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File image: IOL

OPINION: Rand facing hard times during the business cycle downturn

By Ryk de klerk Time of article published Jul 22, 2019

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JOHANNESBURG - THE RAND: where the smart money won’t be going at least for now?

Global equity markets ended strongly at the end of the second quarter while the JSE had an above-average run as South African assets regained favour after the elections with the rand recovering its losses caused by the implosion of Eskom.

According to my calculations, the rand has recovered to a discount of 3.8percent from 7.2percent at the May elections against my derived equity market-weighted emerging market currency index where August 2015 was set at 100.

But how sustainable is the recovery of the rand? The average discount of the rand against the emerging market currency index is slightly above 4percent since August 2015, thereby indicating that our currency is priced in line with the emerging market currency universe.

South African long-term bonds have also attracted interest as the 10-year government bond yield dropped from just over 9 percent to 8.5 percent after the election but all it did was to narrow the gap between US bonds to the average since the start of the year.

What the rand and our bond rates tell me is that, from a global point of view, nothing spectacular happened after the May elections.

The uncertainties surrounding the leadership, leaving more questions than answers, are unlikely to boost the rand relative to hard currencies and other major emerging market currencies. Nor will it lead to a re-rating of South Africa's long-term bonds as the circumstances for a higher sovereign credit rating are not on the radar screen yet.

The outlook for the rand and South African bonds is therefore highly dependent on how global financial markets behave during the downturn in the global business cycle and it surely does not look good at all.

The current stage of the global business cycle is unfortunately not on emerging markets' side, though, and market forces may be setting up the rand and other emerging market currencies for a major onslaught.

Numbers recently released by Markit indicate that the global downswing in manufacturing activity as measured by the purchasing managers’ indices (PMIs) is intensifying.

Furthermore, consumer sentiment is tanking worldwide, even in the US, as consumers fret over potential job losses and the further fall-out of Brexit.

The smart money flows also indicate that the odds are increasingly stacking up that investors will find it hard to achieve solid positive returns from investing in global equity markets in general going forward.

Defensive stocks as measured by the MSCI World Consumer Staples Index have outperformed economically cyclical stocks as measured by the MSCI World Consumer Discretionary Index by 7.6 percent since bottoming in June last year.

Global bond yields have been in a downward trajectory since March last year while the ratio of the gold price in US dollars relative to the MSCI Emerging Markets Index in terms of US dollars - a very useful indicator of investment demand for gold - is up by 25 percent since January last year.

This is corroborated by my analysis of the asset class performances when recessionary conditions set in in the manufacturing sector of the US economy over the past 25 years. That was when the US manufacturing PMI dropped below 50, indicating contraction.

During the downswings, global bonds as measured by the JP Morgan Global Bond Index were the top asset class, returning 9.8percent on average, monthly annualised, and followed by gold with 7.9percent. The MSCI World Consumer Staples Index returned 4.8percent, while developed market equities returned a paltry 1.3 percent.

The big losers during the downswings were oil, as measured by Brent Crude, with minus 23.9 percent; emerging market equities (MSCI Emerging Market Equities in US dollars) with minus 9.9 percent; while metal prices (Economist Metal Price Index) returned minus 6.5 percent.

Emerging market currencies (my derived equity market-weighted emerging market currency index) returned minus 3.2 percent, and economically cyclical stocks as measured by the MSCI Developed Consumer Discretionary Index in terms of US dollars returned minus 1.6 percent annualised.

The biggest concern to me is that although gold, global bonds and consumer staple stocks in developed countries are outperforming as expected to in the current global economic downturn, the returns of asset classes that would normally be the big losers at this stage of the global business cycle are still positive.

Furthermore, the major divergence of developed market equities (MSCI World$ Index) valuations, using the Shiller PE10 metrics, and underlying economic realities (G7 business confidence) continues.

The gap currently indicates that developed market equities are currently overvalued by around a third. Something needs to give.

Consumer confidence must soar or equity markets must crash. Asset and sector rotation will separate the wheat from the chaff as asset managers’ skills will be tested to their limits.

Miracles happen, but at this stage it's unlikely that the smart money will be flowing to the South African rand.

Ryk de Klerk is an analyst-at-large. Contact: [email protected] His views expressed above are his own. You should consult your broker and/or investment adviser for advice.


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