Rand Prospects

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By Cees Bruggemans, Chief Economist of FNB.

After decade-long overvaluation, rudely interrupted in late 2008 by a severe bout of global risk aversion and Rand undervaluation, the Rand finds itself today once again subjected to a spell of global risk aversion on account of crisis, its severe overvaluation reduced to mild proportions in 7.50-8.50:$ territory.

Little of the Rand’s movements since 2002 had anything to do with domestic reality. This may well continue to be the case for some years to come, as global events loom large where Rand asset classes are concerned.

To foresee where the Rand will be travelling next week/month/year/decade, one needs to be most clairvoyant regarding coming global events.

The most obvious question is whether global events will be Rand negative or positive, and when.

Expecting the Rand to hug neutral territory these next ten years, starting at 8-8.50:$ and weakening at our inflation differential (4% annually?) would be the only truly surprising outcome.

The Rand is never very stable for long under present global conditions.

Still, the past decade does offer insight of a sort.

When global conditions become Rand-friendly (as they have been most of the time this past decade), the Rand has tended to become seriously overvalued for years of the order of 10%-20% on real trade-weighted.

When things go seriously wrong, as is the periodic fashion, the Rand can easily become 50% undervalued for a few months.

Having established the pattern of recent times, there remains the matter of event equivalence.

Will we in the coming decade really ever be able to replicate the Anglo-Saxon banking system popping like a ripe melon as it did in late 2011, or repeat the Euro Project build-up and its popping of 2010-2011?

Probably not to the same extent in these same spaces in this decade.

Even so, US fiscal finances deserve a mention. There, the political standoff could continue until either the one or the other party dominates the entire scene, something the US electorate may well prefer to prevent.

The US finances will either be resolved in one of two ways (a Democrat or Republican preference) or political gridlock may eventually invite a forced market solution.

That’s three options that could have a major bearing on us this coming decade – good, bad or seriously either.

Europe will either belly and fragment shortly or float Euro 2.0, after which a period of licking wounds and some stability may prevail, potentially through the decade.

In other words, Europe is going through now what the US will still need to face up to eventually. This leaves two rather extreme EU options, very good and not good for the Euro and outsiders closely aligned with her. This crisis may come to finality within months, thereafter having to live with the playout for years to come.

Then we still have China, either its good growth scenario continuing or a property-cum-banking pop flooring the growth story, with this scenario being possible in any year of the decade.

This gives two more global game changers.

The Middle East remains a very unstable place. Iranian ambitions are nuclear, the region’s youth likes more democracy, the clergy would prefer something quite different still. Three more global scenarios played out via commodity prices.

That gives at least ten serious global plays this decade, all unfolding through capital flows, commodity prices, currencies and inflation performances, together seriously impacting growth prospects regionally and globally, and this feeding back into the financial plays.

For my penny worth, US political gridlock continues, with the US as yet not at the end of its creditworthiness.

Its housing weaknesses are not adequately addressed, keeping banking weak too, while politics enforces slow-puncture fiscal austerity.

America will take its time to digest these imbalances, for the duration encountering slow growth and an accommodative Fed, with loads of liquidity, low interest rates, much quantitative easing, weaker Dollar.

Europe is busily forcing itself into a new corset (Euro 2.0) guided by Germanic discipline and austerity over peripherals and banks.

That will prove very severe for peripherals who don’t want to be wandering around on their own in the wilderness, even as banks get recapped (probably in a very torturous way) and select sovereigns are given debt haircuts for belated good behavior and promises of more.

Poorer and wiser, the new Europe will be more severe on its citizens, but eventually also more trade-competitive if Germany these past two decades is anything to go by.

All this will take time. Growth should underperform for the duration, markets remaining skeptical for long, risk differentiation vicious, the ECB accommodating, and like with the US other destinations more attractive qua asset yields and currency carry.

China should pull through while subduing property and banking excesses a bit (but probably not enough). Its next generational tests loom, but may not arrive this decade. Something to look forward to in the 2020s?

The Middle East may remain a bubbling cauldron, capable of yielding Black oily Swans, unpredictable at best and possibly more dangerous in times to come.

This overall picture suggests the world will not shortly go up in US, EU or Chinese smoke, though their potential to surprise remains immense, with the Middle East a major wild card.

The main scenario remains catch-up growth in the East pulling commodity prices along, and financial repair in the West greasing the liquidity spigots enough for yield-seeking capital to push global asset markets, commodities and currencies.

In other words, the story of the past six decades (Eastern catch-up) and past three years (Western repair) still have enormous playout potential this decade (and indeed beyond, even if the shape of forces changes).

That makes for a volatile Rand prospect, on balance mostly mildly to severely overvalued (as long as we don’t internally make serious mistakes affecting the global view of us), with at times severe pullback and relatively short periods of underperformance when the world hits the odd crisis air pocket, as it is bound to do.

Starting from a condition of near neutrality at 8:$, with the world still in thrall to US growth fears and EU crisis conditions, coming weeks and months could still see the Rand relatively ‘weak’ in 7.50-8.50:$ territory.

But thereafter looms slow US progress, large output gap, suppressed inflation, Euro 2.0 discipline and continuing Chinese catch-up. To me, this suggests a return to Rand overvaluation (10%-20% on real trade-weighted).

Sometime in 2012 we may break below 7:$ again as she firms anew, driven by yield-seeking capital inflows and higher commodity prices.

Source: Cees Bruggemans, FNB, October 10, 2011.

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