Global risk-on sees EM inflows persist, but there is not yet resumption of the previous heady risk-on cycle

11 Sep 2018

Annabel Bishop

Chief Economic

Since May last year the rand has strengthened from R15.65/USD, R17.46/EUR and R23.00/GBP to R12.83/USD, R14.34/EUR and R16.44/GBP, returning to 2015 levels against the USD and euro, and  2013 levels against the British pound.

Emerging market assets have benefitted from the global risk-on environment, with the Institute of International Finance (IIF) showing that US$89bn worth of EM bonds and equities were purchased (net of sales) by non-residents in the first four months of this year, with emerging Asia receiving over 80%.

The IIF also shows that last year only US$38bn worth of EM bonds and equities were purchased (net of sales) by non-residents, US$48bn in 2015. While this year is off to a strong start, it could either ultimately shape up to the previous cycle’s risk-on period (2009 to 2014) or peter out by mid-year, as 2015 did.

Specifically, 2009 to 2014 saw net purchases of US$1.7tn worth of EM bonds and equities (net of sales) by non-residents, with an average of US$95bn worth of EM bonds and equities were purchased (net of sales) by non-residents in the first four months of each year. 2017 shows US$89bn in its first four months.

Risk-on is the strong global appetite for foreign purchases of ‘risky assets’. This year risk-on has fuelled the purchase of local currency EM debt on the high yield differential with advanced economies debt, reported low fund weightings on EM assets and improved currency risk for EM’s on some dollar weakness.

Expectations of stronger global growth also fuel risk-on, while fears of a slowdown or worse in world economic growth, such as secular stagnation globally, dampens financial market investor enthusiasm, resulting in a risk-of investment environment.

A hard Brexit, increased global trade protectionism or a trade war would also fuel risk-off, as would a major terrorist attack, likely halting, then reversing risk-on if the negative sentiment persists. While SA has now been recipient of net foreign purchases of its equities, this has been a feature for other EMs this year

The up swell in positive market sentiment has seen the rand convincingly pierce the R13.00/USD mark, gaining against the crosses, on its current momentum. R12.80/USD however is a key resistance level, which the domestic currency will struggle to break without further momentum.

With the PPP (purchasing power parity) around R10.50/USD and the rand not strong on a real effective exchange rate basis, the rand could strengthen further should risk-on behaviour persist in markets globally. Permanent risk-on is unlikely, but bouts of risk-on support the rand back to its PPP valuation.

Domestic currency strength, if substantial and sustained, has a dampening effect on inflation, assisting households financially and so likely improving consumer sentiment. Currency strength is also supportive of capital equipment imports in an environment of strengthening demand.

So far, the rand has averaged R13.37/USD in Q2.17, against our forecast of R13.45/USD (and forecast of R13.37/USD for the year). Should the momentum continue, we could strengthen our forecasts. The rand is very liquid, fluctuating with the vagaries of the carry trade leading to its high volatility.

While clarity on rumoured potential NEC decisions and Nuclear deals, if any, is outstanding, global events prove to be the key determinant of the domestic currency’s path longer-term. South Africa remains a small open economy, with its currency particularly influenced by global developments.