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South Africa sell-off expected to continue until land reform is resolved

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South Africa sell-off expected to continue until land reform is resolved

The South Africa rand has tumbled further and the cost of borrowing increased on the news Sept. 4 that the country has entered into recession, but emerging-market investors remain confident that South Africa will not go the way of struggling Argentina or Turkey so long as it deals with its political problems.

Investor confidence in much of the emerging-market space has been sapped in recent months by the crises in Argentina and Turkey, with the former forced to go cap in hand to the International Monetary Fund to secure a $50 billion loan, and the latter suffering from a spike in inflation and a weakening currency.

Despite healthy foreign-exchange reserves, South Africa has been one of the emerging-market countries to suffer most from contagion fears as investors look for the next domino to fall. The combination of a growing current-account deficit and short-term debt securities has left South Africa among the most vulnerable to portfolio outflows.

The news that the country had recorded a second consecutive quarter of negative growth from April through June pushed the rand further downward. As of 4:40 a.m. ET on Sept. 5, the rand had lost 20.5% of its value against the dollar since the beginning of the year.

"Our assessment is that Argentina and South Africa look vulnerable based on fundamentals, and are therefore prone to attract the negative attention of those spooked by events in Istanbul," wrote Stéphane Monier, chief investment officer at Lombard Odier Private Bank.

The country's cost of insuring debt has also risen, with five-year credit default swaps up by almost 100 basis points from the start of the year to 254.62 basis points as of Sept. 4. But this remains relatively low compared to others emerging markets. By comparison, CDS spreads on the much maligned Argentinian and Turkish economies are 837.14 and 576.21, respectively, while spreads for Brazil — another emerging market facing political and economic turbulence — are 311.13 basis points.

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Investors are wary of markets with high debt and deteriorating growth, favoring countries in Asia which learned lessons from the region's debt crisis in the late 1990s and reduced their exposure to foreign currencies. South Africa's current account deficit grew to 2.9% of GDP in the first quarter, which means the country is dependent on inflows of capital to finance its spending. The current account data for the second quarter is due to be announced Sept. 6 and is expected to have again grown.

Erin Browne, head of asset allocation at UBS Wealth Management, said South Africa is, along with countries such as Colombia and Malaysia, among the most worrying due to their external funding requirements. "But the critical point is that [emerging-market space] overall is in much better shape than during the 2013 Taper Tantrum, when similar fears arose about the impact on emerging-market assets of tightening U.S. financial conditions," he said.

But at just 2.5% of GDP in 2017, South Africa's deficit is not a significant concern and, according to ABN AMRO senior economist Philip Bokeloh, is expected to moderate as the price of gold — a key export product is expected to rise. Similarly, South Africa's major banks have outperformed the economy and are well-capitalized, unlike their counterparts in, for example, Turkey.

The concern over emerging markets and the potential for contagion have led many to worry about South Africa, largely due to political problems that have been exacerbated by the intervention of U.S. President Donald Trump.

"South Africa will be characterized by political noise that will make it vulnerable to some sell-off," said Jan Dehn, head of research at Ashmore, a specialist emerging-markets investment manager.

Land reform is at the heart of President Cyril Ramaphosa's agenda heading into elections in 2019, a thorny issue that many investors link to the disastrous policies of former Zimbabwe President Robert Mugabe, which saw white farmers forcibly evicted from their land, and resulted in a loss of agricultural productivity.

"The uncertainty is going to weigh on South Africa until there is more clarity," Dehn said. Ashmore is broadly confident that the emerging-market sector is undervalued, writing in a research note Sept. 3, that too much attention is being paid to Turkey and Argentina, which it says makes up less than 5% of the emerging-market bond market.

"Buying into general [emerging-market] weakness when troubles are confined to just two countries gives extremely good odds of making money on the trade," Ashmore wrote.

Bokeloh said addressing public debt will be crucial for absorbing economic shocks and said the reappointment of Nhlanhla Nene as finance minister was a good start to reassuring credit rating agencies. "Nene quickly introduced measures that herald a sounder budget, such as an increase in the VAT rate by one percentage point to 15%," Bokeloh said.

Fundamental issue for emerging markets is the constant threat of further disruption to global trade. "That's what sits out there as the sword of Damocles over [emerging markets] right now," Dehn said, noting that if U.S. politicians push back against Trump's protectionist rhetoric, emerging-market economies will be under less pressure. "The market is oversold, but it will be difficult for the market to move on before we get past the mid-term elections," Dehn said.