramaphoria to Ramaphobia was extreme, but the market quickly realized that it is impossible to expect 10 years of economic mismanagement to be turned around in a few months. But there are other factors at play here.
Here at home the political, economic, state capture and emotional temperature fluctuates with wide swings daily, caused by several factors. The announcement of a recession should not have come as a surprise. Declines in employment, business confidence, agricultural and manufacturing output and industrial production, as well as falling retail and vehicle sales over the last few quarters, was a clear indication that all was not well.
South Africa’s economy is hamstrung by structural problems, the burden of inefficient SOEs [state-owned enterprises] and a lack of foreign direct investment. None of this is new, and none of this changed just with the changing of the ANC president.
Emerging Markets and the Carry Trade
Both internal and external factors affect the value of our currency. What is and has been happening during the last months has more to do with external factors than internal ones. The fall in the value of the rand was predictable from as far back as January. The expansionary monetary policy followed by the US, European and Japanese central banks over the last decade has resulted in excess liquidity in those and in world money-, capital- and equity markets. But now that the quantitative easing is over, this excess liquidity is receding, and as it does it reveals the misallocation of capital and the mispricing of risk.
Or in ordinary parlance – what used to be cheap money allocated to assets in emerging economies are flowing back to where they were borrowed from. Bond managers and traders all over the world would refer to this as “the unwinding of a carry trade”.
We are midst an economic process where the fundamentals of emerging markets drift back to close to where they were in 2009/10. Even though their sovereign credit ratings reflected higher levels of risk, investors continued to pour money into these markets. The chart below shows that between 2008 and 2016 capital flows moved in lockstep with investment ratings. In 2016 this trend diverged with negative ratings no longer serving to slow or stop the inflows of capital into emerging economies.
With zero or negative interest rates in developed markets, returns were hard to find. The result was that international investors followed the opportunities into markets with higher returns – such as South Africa, Brazil, Turkey and emerging markets in general.
SA is a very good example. During the worst years of the Zuma presidency (2015 – 2017), the rand strengthened from R15 to R11 against the dollar. This had nothing to do with improving SA fundamentals, but everything to do with capital inflows. During this period of zero interest rates in the developed world, investors placed less emphasis on the underlying fundamentals of the emerging markets and much more on the returns that those destinations could generate.
But now, as the tide of excess liquidity recedes, many emerging markets have found themselves exposed, and they are feeling the pain of this “misallocation” of credit. If the US Federal Reserve slows their interest rates hikes the dollar will stabilise and this will slow the unwinding of the investments in the emerging markets. But they have no reason to do so because their economy is doing so well.
The Argentinian peso and Turkish lira have both been in free fall, losing half their value during 2018. Indonesia’s rupiah fell to its weakest level since the 1998 Asian financial crisis, and the Indian and Sri Lankan rupee dropped to all-time lows.
If the dollar remains the reserve currency and most of the foreign-owned debt is denominated in US dollars (USD), the dollar will remain king. A weaker USD is associated with a stable and healthy global environment where the global supply of USDs is abundant. A stronger USD is usually associated with volatility and a risk-off phase as liquidity contracts. In this process capital is extracted from emerging economies.
South Africa, possibly more than any other emerging market, feels the pain of this process first hand. The ZAR is a very liquid currency. The volume of ZAR that trades daily is 20% of GDP – that is enormous for a small economy that is less than a percent of global trade. As a result of its tradability, the rand has become the proxy currency for all emerging market currencies.
The end of quantitative easing is not the only factor dragging emerging currencies lower against the dollar. Escalating trade tensions are also fuelling the problem. When broad tariffs on steel and aluminium were first imposed by the US in March, it was considered as a cold war that would soon be resolved after some negotiations. But there are no signs of this trade war ending and we are expecting now that the US will impose an additional $200 billion on Chinese imports, potentially soon. This will not only harm the two largest economies but would severely disrupt global economic growth and supply chains, particularly in emerging markets which may see their currencies fall further in the weeks ahead.
Emerging Markets and Other Factors
This year’s global emerging-market selloff has its roots in a slew of mini-routs as the era of easy-money came to an end. Consider Turkey, now paying the price for its refusal to follow orthodox monetary policy; Argentina, facing a crisis of confidence just four years after its last default; China, targeted in a trade war; and South Africa, the emerging-market proxy punished for crisis in any corner of the asset class.
We present a brief précis of what is behind declines in markets most vulnerable in the current geopolitical and monetary environment.
South America’s No. 2 economy has a benchmark interest rate of 60% and inflation tops 31%. The real policy rate now ranks among the world’s highest and is pushing the economy back into recession. Economic activity fell 6.7% in June. New taxes announced this week to restore a balanced budget would only compound the suffering.
Argentina is targeting a primary budget surplus by 2020 to ease its demand for foreign financing and prop up the peso, which slumped more than 50% this year. Whether those economically sound and highly unpopular policies can survive the next few years remain to be seen. National elections are scheduled for just 13 months from now.
Brazil’s key weakness lies in fiscal shortfalls thanks to anemic economic growth. While the public sector’s primary budget balance, a measure of fiscal health before interest payments, now stands at a 1.1% deficit of gross domestic product compared with 3% at the worst point of 2016, it still compares unfavourably with an average 2.9% surplus between 2000 and 2014. Further complicating things is October’s wide-open presidential election. Its proximity and close trade links to Argentina mean contagion could also weigh on sentiment.
Donald Trump’s trade war could not have been more poorly timed for the world’s second-largest economy. China’s current account surplus has plunged to near zero and is threatening to tip into a deficit. The yuan’s real effective exchange rate against a basket of trading partners is hovering near a record high, signalling the currency may have room to depreciate.
The twin pressures pose a challenge to China’s efforts to keep yuan volatility to a minimum and may also undermine a core economic objective: Gaining an enhanced role for the yuan as a means of international payments. The currency’s share in global transactions has fallen to just 1.8% from 2.8% three years ago. Shanghai stocks have underperformed emerging-market peers in 10 of the past 12 quarters and trade near the lowest valuations in four years.
All that said, a historically low policy rate means Brazil has plenty of room to tighten monetary policy and fend off speculative attacks on the real, the third-worst emerging-market currency this year.
Annual expansion above 7% and a relative isolation from global economic and trade headwinds make India a consensus “buy” among emerging-market investors. Oil remains the chief vulnerability: India imports 70% of its energy needs and crude-price fluctuations have taken its current-account deficit to almost 2% of GDP.
Prime Minister Narendra Modi is seeking re-election in just eight months. Victories for the opposition Congress party in recent state and local elections have shown that his support may be slipping. Even though India’s major parties all agree on the direction of economic reform, a hung parliament could result in policy paralysis.
While the rupiah lost about 9% this year, a pittance compared with Turkey and Argentina, the Indonesian currency is now the weakest since the 1998 Asian financial crisis. Repeated rate hikes and forex interventions by Bank Indonesia have failed to stem the depreciation.
While monetary tightening, as well as the delay of major investment projects to save foreign-exchange reserves will slow growth, the risk of outright recession is less than in many other countries because the economy has expanded at a clip of about 5% since 2014. Subdued inflation may also alleviate concern of the price pass-through of a weaker currency.
Africa’s most industrialized economy is already in recession, driven by a slump in agricultural output. In addition, South Africa has one of the worst current accounts deficit in the developing world - a shortfall of 4.8% of GDP. Optimism over President Cyril Ramaphosa’s economic plan has waned, while a worsening trade war, or a slowdown in China, may push the commodity-dependent economy further downhill.
South Africa’s main weakness is excess liquidity. We have the highest foreign-exchange turnover-to-GDP ratio among emerging markets - as we mentioned above. This explains why South Africa is often at the forefront of developing-world routs.
Talks of land reform are not supporting the financial markets or economic activity and employment. The economic growth numbers released by Statistics SA (Stats SA) reflected several factors including investor fears that the government persists with plans to seize property and not pay for it. Stats SA data showed that the economy contracted by 0.7% in the second quarter of the year after contracting by 2.6 percent in the first quarter. The sector which saw the biggest decline was agriculture, forestry, and fishing, which declined by nearly 30% in the second quarter.
These growth figures clearly attest to the lack of economic activity, partially driven by policy uncertainty. Structural issues remain prevalent, while investment in manufacturing and development has been hampered by uncertainty regarding the mining charter, independence of the SA Reserve Bank and land redistribution.
By comparison, emerging markets are expected to average economic growth rates of around 5 percent this year. Unemployment is the single greatest driver of poverty in South Africa and our unemployment rate is a multiple of emerging market norms. Short of economic growth rates approaching 5%, we have little prospect of decreasing unemployment. Investor fears that the government was committed to push ahead with its expropriation policy is another factor that played a role in the weakening of the rand which has given up 25% of its value since the beginning of the year.
Events during the past several months underscore the grave political risks facing investors in the Turkish market. The appointment of a new cabinet, in which President Recep Tayyip Erdogan’s son-in-law took over economic affairs, the leader’s own opposition to rate hikes and the diplomatic spat over a detained US pastor have all dented confidence, prompting a 31% collapse in the lira since the end of June, the most among emerging-market currencies. In addition, Turkey is coping with double-digit inflation and the biggest current-account deficit among major emerging economies.
Currency depreciation may be sorely needed to help drastically cut imports and trim the current account gap.
So, Quo Vadis SA Equity Markets?
Back to Cyril, that is where we started. So far 2018 has not been easy. But then the last 5 years has not been much fun for our equity markets. Or for that matter, few things in our beautiful country have been much fun for a while
However, Cyril may just have an ace up his sleeve for quarter three of 2018. His foreign investment drive might just drag South Africa back into the green and out of recession. From July onwards, Ramaphosa’s investment drive started bringing in some big results. And there is the potential to see more positive outcomes in a few months’ time. All is not lost.
In the space of a few months, Cyril has pinned down trade deals that have raked in just under half a trillion rand for this country – that works out to be around $34 billion. It is part of the president’s excellent plan to eventually bring $100 billion into the economy from foreign investment.
His investment drive began shortly before he assumed the presidency of South Africa in February. He traveled to the World Economic Forum in Switzerland, armed with a plan and a team of clued-up dignitaries. When he left Davos, he promised that money would soon be flowing into South Africa.
Mr Ramaphosa attended the G7 summit in June. There he mixed it with leaders of Canada, France and Germany. In fact, German Chancellor Angela Merkel confirmed she would embark on a state visit to South Africa later in 2018. No doubt the Cyril-charm will be in full swing then. We are all holding thumbs Mr President!
Here is a list of the excellent results of Mr Ramaphosa’s investment drive (below). These investments must be able to make huge difference to our GDP numbers. So, the quicker these projects are started, the quicker we shall see economic growth and as important, a change in sentiment in our local financial markets.
UK agree to invest R850 million
After bilateral talks with Theresa May, the British Prime Minister agreed to support South Africa with an investment of more than R850 million ($64 million dollars) in April. Desperate to secure post-Brexit trade deals, May was in Cape Town during early September. She proposed that the UK would invest up to £8 billion – nearly R160 billion – into Africa, as well.
Saudi Arabia confirms R133bn deal
In July King Salman bin Abdulaziz al Saud vowed to invest R133.5 billion (about $10 billion) into the South African renewable energy sector.
UAE match the Saudi investment
The Crown Prince of Abu Dhabi, Mohammed Bin Nahyan, agreed to match Saudi Arabia’s $10bn pledge just a few days later. The two heads-of-state met at the Royal Palace, where Ramaphosa addressed a business committee from both countries to secure another R133.5 billion.
China raise the stakes to R196 billion
Discussions between the two heads-of-state, regarding investment deals and memorandums, yielded a promised financial investment in South Africa to the value of R196 billion on Tuesday.
As previously mentioned, Germany’s Angela Merkel is expected here later in the year. If her visit follows the success of Xi Jinping’s, Ramaphosa can expect to be successful again.
The country has also maintained its access to the Brics global development bank, following the July summit held between Cyril Ramaphosa and the leaders of Brazil, Russia, India and China. The rapid-growing economies also promised more funding for Africa, which brings us on to our next topic.
Africa: The investment destination
The last couple of weeks have seen Cyril involved in deals that look to “share the wealth” across the continent. Following the President’s state visit to China, the Far East nation pledged a further $60 billion – up and above R900 billion – for emerging economic developments in Africa.
With South Africa set to get a slice of the pie, you can add at least a few billion dollars to the already-impressive accumulation. It isn’t just Xi Jinping wanting to maximise (and not “colonise“) Africa’s potential, however: British PM Theresa May has also been putting her money with her mouth is.
With all major investment deals brokered between July and September, the next GDP stats – released in December and hopefully recession-free – should be a more welcome sight for sore eyes. And, of course, our markets will like it a lot!
Source 1: Moneyweb. The tide is out and SA is exposed. Sasha Planting. 6 September 2018
Source 2: Bloomberg: Contagion or not, these emerging markets hold key to selloff. Srinivasan Sivabalan and George Lei. 5 September 2018
Source 3: Bloomberg. Emerging-market sell-off deepens. Bloomberg News. 5 September
Source 4: Business News: SA recession: Six foreign investment deals set to boost the economy in Q3. Tom Head. 4 September 2018.
Source 5: FAL Research. September 2018