South Africa Flash Crash A Sign of Things to Come

cape town aerial, south africa

South African assets are likely to remain under pressure from a toxic combination of heightened political concerns, poor economic fundamentals, and growing downgrade risks. While today’s “flash crash” was overdone, the likely direction for the rand seems clear.

POLITICAL OUTLOOK

President Zuma has injected policy risk after the recent fiasco regarding the Finance Ministry. As a result, the rest of his second (and last) term will be viewed with even greater concern and suspicion. Still, the ruling ANZ is expected to remain in power after the next elections in 2019, as the opposition Democratic Alliance (market-friendly) has not yet been able to mount a credible challenge. Deputy President Cyril Ramaphosa of the ANZ is widely regarded as Zuma’s likely successor.

The real risks will likely come from the left. Splinter group Economic Freedom Fighters (formed by former ANZ youth leader Julius Malema) may force the ANZ towards more populist policies. Municipal elections this year could offer some clues as to voter intent. It will be the first time that the EEF will run candidates at the municipal level.

ECONOMIC OUTLOOK

The economy continues to suffer from energy shortages, low commodity prices, and both fiscal and monetary tightening. GDP growth is forecast to slow to around 1.4% in 2015 and 1.3% in 2016 from 1.5% in 2014. GDP rose only 1.0% y/y in Q3, slower than expected and the weakest since Q4 2009. As such, we see downside risks to growth ahead.

Price pressures are picking up, with CPI rising 4.8% y/y in November. This is the highest rate since July, and is moving towards the top of the 3-6% target range. With the rand coming under severe pressure, the SARB is likely to continue tightening despite the sluggish economy. Its next policy meeting is January 28, and another 25 bp hike to 6.5% is likely.

Fiscal policy is a key concern in light of Zuma’s decision to jettison Nene. While Nene’s replacement’s replacement Gordhan is well respected, the fact that Zuma made the move in the first place suggests that the government is not as committed to fiscal austerity as one might hope.

The budget deficit widened out again in 2015 to an estimated -4.1% of GDP. The deficit is forecast by the IMF to narrow to -3.7% of GDP this year and -3.5% next year, but we see upside risks in light of feeble economic growth. Nene embarked on a program of fiscal tightening last year, but it remains to be seen if Gordhan can obtain better results.

The external accounts are in decent shape but worsening. Lower oil prices will help reduce imports, as will sluggish growth, but this is unlikely to outweigh downward pressure on exports as commodity prices remain under pressure. The current account deficit rose to -4.1% of GDP in Q3, up from the trough of -3.1% in Q2. For the entire year, the gap is seen at -4.3% of GDP before rising to -4.5% in 2016 and -4.6% in 2017. Here too, we see upside risks.

We believe downgrade risk remains high. Our own sovereign rating model shows South Africa as a BB/Ba2/BB credit, well below actual ratings of BBB-/Baa2/BBB-. In December, Moody’s cut the outlook on its Baa2 rating from stable to negative, while Fitch cut its rating by a notch to BBB- but with a stable outlook. S&P has been the toughest of the three agencies, and was the first to cut its rating to BBB- back in June 2014. We think it will be the first to move the nation to sub-investment grade this year, but the others should follow suit.

INVESTMENT OUTLOOK

The rand has been one of the worst performers in EM, and that is likely to continue. Our EM FX model has South Africa near the bottom of our league table with VERY WEAK FUNDAMENTALS. In 2015, ZAR was the third worst performer in EM, down -26% vs. USD and behind only BRL (-33%) and ARS (-35%). This continues in 2016, with ZAR the worst EM currency at -8% YTD. USD/ZAR made a new record high today near 18 with a “flash crash” during the Asian session. The pair has since fallen back, but we expect further dollar gains ahead.

South African equities have outperformed within EM, but this appears unsustainable. MSCI South Africa was down only -1.9% in 2015 vs. -16.6% for MSCI EM. Equities are already starting to perform a bit worse in 2016, as MSCI South Africa is down -8.3% YTD vs. -9.5% YTD for MSCI EM. Our EM Equity model has South Africa right at the bottom of our league table as VERY UNDERWEIGHT.

South African bonds have done poorly. The yield on 10-year local currency government bonds is up +204 bp over the past year. This is amongst the worst performers, which include Brazil (+396 bp), Turkey (+379 bp), Peru (+203 bp), and Colombia (+192 bp). With inflation likely to rise and the SARB tightening cycle likely to continue, we think South African bonds are likely to continue underperforming.