3rd Quarter 2004: Global Markets 3rd quarter 2004 - The roller coaster ride of the Rand

These days, the word "certainty" is seldom used in conjunction with the Rand. However, there is one certainty that we have come to associate with the Rand in more recent years. It is neither the strength nor weakness of the Rand, but rather something connected to both - it's VOLATILITY.

During the last four years, we have witnessed the Rand weakening to levels of R13,85 to the US Dollar (late December 2001), followed by unprecedented Rand strength. The Rand recently recorded levels close to R5,88 to the US Dollar. What drives this roller coaster ride? While there are a number of less significant reasons, the main reason for recent Rand strength has been the weakness in the US Dollar. But it was the Zimbabwe link, plus poor international sentiment towards South Africa, which were the main culprits cited for Rand weakness in 2001. Do these factors alone justify the extreme volatility that we have come to associate with the Rand?

A recent article in Business Day by a well regarded South African fund manager (written in his personal capacity) gives a hint of other fundamental causes. The article highlights that South Africa compared with the world's other 24 emerging markets ranks 1st out of 25 under the heading, "currency strength" and 3rd under "lowest inflation". Sadly, the statistics are not all good. Under "foreign exchange reserves", South Africa ranks last in 25. Furthermore, under the headings "Current Account" and "industrial production", South Africa is ranked 20th and 21st out of 25, respectively. The wide disparity in these statistics is cause for concern.

Another article in Business Day, which quoting an international investment analyst who focuses on Eastern Europe, the Middle East and African Regions, points out that some international businesses are now questioning the rationale of investing in South Africa. They refer to "difficult operating conditions" in South Africa. The article highlights three growing areas of concern. The first is the volatility of the Rand. The second is the way South Africa is perceived to be dealing with the HIV / AIDS crisis. The third is black empowerment.

As to the aids crisis, the article points out that many other emerging market countries appear to be dealing with the issue far more effectively. This brings to mind a presentation by Clem Sunter some years ago, where he used a memorable analogy in discussing the HIV / AIDS crisis in South Africa. In his view the AIDS crisis should be viewed in the same light as outright warfare. The disease should be tackled with the same strategies and urgency we might adopt if dealing with the threat of war.

As to black empowerment and how it is viewed by some potential investors abroad, the Business Day writer quotes as follows:
"Concerns that black empowerment legislation will force foreign investors to sell a substantial stake of their local operations to black shareholders was further discouragement for firms assessing investment opportunities with an impassive eye. Companies are wondering how black empowerment will affect them, and whether they want to do it, so it's part of the whole equation. Why bother if they can set up a plant in Slovakia?"
The article concludes by stating "65% of the Rand's trading took place offshore." This leaves the Rand wide open to further volatility, caused by the whims of international investor sentiment.

Regardless of these "negative" statistics, the Rand has remained relatively strong in recent months. The recent reduction in domestic interest rates caused some loss in value. There has now been further weakening caused by the latest statistics on our foreign exchange reserves. In these circumstances, it has become impossible to predict the Rand's likely path over the short term. The textbook theory that a currency should depreciate by the inflation differentials between itself and its trading partners becomes superfluous. There are however general expectations that the Rand will weaken further.

From a South African perspective, the strong Rand has been the primary driver keeping inflation under control and within the targeted bands set by the Reserve Bank. This has allowed the Reserve Bank to reduce interest rates and to hold them lower for longer.

What can we expect from the Rand in the months ahead? Certainly, more VOLATILITY.

As alluded to in our last report, the Federal Reserve began raising interest rates during the quarter under review - the first rate increases to take place in four years. Two 25 basis point increases were announced, one in June and the second in August. This brings rates to 1,50% - up from 1% at the beginning of the quarter (01 June). These gradual increases are an attempt by the Central Bank to "curtail inflationary pressures without obstructing economic growth".

In a statement that followed the latest rate hike, the Federal Reserve stated, "in recent months output growth has moderated and the pace of improvement in labour market conditions has slowed". However, they again confirmed their assurance that future rate increases would only be instituted "at a pace that is likely to be measured". Of course, this is assuming that inflation remains in check.

It is expected that, US GDP growth in real terms for 2004 should fall into the 4,50% / 4,75% range. However, slowing job creation and rising oil prices could dampen consumer spending in the months ahead.

As expected, rates in the Eurozone remained unchanged at 2%. This against an environment of rising interest rates in both the United States and the United Kingdom. However, unemployment in the Eurozone is still high (at approximately 9%). Economists believe that the European Central Bank "is in no rush to tighten monetary policy, despite short term inflation". Inflation (currently in the region of 2,50%) is slightly above the 2% target level.

The latest statistics from Eurostat indicate that growth in the Eurozone during the second quarter increased by 0,50%, compared to 0,60% during the previous quarter. It is expected that the Eurozone economy is likely to grow by between 0,30% and 0,70% during each of the third and fourth quarters of this year. As stated in our last report, while growth has picked up in this region, it is still well below the current forecasts for world growth.

The Bank of England (BOE) announced another two 25 basis point interest rate increases during the period under review - bringing rates to 4,75%. The last increase was the fifth in the last eight months. In an announcement following the latest rate increase, the BOE said that "continued strong growth is likely to lead to inflationary pressure". As discussed in our last report, another reason for this latest round of interest rate increases has been an attempt to slow down the booming property market.

In the quarterly inflation report issued by the BOE, however, the Bank expects house price growth and inflation both to fall in the near term. This should ease pressure on interest rates. "The Bank confirmed that its forecasts for base rates over the next two years were unchanged and that rates are expected to peak at about 5,1% over the next two years, before reaching 5,2% in 2007".

Businesses in the UK, however, have expressed a concern "that rising interest rates will increase the value of Sterling against other currencies, making their goods more expensive in export markets".

It is interesting to note that, of the G7 countries, the United Kingdom has the second highest consumer debt rate at 126% of GDP (June 2004). Japan takes first prize at 140%.

Support from regions such as the United States, Asia and China for Japanese exports continues. On a year-on year basis (in terms of value, rather than volume), imports increased by 15,3%, while exports rose by 19,4%. The Japanese government recently revised upwards the GDP growth forecast for 2004/5 to 1,80%. In addition, the rate of unemployment in Japan remains unchanged at 4,6%. This is relatively low by international standards.

Amidst this positive news, what of the expected slow-down in the Chinese economy? It is difficult to predict the impact of the anticipated slow-down in the Chinese economy in relation to Japanese exports. Despite these concerns, however, the latest figures (June 2004) show that year-on-year, Japanese exports to China increased 36,3%. This factor will be closely watched over the next months.

It is interesting to note that the volume of mergers and acquisitions (M&A's) in Japan during the first quarter of this year increased by 13%. Some 537 transactions, with an approximate total value of $23,2 billion, were recorded.

In a surprise move, the Reserve Bank on August 12th announced a 0,50% reduction in the Repo Rate - from 8% to 7,50%. This is the first rate reduction since December 2003. The announcement caught the market off guard, as the Reserve Bank had given the impression that further interest rate cuts were unlikely. They indicated that "the party was over", after the June meeting of the MPC. The interest rate announcement came amid mounting pressure from business and unions to weaken the Rand (to levels of between R7,50 and R9,00 to the US Dollar). Following the announcement, the Rand declined to R6,47 (a two month low against the US Dollar). It now stands at R6,66.

The decision to further reduce interest rates was supported by the encouraging outlook for CPIX, which is expected to remain within the targeted range of between 3% and 6% for the next two years. We need to remember, however, that the strong Rand has been the primary driver of low inflation - any marked depreciation in the Rand going forward will not be favorable for the inflation target and consequently for interest rates. The Rand ended the quarter (31 August 2004) at R6,66, R8,11 and R11,98 to the US Dollar, Euro and Sterling, respectively.

The price of Brent crude oil continued to rise sharply throughout the quarter under review. While prices breached $49 a barrel, the price ended the period at $39,32 a barrel (31 August 2004). Prices in excess of $45 per barrel were last seen in the 1980's. High oil prices are not popular as they impede global economic growth, while at the same time adding to inflationary pressure. Several reasons explaining the rising oil price were listed in our last report. However, with the oil price having continued on its upward trend, it may be appropriate to revisit this issue.

Increased demand is the most obvious reason for the spike in the oil price - the International Energy Agency attributes the "biggest increase in oil demand for sixteen years" to global economic expansion. The demand from China, alone, has risen by more than 20% in the last year.

Low stock is another reason for rising prices. In an attempt to become more efficient, oil companies are trying to "operate with lower stocks of crude oil". As a result, interruptions to the oil supply impact more significantly on the oil price. The strikes in Venezuela as well as the prevailing tension and violence in the Middle East continue to disrupt the oil supply, thereby putting further upward pressure on the oil price.

Speculation can also result in indirect price pressure being put on the market. This can occur when speculators are of the opinion that prices will rise - often their actions in the market (e.g. hedge fund managers) can result in price rises.

Other possible reasons for the rising oil price include OPEC strategies and recent political tensions in Russia. Note that there is currently a dispute between the Russian government and Yukos, the biggest oil company in Russia, which could lead to the shutdown of much of the company's production. Yukos is responsible for about 20% of oil output from Russia. A further reason is insufficient refinery capacity in the United States ("low US gasoline stocks and pressure on US refiners to increase production of new gasoline blends have also helped drive world crude oil prices").

Prices at current levels have raised the average oil price for the last year to more than $35 per barrel. According to the chief economist of the International Energy Agency, Dr Fatih Birol, "oil at $35 per barrel could take half a percentage point off global growth". According to Dr Birol, if we do not see any real increases (in supply) from oil producing countries, and if geopolitical tensions continue, we have every reason to worry about even higher oil prices".

OPEC president, Purnomo Yusgiantoro, announced recently that oil producers from outside the OPEC cartel are to be invited to talks in September, in an attempt to find a solution to rising oil prices.

The gold price ended the quarter largely unchanged at $408 an ounce - compared to $395 at the end of the previous quarter. With interest rates in the United States starting to rise, it will be interesting to see what impact this has on the gold price going forward.

As previously forecast, interest rates are rising in the United States. In addition, the measures being implemented to prevent the Chinese economy from overheating appear to be working.

We still believe that volatility is likely to be the order of the day as macroeconomic factors such as the oil price, global interest rates and inflation remain particularly sensitive. Amidst this global volatility, we expect pockets of positive news. We need to ensure any such good news is not completely overshadowed by market volatility.

QUARTERLY QUOTE
"Isn't it interesting that the same people who laugh at science fiction listen to weather forecasts and economists?"
Kelvin Throop 111

This report is based on information sourced from various institutions, both local and international. The report reflects a variety of views and is not intended to convey investment advice. Please consult us to obtain specific advice relevant to your investment portfolio.