FX Dashboard: South African Rand – Watch for Headwinds in 2022

In the note, Not All Winners are Equal – 2021 EM FX Outliers and Implications for 2022, I mentioned that among the winners from 2021, one that made less sense to me was the South African rand (ZAR). Although the currency gave up much of its earlier outperformance towards the end of last year (see the chart below), it still ended as one of the best performers.

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 22 currencies

Looking ahead, I expect the recent lagging trend for the currency to continue for the following reasons:

• Weak growth: The growth outlook for South Africa has dimmed, especially from a long-term perspective, due to:
  • Covid impact: The fourth wave of coronavirus cases, driven by the omicron variant, has peaked. Consequently, Covid restrictions, including a curfew, were eased. Nevertheless, with the vaccination rate still low compared with other major countries, the number of deaths as a percent of the population was much higher than peers in this wave. Moreover, some of the travel bans are still in place, which combined with previous restrictions hurt the economy just as it had begun to recover from the riots in July.
  • Corruption: A judicial commission investigating graft in South Africa concluded the 4-year probe with a devastating – but not surprising – revelation that the state had been captured during the former President Jacob Zuma’s 9-year tenure. The pressure on President Ramaphosa to address corruption in his own party, ANC, has grown, putting him in a bind. On one hand, the failure to do so may hurt the prospects in the 2024 general election for ANC, which has seen its support slip consistently over the past several elections cycles. On the other hand, taking decisive actions may once again lead to riots like the ones that crimped the economy in Q3 21 following Zuma’s arrest.
  • Structural factors: The restrictions that followed the omicron variant hurt the economy as is clear from the soft December PMI. The economic rebound in 2021 from the 2020 contraction is thus likely to be weaker than previously expected with the SARB lowering their 2021 growth forecast to 5.2%. Moreover, the momentum has slowed going into 2022 when growth was already expected to slow sharply to 1.7% followed by 1.8% in 2023 according to SARB’s forecasts. The slowdown in growth is mainly due to structural constraints limiting the country’s potential growth even before the pandemic, which likely worsened them. Moreover, the Treasury’s target of narrowing the fiscal deficit to 4.9% of GDP in 2024/25 should weigh on growth further.

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 22 currencies

• Low carry: The currency’s carry remains unappealing for a few reasons:
  • Inflationary pressures remain contained: The headline CPI rose to 5.5% in November, higher than the South Africa Reserve Board’s (SARB) inflation target of 4.5% but within the target range of 3-6%. The rise was driven primarily by energy prices, implying that as oil prices stabilize, inflation should drop back towards the midpoint. Indeed, SARB’s forecasts show the same.
  • Limited rate hikes: SARB raised its policy rate by 25 bp in November in contrast with my expectation that it would stay on hold throughout 2021. Nevertheless, currently the pace of the recovery is a greater concern than inflation, which should remain close to the target. As such, I expect the SARB to hike rates by less than currently priced in the curve, which is over 200 bp in 1 year.
  • Unfavorable interest rate differential: With most EM countries far ahead in their monetary tightening cycles and the Fed likely to start raising rates soon, the interest rate differential should work against South Africa. Moreover, on the carry-to-volatility chart above, the rand should remain one of the less attractive currencies especially as its volatility has stayed high even as it has dropped for the broad EM currency universe (see the chart below).

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 22 currencies

• Commodity tailwind becomes headwind: South Africa’s current account benefited in 2021 on the back of the sharp rally in commodities. Indeed, the current account surplus for 2021 is expected to be 3.8%, the highest in 3 decades, according to the Bloomberg consensus. In 2022, however, the surplus is expected to narrow sharply. Prices of precious metals, South Africa’s primary exports, are off last year’s highs while the price of oil, which it imports, continues to be close to its highs. Indeed, the correlation of the rand with commodities has dropped below its long-term average (see the chart below).

Data Source: Refinitiv

Best Longs / Best Shorts

• The list of underperformers based on my models in the attached FX Dashboard pdf is currently empty.
• From the list of outperformers, I removed Chinese renminbi (CNY) as its z-score receded and added Indian rupee (INR), Taiwan dollar (TWD), and Hungarian forint against the euro (EURHUF) as their z-scores crossed 1.
• The list already had Israeli shekel (ILS), Peruvian sol (PEN), and Czech koruna against the euro (EURCZK) on it.

Best Crosses

• The list of the preferred relative-value trades based on my models changed to Long Colombian peso (COP) vs Short ILS or Czech koruna (CZK) or PEN.
• The 3m expected returns for these pairs are in the range of 8-10% (not annualized), assuming mean reversion.