South Africa is not as vulnerable as most emerging economies to an increase global risk aversion

Financial market assets have been under significant pressure in the past few weeks. This has included currencies, equities and bonds. For example, the South African equity market ended Friday, 21 August 2015, down 1.5% compared with the index at the start of the year and has declined by 11.2% since the peak in April 2015. In Dollars, the local equity market has fallen 11.9% since the beginning of the year. Similarly, the yield on the South African government 10-year bond has risen from 7.8% at the start of 2015 to 8.3% last Friday, while the Rand has weakened by 10.7% against the US Dollar and by 11.4% against the UK Pound over the same period. More positively, the Rand has weakened by a more modest 3.9% against a relatively weak Euro.

The weakness in South Africa’s financial markets partly reflects global events, especially policy uncertainty in the United States, and a pronounced economic slowdown in China. The 25% decline in the oil price since the beginning of July, as well as an ongoing slump in a broad-range of commodity prices has intensified the pressure on many emerging economies. Falling commodity prices have prompted persistent downward revisions to earnings forecasts.

Last week’s FOMC minutes from the Fed did little to alleviate the policy uncertainty. Although the Federal Reserve is relatively optimistic about US economic growth, they are concerned about sustained low inflation as well as negative development in other parts of the world. Unsurprisingly, the market-implied probability of a Fed interest rate hike in September has slipped back to around 35% from just over 50% a few weeks ago.

Chinese policymakers haven’t helped either. Their domestic equity market (Shanghai Composite Index) remains extremely volatile (with market participants trying to second-guess how much support the Chinese authorities are willing to provide the market), while the decision by the PBOC to devalue their currency (albeit by only 2.9%) has compounded the lack of confidence in emerging markets. Fortunately, the RMB has been much steadier against the dollar in the past week.

The emerging markets hardest hit (especially currencies) by recent events has been those with the close trade links to China (notably emerging Asia, including Indonesia, Malaysia and Vietnam), as well as those emerging economies that are regarded as particularly vulnerable to an increase in global risk aversion, including Brazil, and Turkey. Russia has been hurt by poor domestic economics, weak commodity prices, and large exports to China, while the weakness of the Chilean Peso reflects the fact that almost 25% of Chile’s exports go to China.

Interestingly, according to information provided by the Institute of International Finance last week, although South Africa is relatively fragile, it is not especially sensitive to an increase in global risk aversion (see chart attached); certainly not as sensitive as many other emerging economies such as Brazil, Mexico and Turkey. This is despite the fact that foreign investors own a relatively large share of South Africa’s equity market when measured against the size of the country’s GDP (see chart attached). This makes South Africa a somewhat defensive market in emerging markets terms.

The reasons for the relative defensiveness of South Africa’s financial markets (especially the bond and equity markets, but not necessarily the currency market) has always been difficult to articulate. It seems to include the sophistication and regulation of the financial system, visibility of company earnings, the transparency of government’s budgets, the relatively high level of market liquidity and the fact that most foreign investors has seldom been overweight South African assets in their emerging market portfolios.

This does not mean that South Africa’s assets are not at risk of weakening significantly; especially considering their current high valuation (particularly equities). But is does suggest that while the Rand remains extremely weak and in the past has regularly been one of the weakest emerging market currencies, there has been an inherent resilience in South Africa’s bond and equity markets during spikes in global risk aversion. Hopefully, this remains the case, although the current systematic deterioration in South Africa’s economic fundamentals (including the country’s institutional capacity and credit rating) could ultimately undermine the country’s defensive qualities.

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