USD/ZAR - The Worst Is Over?

by: Dmitry Lifatov

The South African economy just exited a recession in Q2 2017, facilitating USD/ZAR exchange rate decline.

This decline was caused predominantly by a positive GDP growth in Q2 2017, interest rate cut in July 2017 and a normalization of inflation.

However, we have strong doubt that the SA economy will continue its rebound in H2 2017, with weaker retail sales, mining and manufacturing sector data.

To be able to continue its climb, the rand needs more upbeat economic statistics in the coming months. If the SA macro indicators signal a deterioration of economic prospects, USD/ZAR will head to the north.

The South African Absa Manufacturing PMI in August 2017 stood below a threshold level of 50 at 44.0, meaning generally declining economic prospects. The Standard Bank's Composite PMI also fell below 50, down to 49.8 in August 2017, supporting contracting economic growth expectations. Business confidence, measured by the RMB/BER Business Confidence Index, declined to 29 in Q2 2017 from 40 in Q1 2017, which is the lowest value since 2010. Consumer optimism, measured by the FNB/BER Consumer Confidence Index, dropped to -9 in Q2 2017, amid mounting concerns about future economic conditions. For a consumer-based economy like South Africa, it has extremely negative implications.

In Q4 2016 and Q1 2017, the South African economy experienced a recession, with negative growth of -0.3% and -0.6%, correspondingly. In Q2 2017, with an annualized 2.5% GDP growth, it exited the recession, and now the main question is whether it continues to demonstrate a strong rebound in H2 2017. Very few economists expect as much momentum in Q3 2017 as in the previous quarter, citing weaker retail sales, mining and manufacturing sector data.

The CPI in South Africa in July 2017 slowed down to 4.6% y/y from 5.1% y/y during the previous month. The downward trend in headline consumer inflation lasts since the beginning of the year and now is approximately in a mid-range of a 3-6% SARB target. Core CPI rate in July 2017 cooled down to 4.7% y/y from 5.5% y/y in January 2017. PPI, standing at 3.6% y/y in July 2017, is also going down.

One of the main problems in the South African economy is an extremely high unemployment rate - 27.7% in Q2 2017 - this is the highest value since 2004. The SA unemployment was always high, with a low of just 21.5% in Q4 2008, reflecting problems largely of a social nature.

The interest rate in South Africa currently stands at the level of 6.75%, down from 7% in July 2017. Economists expect further rate cuts in September and November 2017, but the situation is too unstable to predict the SARB's moves with a high probability.

Aside from purely economic woes, South Africa also experiences political turmoil. The attempts of the opposition parties to force an early general election, which is scheduled for 2019, and to oust SA President Jacob Zuma from office fuel political instability in this country, which negatively influences its economic prospects.

So it might be surprising to you even in such circumstances, the USD/ZAR exchange rate moves lower, down by more than 3% since August 2017. The probable reasons for such remarkable strength of the South African rand amid adverse internal economic conditions can include a positive GDP growth in Q2 2017 and interest rate cuts, leading to less demand for ZAR carry trade operations and a normalization of inflation.

Will all these factors be in place in H2 2017, causing more ZAR strength? We have already said that prospects for a similar robust GDP growth in Q3 and Q4 2017 are rather weak. Worsening leading macro indicators also support deterioration of economic conditions in South Africa in the coming months.

That is why we cannot agree that the USD/ZAR exchange rate will decline even further. The market participants have already absorbed all positive news released in August 2017; and now, for the rand to be able to continue its climb, more upbeat economic data is necessary to support a strong rebound of the South African economy.

Currently, from a technical point of view, USD/ZAR is in a classical downtrend on a weekly timeframe. If the pair is able to print a lower low, breaking below a 12.30 level, this will mean the continuation of a decline. However, if the pair is unable to close below this support level, we have high chances of a reversal.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.