BRICS - Q3 2017

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Brazilian Real (BRL)

The Brazilian Real (BRL) has suffered from a particularly volatile few months in 2017 (Figure 1). The currency was one of the best performing emerging market currencies in the world in the six months from November. Then in mid-May the Real fell sharply by almost 10% in one trading session after the Supreme Court authorised an investigation into President Michel Temer, the latest in a string of political scandals that has plagued Brazil and its currency in the past few years.

Figure 1: USD/BRL (2012 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

Last year’s recovery in the Real was largely in line with a recovery in domestic economic activity, the rebound in commodity prices and decreased political uncertainty following the impeachment of President Dilma Rousseff. However, Brazil fell back into political turmoil in May following allegations that President Temer played a part in covering up corruption involving the imprisoned former house speaker Eduardo Cunha. Accusations of corruption have so far failed to bring down Temer’s government, and it appears political pressure would have to be considerably amplified in order to force the President’s resignation. There remains the possibility of another impeachment before the October 2018 election, although as we have seen this is a long and rather complicated process. Regardless, it is clear that political instability remains a key downside risk to the outlook for the Brazilian currency.

Amid the ongoing political uncertainty the Brazilian economy has finally emerged from a deep period of contraction that has led to one of the worst recessions in the country in decades. Brazil’s economy has contracted in each of the past fourteen quarters on a year-on-year basis, with GDP declining by 0.4% on a year previous in the first quarter (Figure 2). However Brazil finally posted its first positive period of quarterly growth since 2014 in the first three months of the year. The Brazilian economy expanded by 1% in the first quarter following a bumper harvest of corn and soy. The IMF recently raised its growth forecast for Brazil for 2017 to 0.3%, although it now expects it to grow by just 1.3% in 2018 versus the previous estimate of 1.7%.

Figure 2: Brazil Annual GDP Growth Rate (2006 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

Signs for the rest of the year have been fairly encouraging. The country’s balance of trade is heading in the right direction amid an improvement in global growth and a fairly weak BRL, posting an all-time record surplus in May. The manufacturing PMI has finally edged back above the level of 50 that denotes expansion for the first time in over two years, while industrial production posted its largest yearly growth since the beginning of 2014.

The relative improvement in economic conditions has been helped, in part, by recent actions of the central bank which has continued to loosen its monetary policy in the past few months. The Central Bank of Brazil (BACEN) unanimously voted to lower its main Selic rate by an additional 100 basis points to 10.25% at the end of May in an ongoing attempt to spur growth in the country. Interest rates have now been lowered by 4% since October with rhetoric from BACEN suggesting that more rate cuts may be on the horizon. The central bank looks likely to continue cutting rates this year, although claimed in May that a “moderate reduction of the pace of monetary easing” would be “adequate” following the high levels of political uncertainty. Financial markets are pricing in another 100 basis point cut in July. The combination of lower inflation, political risk, mediocre growth prospects and currency strength in our view mean that the current rate cut cycle is going to be more aggressive than markets expect.

Despite the series of interest rate cuts, inflation in Brazil has continued to trend downwards in the past few months. Headline inflation slumped to its lowest level in over ten years in June with consumer prices increasing by just 3%, right at the lower end of the central bank’s 3-6% target. The sharp decrease in inflation does, however, mean that real interest rates are still comfortably in positive territory and in excess of 6% (Figure 3).

Figure 3: Brazil Interest Rate vs. Inflation (2009 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

The Brazilian Real has continued to remain susceptible to political turmoil, and that will clearly present a fairly significant downside risk to the currency. The strong rally it has experienced recently leaves the Real vulnerable to a sell off, either due to internal political developments or to a general correction in emerging markets.

 

 

USD/BRL

EUR/BRL

GBP/BRL

Q3-2017

3.40

3.90

4.40

E-2017

3.40

3.80

4.40

Q1-2018

3.40

3.75

4.40

Q2-2018

3.40

3.75

4.40

E-2018

3.40

3.75

4.50

 

 

Russian Ruble (RUB)

The Russian Ruble (RUB) has continued on its steady path of appreciation against the US Dollar this year, recovering well from its record low level in January 2016. The currency did fall back to a five month low in July following a slump in oil prices, although remains one of the best performing emerging market currencies in the world against the Dollar over the past year (Figure 4).

Figure 4: USD/RUB (2012 – 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

Russia’s economy remains highly dependent on global commodity prices, given oil and gas exports account for around two-thirds of the country’s overall export revenue and one-third of GDP. Considering the above it is no surprise that the value of Russian Ruble is highly dependent on the price of oil and the two have traded almost hand-in-hand since oil prices plunged back in late-2014 (Figure 5). Brent Crude Oil rose to an eighteen month high back above $58 a barrel in January after OPEC announced its first production cut in eight years. However, oil slumped back to its lowest level since November 2016 in June after production data out of the US cast doubts over efforts to curb global oversupply. The average of oil price forecasts continues to suggest a gradual recovery in oil during the remainder of the year, although at a slightly slower pace than originally anticipated. Brent Crude oil is expected to rise to around $57 a barrel this year, which should continue to provide good support for the Ruble.

Figure 5: RUB/USD & Brent Crude Oil Prices (2014 – 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

The rebound in oil prices is beginning to filter its way through to economic activity in Russia following a bout of negative growth that led to one of the worst recessions in decades. GDP expanded by 0.5% on a year previous in the first quarter, although growth remains disappointing and well below the 5-10% levels the economy managed to achieve on a regular basis before the global financial crisis.

Russian exports have increased after falling to a record-low level at the end of last year. Exports do, however, remain subdued by low oil prices and systematically prolonged international sanctions from the EU, US and other mostly western countries. Rising commodity prices and responsible monetary and fiscal policies should support stable growth throughout the remainder of the year. The IMF is now forecasting the economy to grow by 1.4% this year, slightly higher than the 1.1% previous estimate.

Inflation in the country is continuing to trend downwards and we think that reaching the central bank’s 4% inflation target before the end of 2017 looks realistic. Headline inflation rose to 4.4% in June (Figure 6), although remains at a much healthier level than the near 18% recorded during the height of Russia’s financial crisis in 2015. The Ruble’s appreciation has helped in calming inflationary pressures in the past few quarters, although the pass-through effect of the exchange rate seems to be filtering out of the index.

Figure 6: Russia Inflation Rate (2012 – 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

Following the rapid decline in inflation, Russia’s central bank has embarked on introducing a more accommodating monetary policy. The Central Bank of Russia (CBR) has cut its main interest rate by a total of 100 basis points since the beginning of 2017, lowering the reference rate by an additional 25 basis points to 9% at the June meeting. The central bank has emphasises that current economic conditions, particularly following the drop in inflation, will mean lower interest rates are on the horizon in the second half of the year.

In our view the Russian Ruble remains well supported by a number of factors. Real interest rates remain high at around 5% despite the recent cuts, a relatively lofty level in today’s global financial climate and should remain a strong allure for investors. Oil prices continue to stabilise, albeit gradually, and the implementation of structural reforms should help economic activity accelerate this year. Russia’s FX reserves are also on the rise again and the country has accumulated one of the largest reserve-to-import ratios among emerging market economies at around 20 months’ worth of import cover. The Central Bank of Russia therefore has plenty of room to intervene in the currency market if required.

Given the raft of supportive factors for the Ruble, primarily the gradual increase in oil prices, we maintain our forecasts for an appreciation in RUB against almost every major currency.

 

 

USD/RUB

EUR/RUB

GBP/RUB

Q3-2017

60

64

78

E-2017

59

62

77

Q1-2018

58

61

76

Q2-2018

58

61

77

E-2018

57

60

75

 

 

Indian Rupee (INR)

Along with almost every other major emerging market currency, the Indian Rupee (INR) has rallied fairly sharply against the US Dollar this year. The Rupee surged back below 66 to the USD in March following the state election in India, while rising to a 21 month high in May off the back of broad Dollar weakness (Figure 7).

Figure 7: USD/INR (2015 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

The elections earlier in the year were positive for Indian assets in general. The governing Prime Minister Narendra Modi of the Bharatiya Janata Party surpassed expectations and obtained a resounding victory in a number of the country’s key states including its most populous area, Uttar Pradesh. The Rupee strengthened by over 3% in a little fewer than three weeks off the back of the news, with Modi now in a very strong position ahead of the next general election in 2019.

As we anticipated at the time the impact on the Indian economy of the high denomination bank note scrap aimed at stamping out corruption and tax evasion in November 2016 has been negative, but only modestly so. The scrapping of high denomination notes accounting for about 85% of currency has caused the Indian economy to slow so far this year. GDP grew by just 6.1% in the first quarter, a significant departure from the 7.1% consensus and its lowest level in over two years. Activity is expected to pick up pace during the remainder of the year.

The services PMI has risen back above the level of 50 that denotes expansion in each of the past five months after increasing to 53.1 in June, its highest level since October 2016. Export demand has also been stronger than expected so far this year, while the drop in inflation should help support consumer spending. In July, the IMF actually kept its growth forecast for India unchanged despite the recent economic slowdown, forecasting growth in the order to 7.2% in 2017/18 and 7.7% in 2018/19. This still puts India as the fastest growing major economies in the world. We think that the net effect of the bank note scrap will also be merely a postponement of consumption, so that the reduction in economic activity should be compensated by a similar increase over the second half of 2017. Growth of around 7% throughout the rest of the year looks feasible in our view.

Low oil prices by historical standards have also supported growth by improving the country’s balance of trade. With oil imports now double that of oil exports, the sharp decline in oil prices has been a net positive for the deficit, which has experienced one of the sharpest improvements of any major emerging market economy over the past few years (Figure 8).

Figure 8: India Current Account Balance (2000 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

Policymakers in India have kept interest rates unchanged since October, although the recent slowdown in growth and weak inflation means that risks of a cut in the main rate have increased significantly of late. Headline inflation fell sharply to just 1.5% in June, its lowest level on record and below the lower limit of the RBI’s 2-6% inflation target. The Reserve Bank of India (RBI) turned somewhat dovish on policy at its June meeting, softening its hawkish rhetoric and significantly lowering its inflation projection for 2017 to 2-3.5%. Financial markets are now pricing in around a 90% chance of an interest rate cut at the RBI’s next meeting in August.

Despite the recent slowdown in growth in India, and possibility of an interest rate cut by the Reserve Bank of India, we remain optimistic about the prospects for the Rupee. Firstly, the sharp drop off in the rate of inflation has led to an increase in the level of real interest rates. Real interest rates are now at around 5% which is very high in the present financial climate and should provide solid support for INR (Figure 9). Foreign exchange reserves have increased at a gradual pace and at the equivalent of ten months’ worth of import cover is more than enough ammunition for the central bank to intervene in order to protect the currency.

Figure 9: India Interest Rate vs. Inflation (2012 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

While we think the slowdown in growth in India will prove temporary, low inflation below the central bank’s target range looks likely to force the RBI into cutting interest rates this year, which could prove negative for the Rupee. However, given high real interest rates, large reserves and a small current account deficit, we continue to expect the Rupee to hold its own against the US Dollar next year, just higher than current levels.

 

 

USD/INR

EUR/INR

GBP/INR

Q3-2017

64

74

83

E-2017

64

72

83

Q1-2018

64

70

83

Q2-2018

65

72

85

E-2018

65

72

86

 

 

Chinese Yuan (CNY)

The Chinese Yuan (CNY) has had a solid 2017, rallying off January’s near eight year low and recovering around 3% of its value in the first half of the year against a broadly weaker US Dollar (Figure 10). The currency remains around 8-9% lower against the Dollar since the People’s Bank of China removed the currency’s soft peg back in August 2015 and began closely managing CNY against a trade-weighted basket.

Figure 10: USD/CNY (2015 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

The PBoC has remained committed to keeping its currency stable against the basket of currencies since the devaluation. Following a rebasing in December 2016 this now comprises of around 22% US Dollar, 16% Euro, 12% Japanese Yen, 11% South Korean Won and an additional twenty currencies all of which are weighted based on China’s dependence on the country for international trade. The central bank has, so far, done a reasonable job in ensuring stability against this basket, known as the CFETS RMB index, which has been broadly unchanged since mid-2016 (Figure 11).

Figure 11: PBoC’s CFETS RMB Index (2016 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

This year’s rebound in the Yuan has also come off the back of a general improvement in economic conditions in China. Boosted by higher government spending and bank lending, China’s economy has surprised to the upside so far in 2017, expanding at an annual rate of 6.9% in both the first and second quarter, up on the seven year low 6.7% recorded last year (Figure 12). A continuation of this throughout the remainder of the year would be the first time growth in China has accelerated on the previous year since 2010.

Figure 12: China Annual GDP Growth (2007 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

Economic news in the past couple of months has also been fairly encouraging and we think risks to growth are tilted slightly to the upside. The latest business activity PMI’s have been particularly impressive. The Caixin manufacturing PMI has been on a steady upward trend since the beginning of last year, with the index exceeding the level of 50 that represent expansion in 11 of the last 12 months (Figure 13), and is now back over that critical 50 level. Exports in China have also risen in each of the past eight months in CNY terms. The prospects of a serious protectionist move against China from the Trump administration looks fairly remote now given the many other open fronts for the US executive. This removes one of the downside scenarios for the Chinese economy and the Yuan.

Figure 13: Markit & Caixin Manufacturing PMI’s (2014 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

Policymakers in China have kept continued to keep interest rates unchanged, despite inflation falling comfortably below the government’s 3% target. Inflation slumped to just 0.8% in February, its lowest level since 2009, although has since rebounded to 1.5% in June. Amid a still shaky economic recovery and weak inflation, the central bank is unlikely to alter its main lending rate any time soon, which it has kept steady at 4.35% since October 2015.

The modest upswing in foreign exchange reserves in China also provides reason to be optimistic about the central bank’s ability to maintain a stable Yuan against its trade-weighted basket. Reserves fell by around a quarter in the three years from early 2014, although have since stabilised and actually grew again quarter-on-quarter in May and June for the first time in three years. This is a clear sign that restrictions to capital outflows are having an impact and that steady intervention is no longer necessary to stabilise the exchange rate. At any rate, reserves are vast and Chinese authorities should have plenty of room to intervene, should they deem necessary.

The People’s Bank of China has remained committed to maintaining the Yuan against its trade weighted basket of currencies this year. One of China’s key long term goals is the internationalisation of the Yuan as a means of exchange and a further decline in the currency would shake faith in the currency as a store of value and ultimately be self-defeating.

We think the People’s Bank of China has the necessary tools to maintain a roughly stable value of the Yuan against its trade basket. Given the recent downward revision to our US Dollar forecasts, we now expect a slightly more gradual depreciation of CNY versus both the Dollar and Sterling and only a very modest appreciation against the Euro. We do revise modestly upwards our forecast against the dollar given greenback weakness so far this year.

 

 

USD/CNY

EUR/CNY

GBP/CNY

Q3-2017

6.80

7.80

8.75

E-2017

6.85

7.65

8.85

Q1-2018

6.90

7.60

9.00

Q2-2018

6.95

7.65

9.05

E-2018

7.00

7.70

9.25

 

 

South African Rand (ZAR)

The South African Rand (ZAR) has remained one of the more volatile and unpredictable emerging market currencies so far in 2017. The currency appreciated to its strongest position in over a year-and-a-half in the first quarter before running into serious headwinds in early April following President Zuma’s cabinet reshuffle. However, the Rand has since stabilised again and is now trading around 6% higher for the year against the US Dollar (Figure 14).

Figure 14: USD/ZAR (2015 - 2017)

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Source: Thomson Reuters Datastream Date: 25/07/2017

Pressure on South Africa’s long standing President Jacob Zuma has intensified this year. Zuma shocked the market by unexpectedly orchestrating a mass reshuffle of his cabinet in March, firing Finance Minister Gordham along with a further nine ministers. Zuma has also been plagued with allegations of corruption since he came to office in 2009. In June, the ruling ANC Party called for an investigation into emails that allegedly showed links between Zuma’s family and wealthy businessmen. While the claims have been denied, years of corruption allegations and an inability of the President to tackle poverty in South Africa have severely damaged his popularity. Recent political uncertainty has had a detrimental effect on the country’s credit rating. S&P became the latest organisation to slash the country’s credit rating to junk in April in light of the political upheaval and concerns over government debt.

The recent stabilisation in ZAR has also come despite the South African economy falling into a surprise recession for the first time since 2009 in the second quarter. GDP contracted by 0.7% in the three months to June following on from a 0.3% quarterly decline in output in the first quarter and dumfounding expectations of a 1% expansion (Figure 15). The slowdown in activity was broad based with every industry baring agriculture and mining suffering from a contraction. The central bank has now revised downwards its growth forecasts for the South African economy and expects it to grow by just 0.5% in 2017 compared to the 1.0% previous projection.

Figure 15: South Africa Annual GDP Growth Rate (2006 - 2017)

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Source: Thomson Reuters Datastream Date: 25/07/2017

Policymakers surprised the market in July with the South African Reserve Bank (SARB) unexpectedly voting 4:2 in favour of cutting its main interest rate, while also adopting a much move dovish stance in its communications. The central bank lowered its interest rate by 25 basis points to 6.75%, having held rates steady since April 2016. The bank’s statement took a more sanguine view about upside risks, while also issuing a downward revision to its inflation forecasts. The SARB lowered its forecast for inflation by 0.4% for both 2017 and 2018 to 5.3% and 4.9% respectively.

Headline inflation has eased in the past few months and has fallen back towards its lowest level since late-2015 at 5.1% in June (Figure 16). The rather sharp downward revision in the central bank’s inflation forecast and shift to a more dovish stance means that there is now a good chance we could see another 25 basis point cut at the September meeting, which could prove negative for the Rand.

Figure 16: South Africa Inflation Rate (2008 - 2017)

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Source: Thomson Reuters Datastream Date: 19/07/2017

On a more positive note, the Rand remains well supported by the positive real rates in South Africa. The fairly sharp slowdown in inflation in the past few months means that real interest rates have increased at a steady pace and are now at just shy of 2%, its highest level since February 2011 (Figure 17). The recent rebound in commodity prices should also help support the country’s balance of trade, given the production of commodities account for around 60% of overall export revenue and approximately 25% of total imports. Foreign exchange reserves have also increased in relative terms and are now at the equivalent of around seven months’ worth of import cover. This should provide enough ammunition for the central bank to intervene in order to protect the currency.

Figure 17: South Africa Real Interest Rate (2008 - 2017)

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Source: Thomson Reuters Datastream Date: 27/07/2017

The South African Rand remains susceptible to political risk and it remains unclear as to whether Zuma will continue to be in power through to the next general election in 2019. This, combined with the likelihood of additional interest rate cuts from the central bank should, in our view, lead to a modest depreciation of ZAR against the US Dollar in the short term. However, we think the supportive factors for the currency should limit any significant long term losses. We do nudge upwards our short term forecast for the Rand in view of the surprising Dollar weakness so far this year.

 

 

USD/ZAR

EUR/ZAR

GBP/ZAR

Q3-2017

13.50

15.55

17.40

E-2017

13.70

15.35

17.65

Q1-2018

13.80

15.20

17.95

Q2-2018

13.80

15.20

17.95

E-2018

13.80

15.20

18.20

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