South Africa – Zar - Rally Nearing Its End

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September 4, 2017 7:50 AM / BMI

BMI View: The South African rand's multi-quarter rally is likely nearing an end, in the face of cooling market sentiment towards EM FX and a gradual shift towards monetary easing in South Africa. Over the long term, structurally high inflation and tepid growth look poised to exert further downward pressure on the rand.

Short-Term Outlook (three-to-six months)
We believe that the lion's share of the South African rand's appreciation is behind us. Indeed, after averaging ZAR13.21/USD in the yearto-date, we forecast the rand will average ZAR13.03/USD in 2017. This forecast implies that the rand will average ZAR12.85/USD in the last half of 2017, reflecting our view that the currency will struggle to push substantially higher from its current ZAR12.95/USD level, with potential for the appreciatory trend to begin to reverse towards the final months of the year. The country has benefited from increasingly attractive real yields over the last year.

While we see this as likely to continue in the next few months as food price inflation continues to cool, gains are likely nearing their peak. Indeed, we are now factoring in a shift towards gradual monetary easing in South Africa in H217, forecasting 25 basis points (bps) worth of cuts before end-2017, which will begin to narrow real yields towards the end of the year. At the same time, with faltering commodity prices likely to begin weighing on market appetite for emerging market currencies, we believe this will offer increasing headwinds to the rally.

While the rand is likely still modestly undervalued, the real effective exchange rate has rallied substantially and is nearing its 10- and 20-year averages. Currently, the unit remains well supported from a technical perspective, trading in a broad appreciatory trend channel since early 2016. However, we will continue to closely monitor the technical indicators, with a break in the multi-quarter trend channel a key signal that the rally has come to an end.

Long-Term Outlook (six-to-24 months)

Over a multi-quarter timeframe we anticipate the rand will resume a broad depreciatory trajectory with sluggish growth and higher inflation relative to the US weighing on economic competitiveness. We forecast that the currency will average ZAR13.05/USD in 2018, implying 2.3% depreciation in spot terms from the 2016 average.

While a strong harvest will temper price growth in the coming months, a number of factors suggest that inflation will remain structurally high compared to the US. Strong unions ensure significant wage gains on an annual or semi-annual basis, even when not matched by improving productivity in a sector. The relatively limited amount of skilled workers also drives up wages and production costs. Furthermore, market monopolisation in certain sectors allows firms to form de facto cartels and inhibits a downward adjustment in prices.

We also see constraints in terms of future growth. Indeed, we continue to believe that South Africa's relatively low savings rate (16.3% of GDP as of 2016) coupled with limited reform momentum (undermining scope for a significant injection of foreign savings) will weigh on growth prospects.

While precious and heavy metals have climbed higher in H117, offering tailwinds to the mining sector, a history of frequent strikes coupled with recent regulatory changes will continue to undermine sentiment towards the beleaguered sector. A new mining charter has received significant backlash from mining firms and the Chamber of Mines has indicated its intention to bring an injunction to stop the implementation of the regulation (see 'New Mining Charter To Cause Investment Uncertainty', July 1).

The new legislation has raised the required percentage of black ownership of mines to 30% and has removed the 'once empowered, always empowered' language that was in previous iterations of the charter. This means that firms will have to continue to 'top up' the black ownership rates over the life of the mines, increasing compliance costs.

Even if the new charter is ultimately struck down by the constitutional court, the government seems to be embracing a less business friendly policy direction which is likely to encourage heightened caution – and this is true across the entire economy, not just the mining sector.

In recent months, the African National Congress (ANC) has increasingly embraced what they have called 'radical economic transformation'. The move towards more left-leaning policies is likely aimed at boosting the party's flagging support and we believe that some of the more radical policy ideas – such as land expropriation without compensation – are unlikely to move ahead. That said, businesses are likely to remain cautious.

Not All Bad News

While we expect broad rand depreciation in spot terms, there are a few important caveats. First, our forecasts are noticeably less bearish than the current forward market expectations. This is in large part due to our more bullish view of the currency's trajectory in H217 compared to consensus. Meanwhile, even as we anticipate gradual depreciation in spot terms, the continued interest rate differential with the US should ensure continued gains in total return terms.

Risks To View

We see both upside and downside risks to our currency forecast. On the one hand, with the recent market risk-on sentiment likely to fade in the months ahead, there may be less willingness on the part of investors to overlook South Africa's domestic political challenges. After the massive cabinet reshuffle in late March 2017 prompted a brief sell-off, the rand returned to a sharp appreciatory trend, in line with moves across EM FX.

However, in a more risk-off environment, we believe the markets will not be as forgiving. With the ruling ANC faced with increasing infighting ahead of the December 2017 National Elective Conference (when a new party leader will be chosen), there is a relatively high likelihood of 'event risk' in the months ahead.

On the other hand, should we see market sentiment remain more bullish towards emerging markets than we currently anticipate, potentially in the face of stronger commodity performance in H217, the rand could take another significant leg higher before reaching the end of its run.         

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