Pound Breaks 20.00 Against the South African Rand, but ZAR Could now be Undervalued

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- Key 20 cap for GBP/ZAR now breached as SA slides into recession

- Rand swept away with other EM FX as investors seek safety

- But ZAR considered undervalued by Standard Bank

A frantic sell-off in the South African Rand is extending through the mid-week session.

A further 2.0% dip against Sterling allows the Pound-to-Rand exchange rate to break back above the key 20.00 Rand level; a rarity by historical standards. 

The latest driver of the ZAR's weakness was the surprisingly poor economic growth data from South Africa released Tuesday, September 05, which confirm the South Africa economy has now fallen into a technical recession after the economy shrank by -0.7% in the second quarter, following a decline of -2.2% in Q1.

The GDP miss followed a release on Monday which showed a surprise fall in Manufacturing PMI data to 43 from 51 in August, and, therefore, activity in the sector falling below the 50 watershed which differentiates expansion from contraction.

The broader sell-off in Emerging Market assets is meanwhile proving contagious for South Africa, informing the broader decline in the currency.

And, it looks like further declines on this theme might be in store, for the near-term at least.

"We expect emerging market currencies to fall further over the coming year. Slower growth in EM and China coupled with additional Fed tightening will likely keep sentiment depressed and lead to periodic episodes of stress," says Jason Daw with investment bank Société Générale.

The Rand and other Emerging Market currencies have been hit by Dollar-strength which - because of the high proportion of Dollar-denominated debt the country holds - pushes up the cost of repayments.

Trade war fears and concerns about a broader global slowdown have also hit many Emerging Market currencies, especially those with high current account deficits which need to be funded externally.

Increased investor concerns have led to a flight of capital out of risky EM assets into less-risky US assets such as US treasury bonds, which has led to the fall in EM currencies versus the Dollar.

"This is the key thing for the EM the deficit currencies reliant on funding are weakening because capital is being reallocated back into the US," says George Saravelos, global co-head of FX research for Deutsche Bank.

"Each EM country has its own idiosyncratic risk profile - for SA a major risk is the fact that it is a popular destination for EM investors to allocate funds, and these are now being retrieved or reallocated to the US," says Saravelos.

Saravelos thinks the biggest issue that SA is facing is that it has been swept away by all the weakness in other emerging markets - Turkey and Argentina, and remember that SA is one of the biggest destinations of EM fund allocations.

Positioning is another factor behind the Rand's troubles.

Investors have bought-in to SA assets relatively heavily; perhaps because of optimism following the election of Cyril Ramaphosa at the start of 2018, on a economic reform agenda.

"The market has not been as underweight SA as it has been other markets, and now we are seeing a readjustment in that position, so we are actually quite negative the Rand because of these exposure," says Deutsche's Saravelos, who thinks the current weakness in the currency reflects some 'catching up' it has to do with other EM currencies.

Where Next for ZAR?

"We are near the 15.50 (USD/ZAR) which is the high of the year but I think we will see a move through 16.00 - and all that would do is represent a catch-up of the USD/ZAR with other Dollar-EM risky currency pairs with current account deficits," says Deutsche's Saravelos.  

Such a move should cement GBP/ZAR above 20.00.

Indeed, there are greater risks to this exchange rate should Sterling finally start strengthening on its own: the Pound has been under pressure for some time now amidst growing Brexit anxieties.

Most analysts are in agreement that should these anxieties fade and a deal between the EU and UK be reached, the Pound will rally.

This could light a fire under GBP/ZAR should Emerging Market stresses still be in place.

However, timing suggests this 'sweet spot' might not be reached: Most analysts only see a relief rally on Brexit clarity occurring in early 2019, or at the turn of the year.

By that stage there is a good chance the Emerging Market sell-off will have faded and potentially turned.

It's at this point that ZAR will start to recover.

"We maintain that the Rand and SA bonds are undervalued, even when the substantially weaker growth momentum is taken into account," says Zaakirah Ismail with Standard Bank in Johannesburg.

Therefore, we would suggest that a GBP/ZAR above 20.00 - as is the case now - is as good a time as any to purchase ZAR.

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