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South Africa Retains Investment Grade

In a highly anticipated decision, S&P has elected to affirm South Africa’s credit rating on foreign currency denominated government debt at its current investment grade, just one notch above “junk”. This was considered the less likely option by economists that were surveyed by Bloomberg in November. The ratings agency did, however, cut the rating on South African local currency denominated government debt to two notches above junk.

The reasons cited include:

  • Political events transpiring which have been distracting the government from implementing reforms to enhance growth.
  • Low growth potentially having adverse consequences on the “public balance sheet”.

The immediate reaction of the currency is shown in the chart below, which displays intraday exchange rates. As at the time of writing, the Rand had gained 1.57% against the Dollar for the day.

[caption id="attachment_2486" align="aligncenter" width="625"]Chart showing intraday performance of the South African Rand against the Dollar. Source: Bloomberg[/caption]

This decision comes after last week’s ratings action by Fitch, who also affirmed our foreign currency denominated government debt at investment grade, however they lowered their outlook to “Negative”. S&P’s affirmation today leaves the two agencies with the same rating and outlook. Moody’s did not issue a credit rating action last week, however they did publish a note on South African credit, citing political infighting, lack of structural reforms and protracted low business confidence as threats to the rating.

With S&P affirming the rating on foreign currency debt, South Africa has avoided what looked like the biggest threat to its investment-grade status. However, it has simply bought time until the next round of assessments halfway through next year. If growth, reform and politics do not improve in the next half-year or so, then South Africa will be back where it started - waiting anxiously on the word of international ratings agencies.

Emerging Market Currencies Get "Trumpled"

In the wake of the largely unexpected election win by Donald Trump, markets have reacted in some interesting ways. The US market reacted initially with a sell-off, but then whip-sawed into a mild relief rally. Treasuries are selling off and yields are rising on the back of what commentators are suggesting is the Trump “regime change”. Why is this happening? Markets are expecting growth and inflation from Trump’s proposed spending plans which would likely be funded by government bond issuance.

Indeed the sell-off is being seen in other markets too, especially emerging market currencies and bonds. (Source for all charts: Bloomberg)

Chart showing performance of emerging market currencies

embi

Regarding specific currencies, the drops that have occurred in the Mexican Peso are easily understood: Trump’s rhetoric on the campaign trail was directed at the economic relationship between the US and Mexico, specifically he pledged to repeal NAFTA and renegotiate trade between the nations. But the sharp drops in the Rand are somewhat surprising. Indeed, in the two trading days since the election result was known, the Rand lost 7%. For comparison’s sake, over the same period the JP Morgan Emerging Market Currency Index (pictured above) lost 1.67%.

The market’s reaction is, in our opinion, based on three possible factors:

  • Trump’s Trade – Donald Trump campaigned on an anti-trade platform, which would be relatively bad news for trade-intensive emerging markets such as South Africa and could impact other emerging market currencies and assets.
  • Investor Uncertainty – With Donald Trump comes a number of questions: Which of his policies will be implemented? To what extent will the rhetoric match reality? This uncertainty tends to create demand for safer assets, reversing portfolio flows into South Africa.
  • The Fed – The market has begun to price in inflation again, and this should improve the probability of a rate hike. If markets continue to be optimistic, we think the Fed will more than likely raise rates.

The chart below displays the annualized volatility in the Rand since 2000. Since 2000, this year has been the second most volatile, after 2008.

Yearly Annualized Volatility in USD Rand

The chart below compares 1 month at-the-money implied volatilities for the Rand and the Peso (against the Dollar).

1 month implied volatility of the Rand and the Peso

With all of the political risk and credit downgrade fears swirling in South Africa this year, these charts could make sense. But it is still a bizarre result, considering the US is Mexico’s biggest trading partner and that they were holding an election, with one candidate from a major party essentially hostile to said trading relationship.

You Can, I Can, We All Can For Nissan

The recent decision by Nissan’s CEO, Carlos Ghosn, to locate production of the new Qashqai and X-Trail at the Sunderland plant in the UK provokes some thought. In particular, exactly what decisions are being made within the UK government, as well as exactly what was agreed when Ghosn met Theresa May at 10 Downing Street recently.

Hitting the Brakes

At the Paris Motor Show earlier this month, Mr Ghosn threatened to cut investment into Nissan’s Sunderland manufacturing plant if no compensation was given by the government for costs borne as a consequence of a hard Brexit (an exit from the Customs Union and Single Market). For instance, costs that would now be added to exports from the “independent” UK into the EU. With such a large proportion of production being exported to the EU (something on the order of 80%), some kind of compensation or guarantee would be required by any sensible Chief Executive.

Indeed, some kind of firm assurance is exactly what appears to have been granted. Mr Ghosn spoke yesterday (27 October 2016) of the assurances and support of the UK government to ensure the Sunderland plant remains competitive.

Some Scenarios

There are roughly four scenarios here:

  1. The UK Government will be compensating Nissan for tariffs which their exports to the EU will face as a result of the UK being out of the EU Customs Union and Single Market.
  2. The UK Government has provided assurances to Nissan that they will actually be retaining Single Market or perhaps Customs Union access, despite the current political noise.
  3. The UK Government has convinced Nissan that it can pull off a good deal which will protect their export interests.
  4. Even when factoring in the cost of tariffs, it would be profit-maximising to locate the plant in Sunderland.

The first scenario is possible and, while it would potentially be breaking EU rules on state aid, that wouldn’t matter as the UK would be safely out of the EU. It may, however, also contravene WTO rules on subsidies which means it is perhaps unlikely that this is the case, as countries could simply enact countervailing duties and make the exports uncompetitive again. However, in July, current Brexit Secretary David Davis noted that the UK could implement a range of measures to keep the industry competitive, including tax breaks and “research support”.  

The second scenario is the one which is of particular interest. While Theresa May’s rhetoric certainly suggests that the UK would like to retain Single Market access while still restricting immigration, it’s likely that this won’t pan out. For the EU, free movement of labour is a crucial pillar of the Single Market. Remaining a member of the Customs Union also seems unlikely – May has specifically set up a Trade Minister role in her cabinet, effectively signalling that she intends for the UK to negotiate their own trade agreements. In our view, some sort of select free-trade agreement will be negotiated with the EU. Considering the volume and value of vehicle imports from the EU into the UK, the UK certainly has leverage to negotiate a tariff-free agreement on vehicles.

The third scenario is relatively unlikely – as mentioned above it is doubtful that the Nissan Chief Executive would base his capital investment decision on a flimsy hope that the UK government will negotiate an excellent deal with the EU who, arguably, has an interest in making the deal as punitive as possible.

The fourth scenario is unlikely given Mr Ghosn’s own words about needing compensation, but is not impossible. Firstly, there may be internal factors and existing deals which simply mean that it would still make sense, from a business point-of-view, to invest in the Sunderland plant. Secondly, the weaker Pound (almost 15% weaker against the Euro since the Brexit referendum) might still mean that production is competitive.

Driving a Hard (Brexit) Bargain

In closing, perhaps the most likely scenario here is a bit of everything. Theresa May has spoken of an industrial strategy and perhaps this is it – negotiate a good free-trade deal with the EU in the sectors where they have the most leverage, provide tax incentives to industry (in the event that they do not secure a favourable deal) and bank on the weaker Pound keeping the export sector competitive. In our opinion, the take-away from this whole event is that the UK will not be a part of the Single Market or the Customs Union (unless significant concessions are made on the EU’s part) and that Theresa May is simply setting the negotiation bar high with her current rhetoric.

Saboteurs, Luddites and Automation

Automation, a buzzword one often comes across, is not new. Indeed, automation has been replacing jobs in industry for hundreds of years; a romanticised etymology of “saboteur” has it that workers who were displaced by mechanical looms would retaliate in anger by throwing a wooden shoe, or “sabot”, into the machinery, thereby “sabotaging” the factory’s output and showing management the error of their ways.

It was the automation and mechanization taking place in the textile industry in 19th century England that gave birth to the Luddite movement. Groups of workers who were put out of a job or under threat from machines, would burn and break machinery used by textile mills. Their actions and subsequent clashes with the British Army grew so intense that at one stage, there were more British soldiers fighting Luddites than there were fighting Napoleon’s armies in the Peninsular War! The British Parliament, in an attempt to stop the riots and clashes, eventually made it possible to be put to death for sabotaging these machines by signing into law the Frame Breaking Act of 1812. Modern-day references to “Luddism” typically mean something quite different - a general aversion to, and mistrust of, technology.

In the 21st century, with the advent of powerful computers, algorithms and industrial robots, the future of employment for many is itself at risk. This paper suggests that up to 47% of U.S jobs are in a high-risk category of being automated in “perhaps a decade or two”. Furthermore, unlike the manual labour tasks of yesteryear replaced with robotic arms, this phase of automation is hitting white-collar “knowledge workers” too. Machine learning and the rise of computing power has made it possible for machines to replace humans in more skilled jobs like radiology, paralegal services and journalism too.

Looking at it from another perspective, economists have a term for the (supposedly) mistaken fear of job loss from technological change – the Luddite fallacy. The argument basically boils down to the idea that the automation of jobs lowers the cost of production, which provides a benefit to the economy as a whole.

Such fears over the loss of jobs, it could be argued, led to the successful rise of Donald Trump’s presidential campaign. His view, however, is different in that he blames losses of manufacturing jobs, at least in part, on China. What his analysis doesn’t mention, is the benefits derived from lower-cost goods which U.S consumers could import from China. However this is not to say that the government couldn’t have done better; retraining displaced workers and giving them the skills to work in other areas of the economy may have been a sound policy.

The fact of the matter is, modern day automation is happening and will likely continue inexorably (at least in the absence of government intervention). It also comes at a time when there is clearly growing economic discontent; the Brexit vote and the rise of Trump are all economic on some level and reflect anger in society bubbling to the surface. In light of these two conflicting forces, it is perhaps only a matter of time before a violent neo-Luddite (in the proper sense of the word) movement begins, shutting down and sabotaging modern-day, digital incarnations of the original mechanical looms which first disrupted the world of work. History sometimes has a funny way of repeating itself.

 

Copyright © ItemBridge inc., 2013

Copyright © ItemBridge inc., 2013

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