USDZAR: What's next for troubled rand?

Summary:

• South African economy enters recession as GDP contracts for the second consecutive quarter

• Depreciation of the ZAR signals inflationary pressures ahead

• Land expropriation in South Africa puts the country’s banking system at risk

• South African 5Y CDS surges to the highest since November 2016

• ZAR plummets against the dollar, where to look for a trading opportunity?

EM currencies have had tough time recently and besides the risk coming from rising rates in the United States some of them have been troubled by domestic issues. We may conclude that the Argentine peso along with Turkish lira have been by far the weakest EM currencies so far this year. The former has lost over 51% being beleaguered by a debt crisis whereas the latter has plunged as much as 43% on the back of an unorthodox stance of the central bank which has already led to double-digit inflation, deteriorating sentiment among consumers and businesses as well as a major dent in CBRT’s credibility which could be tough to restore. Although the South African rand seems to be better positioned compared to the two above-mentioned currencies, it is also not free of an internal headache. In this analysis we briefly outline the state of play of the ZAR with its medium-term outlook.

The South African economy has entered recession after producing the two back-to-back quarterly contractions. Source: Macrobond, XTB Research

In spite of the fact that the ZAR has performed much better than ARS or TRY losing “only” 18% against the greenback thus far this year, it has been recently affected by deteriorating business confidence related to a land expropriation risk (we cover this issue later). As a consequence, the South African economy has entered into a technical recession after contracting by 0.7% (QoQ, seasonally adjusted and annualized). This decline came after the 2.2% decrease registered during the first three months of the year. The Q2 GDP data was a clear disappointment for analysts given the median estimate of a 0.6% economic expansion. The prime reason standing behind the second quarter slide was agriculture which subtracted as much as 0.8 percentage points from growth. The exceptionally weak performance was mainly due to a drop in crop production. On top of that, trade, transport and government spending were also a drag on growth deducting 0.3, 0.4 and 0.1 percentage points from growth respectively. Essentially, growth in the three months through June was driven almost solely by mining and finance as the two categories added 0.4 percentage points each. The release highlights importance of agriculture in economic growth and it seems to be crucial given the fact that the government considers undertaking highly contentious steps aimed at expropriating of land from white farmers.

Land expropriation without compensation is undoubtedly placed among major risks for the South African economy. Although the law allowing the government to do so is still not in place, the ruling party African National Congress plans to amend the current law to permit expropriation of land without compensation. If such a draft law successfully moves through the government, it would spark a fresh selling wave in the rand. Let us make an additional point in this topic to better understand the entire drama in the African country. There is a common ground among investors when it comes to a problem regarding land redistribution as white South Africans currently own as much as 72% of commercial agriculture land according to a state audit. The concern is not the fact the the government wants to deal with it, but the fact that there have been no clear details how it is going to do so, and if so, whether it is able to handle this issue without undermining property rights. Note that if property rights are breached, it could deter foreign investors leading to a massive capital outflow and thereby significantly hurting the ZAR. Finally, it needs to be said that ultimate land expropriation without commensurate compensation could lead to an array of defaults when landlords are stripped of their core production factor - land.

The declining ZAR could put the inflation target at risk. Source: Bloomberg, XTB Research

Notice that the falling currency could fuel higher inflation which again may hurt the currency. This is a doom loop being currently present in Turkey or Argentina. Although in case of South Africa we are quite far away from such a dangerous scenario one need to be cognizant of such a possibility. In fact, price growth increased to 5.1% from 4.6% in July - the highest value since May last year. Yet, on the fundamental side one cannot miss other adverse signals from the South African economy. First of all, the unemployment rate has been steadily rising since the GFC crossing 27% in the three months through June. Second, both the budget gap and current account deficit have widened. Deteriorated consumer confidence has also led to a fall in the underlying retail sales trend. All of these factors along with political risks offer an unfavourable mixture for the ZAR.

5Y CDS has surged to the highest point since November 2016 signalling that investors have to put more money to hedge against the country’s default. Source: Bloomberg, XTB Research

Credit instruments are one of the best barometr of investors’ perception regarding economies. We are getting a confirmation of such thinking in case of South Africa where investors’ demand for 5Y CDS contracts has risen recently. This increase has come along with a rising risk premium in the bond market with the 10Y spread to the US counterpart widening beyond 650 basis points - the highest since December 2017 when a presidential election took place. To sum up, downward pressure on the rand is likely to persist over the nearest term unless the government backs away from a highly controversial amendment concerning land expropriation without compensation. On top of that, the broad block of emerging market currencies could continue suffering amid rising rates by the Federal Reserve. Keep in mind that those economies with the largest external debt exposure, the weakest fundamentals as well as the most uncertain politics are likely to be hurt the most - South Africa could be undoubtedly placed among them.

The USDZAR has recently shot up topping the levels made during an outbreak of the Turkish currency crisis of 15.50 or so. As a result, looking for any trade opportunities does not seem to be easy and entering a long at a market price could turn out a risky strategy. Therefore, we advise considering to enter a long at a limit order placed at 14.60 with a target of 16.40 and a stop loss of 13.70. These levels are based on the assumption that short-lived relief across EM FX will occur but the ruling South African party will not back down from its idea. Source: xStation5