The awesome volatility in EM space continues, this time with sharp swings in both directions. Last week MXN and ZAR experienced wild rides up and down. The peso surged from 12.75 to 13.10 against USD last Wednesday morning, but managed to close around 12.62. ZAR traded in concert, with USD/ZAR spiking to 10.38 before retreating back below 10 late last week. On fundamentals, Mexico appears to have weakened somewhat, but the medium to longterm outlook remains strong. Mexico is likely to benefit from the US recover. It is also worth noting that substantial fiscal drag has weighed heavily on both the US and Mexican economies as both Federal governments tighten their belts.
South Africa on the other hand continues to suffer from twin current account and budget deficits, both around five percent of GDP. Labor unrest ironically coupled with high unemployement, largely the result of a two speed economy, also remains a major concern. South African capital markets have also been stressed by potential monetary tightening in the US. Capital outflows have pushed up bond yields; the yield on the ten year government note has shot up 200 basis points in the last thirty days. With weak growth and even weaker business and consumer confidence (consumer confidence is currently below 2009 levels), the South African economy is ill-equipped to support rising interest rates. South African was downgraded earlier this year by Moody's and Fitch, largely due to South Africa's lack of room to maneuver on counter-cyclical policies. Indeed, with a deficit at 4.6 percent of GDP, interest rates at historic lows, and inflation at the upper end of the central bank's target range, there appears to be space for fiscal or monetary stimulus. In short, the government is running out of policy levers to pull. More disturbingly, the capital outflows which are causing budget busting interest rate rises are the beginning of the vicious cycle we've seen hit so many emerging markets. The central government loses credit worthiness, then rates rise, further stressing the government budget. The endgame is a default followed by a collapse of the currency.
To be sure, South Africa is still a long way off from that future. And one important safety valve standing between the vagaries of the bond market and the real South African economy is the South African Reserve Bank. It is appearing likely that the bank will need to act to stop rates from rising to quickly. Despite admonishments to contrary by Governor Gil Marcus, further rate cuts or asset purchases are still on the table. This, despite that fact that inflation sits at the top of the bank's 4-6 inflation target.
Given these facts, I have adopted the strategy of cautiously buying USD/ZAR on dips, and maintaining a neutral stance towards MXN until a clearer picture emerges on US monetary policy and the reform agenda in Mexico. For the week, the biggest events are South African current account figures due on Wednesday, and the post Fed press conference.
As always, and especially in times of high volatility, great care is required.
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