All eyes on the SA rand
By Shaun le Roux
Last week was a volatile one for currency markets. With European Central Bank (ECB) Chairman Trichet adopting an unexpectedly dovish tone and expressing concerns over growth in the Eurozone, the euro lost substantial ground to the US dollar. On Friday the dollar recorded its best one-day advance against the euro for eight years and is currently trading under 1.50.
The resurgence of the greenback has coincided with an implosion on commodity markets – Brent crude oil is trading 23% lower than a month ago. It is now clear just how correlated the commodity and currency trades were.
China has long been the most important factor in the continued strong demand for raw materials. Urbanisation and industrialisation of the world’s most populous nation will be supportive of high commodity prices for many years to come. The run-up in commodity prices in the first half of 2008 at the same time as the growth rate in demand in places like China was declining, is evidence of a market that was heavily influenced by speculators who in turn were deriving a lot of their confidence from the ever-declining dollar.
On the subject of China, it is interesting to note that the Chinese stock market continues to plumb to new lows on a daily basis. Now almost 60% down from its highs of October last year, the Shanghai Composite is not participating in the rally currently enjoyed by other global stock markets.
As we all know, the bull market on the JSE has been largely driven by its resource component over the past year and a bit. While the long-term trend is still intact, we are close on 20% off the highs of over 33 000 that the All Share registered in May.
In South Africa our lives are further complicated by the influence the rand has on financial markets. The short squeeze that drove the rand to below 7.20 to the dollar has unwound somewhat, though the subsequent unwinding of that excessive strength in the rand is more a function of dollar strength than rand weakness.
With commodity prices looking as though they have peaked (in dollar terms) in this economic cycle, the performance of SA resource shares and the JSE will be heavily influenced by movements in the currency. A significant pull-back in commodity prices usually weighs heavily on the rand and gold and platinum have been especially weak of late. Yet, the rand remains strong. This is most clearly illustrated in the rand’s performance against the Australian dollar, another currency usually tied to commodity price movements. Here it is worth noting that since the end of June, the rand has clawed back a large proportion of the ground it lost to the Aussie dollar in January through March of this year. See chart below.
At present, the rand is being supported on two fronts. Firstly, we have an attractive interest rate differential in comparison to most other countries, particularly developed nations. Secondly, the markets have now latched on to the belief that the South African interest rate cycle has peaked, which has been supportive of portfolio flows into SA bonds and equity. Paradoxically, recent rand strength is a contributing factor to sustained strength as it impacts favourably on the outlook for interest rates and hence attracts foreign capital.
Alphen has a strong belief that the five golden years in financial asset prices of 2003 to 2007 will not easily be repeated anytime soon. There are headwinds on too many fronts: commodity prices have peaked; inflationary pressures are broadly higher, and earnings bases for equities are high. All this points to markets that will stay volatile while dealing with the changes in economic fundamentals. Sustained rand strength and confirmation of the peak in rates will be good for domestic stocks, while resources are likely to continue to underperform while the rand remains strong. All eyes will be on the currency.
That said, good value has emerged in parts of the equity market and when markets are susceptible to such wild swings, money can be made by buying or selling when movements are extreme.
Source: Shaun le Roux, Alphen Asset Management, August 10, 2008.
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