Picture: ISTOCK
Picture: ISTOCK

Clearly investors in emerging market (EM) equities or bonds, including investors in South African equities and bonds, are less afraid. EM equities, including the JSE when measured in dollars, are enjoying a strong run, as is the rand. All have recovered well from their lows of early 2016, though are not yet back to where they were in early 2015 (see figure 1). This recovery has accelerated in 2017, as can be seen in figure 2. The rand/dollar is shown as the rand value of a dollar, rather than the other way round, to make the comparison between rand strength and EM gains more obvious.

Lest we forget, when a dollar costs as little as R12.90, that in January 2015 we were paying a mere R11.55 for the opportunity. Those were the days before weaker global growth sent EM economies and their equity markets lower, and a once seemingly all-powerful President Jacob Zuma installed his man temporarily in the Ministry of Finance, making the rand so much weaker relative to other EM currencies that were also under pressure.

The rand and other EM currencies take their cues, mostly, from global capital flows into EM bond and equity markets. The attractions of EM equities and bonds depend on their growth prospects. More expected economic growth translates into more risk-adjusted value, seen in EM companies.

A similar relationship may be seen in the markets for industrial metals of which EM miners produce a significant volume. In figures 3 and 4 it is shown how well the EM equity indices and the copper price are related. The price of copper has fallen and risen very much in line with EM equities and their currencies as global and EM growth prospects deteriorated after 2011. As can also be noted, the copper price, despite recent strength, is also still well below the dizzy heights of 2011.

Fig 1: EM equities, the JSE in dollars and the dollar value of the rand (Daily Data 2015 January=100)

Source: I-net Investec Wealth and Investment

Fig 2: EM equities, the JSE in dollars and the dollar value of the rand (Daily Data January 2017=100)

Source: I-net Investec Wealth and Investment

Fig 3: EM equities and the dollar price of copper (Daily Data 2011-2017)

Source: I-net Investec Wealth and Investment

Fig 4: EM equities and the dollar price of copper (Daily Data 2017)

Source: I-net Investec Wealth and Investment

In figure 5 the fortunes of the rand since 2013 are traced. The exchange value of the rand is compared with an equally weighted basket of other like EM currencies since 2013, when their exchange rates were equivalent.

It can be seen very clearly that the dollar/rand tracks other EM currencies very closely because they are part of the same global capital markets. But there are SA-specific risks that can also make a difference to the performance of the rand, as it can on other EM currencies — the Zuma effect on the rand and the Trump effect on the Mexican peso are examples of local as opposed to global risks influencing investment intentions and demands for a currency.

We calculate a ratio of the rand to the other EM currencies to identify SA’s risks. As can be seen, the Zuma intervention in December 2015 forced further relative weakness on the rand, sending the exchange rate ratio (1,early 2013) from 1:10 to 1:25. It is now back all the way to square one, presumably because the danger of further Zuma interventions has fully receded.

Fig 5: The rand as an EM currency — with SA’s risks identified (Daily Data 2013-2017)

Source: Bloomberg, I-net, Investec Wealth and Investment

Fig 6: The rand as an EM currency — with SA’s risks identified (Daily Data 2017)

Source: Bloomberg, I-net, Investec Wealth and Investment

Figure 7 provides a close-up view of recent developments in the currency markets. It should be concluded that the surprising strength of the rand is in line with strength in other EM currencies plus a little bit, about 3% according to the decline in the rand/EM ratio from 1:05 in early January to 1:01 today.

As mentioned, EM currencies are strong, even versus a strong dollar, because the outlook for EM economies and commodities has improved with good news and a more favourable outlook for the global economy. The surprise indices, calculated by comparing high frequency economic data releases with what was expected of them, are still pointing strongly up — that is, revealing mostly positive, surprisingly good economic news, as they have been since late 2016. The news from EM economies, after disappointing for much of 2016, has since turned very positive, and encouragingly so for EM companies.

Fig 7: The Citi Bank Economic Surprise Indices for Developed and Emerging economies.

Source: Bloomberg, I-net, Investec Wealth and Investment

The better news about the global economy has also translated into higher long-term interest rates in the US. The 10-year treasury yield is now about 2.5%, up from a mere 1.5% in mid-2016. The real yield represented by the 10-year treasury inflation-protected securities (TIPS) is up by about 40 basis points (4/10ths of 1%) from its lows of mid-2016. Hence the compensation US bond holders receive for accepting inflation risk has risen to more than 2%.

This spread may be regarded as a good measure of expected US inflation, and since 2% inflation is the Fed’s target, such an increase will be welcomed as a sign of a more normal US economy. It may be said of the US economy under Trump that expectations of both real growth and inflation expectations have improved. The increase in the real rate indicates increased real demands for capital to invest — a source, surely, of growth for the US where capital expenditure has been stagnating.

Fig 8: Interest rates and inflation compensation in the US

Source: Bloomberg, I-net, Investec Wealth and Investment

The very good news about these rising interest rates in the US — linked to improved growth — is that they have not damaged the case for EM markets and economies, as may have been feared by some. As we have seen, the Trump rally has also been very positively received by investors in EM equities and bonds. The prospect of faster EM growth has reduced, rather than increased, the sense of EM risks and reduced EM interest rates and risk spreads — if SA is taken to be representative, as it usually is, of EM trends.

As may be seen in figures 8 and 9, higher US rates have seen stable and recently falling South African yields. Accordingly, the spread between these yields has narrowed significantly from well above 7% in early 2016 to about 6%. This risk spread compensates investors for the prospect of rand weakness and can be regarded as the rate at which the rand is expected to depreciate, on average, over the next 10 years.

Thus current rand strength has translated into less rand weakness expected — which must be regarded as better news about inflation to come. Figure 9 also shows how compensation in the South African bond market for taking on inflation risk, a measure of expected inflation, has also declined.

Figure 10 shows the lower cost of insuring South African dollar-denominated debt against default and the improved status of South African debt in global markets. South African debt is now trading as investment grade, which should help the country’s case with the rating agencies.

Fig 9: RSA and US Treasury bond yields (10-year bonds) (Daily data 2016-17 to February 15 2017)

Source: Bloomberg, I-net, Investec Wealth and Investment

Fig 10: South African risk and inflation expected

Source: Bloomberg, I-net, Investec Wealth and Investment

Fig 11: South African default risk (CDS spreads) and relative standing in credit markets

Source: Bloomberg, Investec Wealth and Investment

The good news about growth and inflation — long-term interest rates have not translated very obviously (yet) into good news for South African shareholders on the JSE. The dollar value of the rand has done as well or better than the dollar value of the JSE. Hence the largely sideways movement of the JSE when measured in the much stronger rand. It therefore remains for the stronger rand to translate into higher rand earnings for those companies listed on the JSE who are so dependent directly on the strength of the South African economy.

Resource companies are in a position to deliver strong growth in their rand earnings — thanks to higher dollar prices for their output and less disruption to production. Kumba provides one example where the percentage increase in iron ore prices — in dollars — has more than compensated for a stronger rand, sending the dollar and rand value of Kumba shares much higher. The stronger rand is directly helpful to companies dependent on imports — retailers, for example, benefit from lower import costs, as do manufacturers and wholesalers, who source much of their inputs from abroad. Furthermore, the stronger rand means lower inflation and less inflation expected.

It would mean lower short-term interest rates, including mortgage interest, should the Reserve Bank be persuaded to take its foot off the brake that has slowed the economy down without, it should be added, doing anything for inflation. Lower interest rates are urgently required to encourage depressed household spending — essential for any cyclical recovery.

Perhaps the absence of any Trump tantrum — Washington DC excepted (indeed, a Trump windfall for SA) — will encourage the Reserve Bank to take more notice of the risks to the economy now that the risks to inflation have so obviously abated.

• Kantor is chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity.

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