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South Africa’s fundamental picture remains very challenging with a ballooning fiscal deficit and structurally low growth. We have outlined our structural case for weaker ZAR here, with the currency likely to have to play the role of the adjustment valve vs. the fiscal and growth challenges. Fiscal challenges are now becoming ever more apparent with the appropriation bill seeking extra R59bn of funding for SOEs over two years.
This is consistent with our economist’s assumptions underpinning her 5.7% of GDP fiscal deficit forecast for this year and 5.3% of GDP for next year. Meanwhile, our economist expects GDP growth to be capped at 0.5% this year recovering only marginally to 0.8% next year. This macro backdrop, in our view, is inconsistent with the recent ZAR rally even when accounting for a supportive global environment. ZAR valuation is now stretched (refer 1st chart).
In the past, our BEER model has acted as a very good signal to short ZAR whenever the overvaluation reached stretched levels close to the standard deviation of the model. We have now approached this trigger. Terms of trade have recently boosted ZAR, but our model suggests ZAR appreciation has exceeded this support. Interestingly, we estimate the gold rally explains about 1/3 of the rise in South Africa’s terms of trade since May 20.
However, speculative gold positioning now looks rather extended, which may put breaks on a further rise in the terms of trade.
Overall, J.P. Morgan’s commodity projections are consistent with a 0.7% fall in terms of trade by end Q3’2019 (refer to 2nd chart).
Contemplating the above factors, we recently recommended going short ZAR via a 3-month 14.75 USDZAR call. We have maintained a UW position in our GBI-EM portfolio since May 13, arguing that the sharp deterioration in the fiscal and growth outlook is likely to lead to ZAR underperformance. However, a supportive global environment has lifted ZAR despite fundamentals. We now believe levels are stretched enough to enter outright ZAR shorts. Low implied volatility makes option trades particularly attractive. The call is indicatively offered for 1.2150% (activated when the spot was 13.89 levels). Courtesy: JPM
