RMB FINANCIAL MARKETS RESEARCH ZAR OUTLOOK

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1 CURRENCIES MAINTAINING OUR BEARISH VIEW We maintain our bearish view on the ZAR. The driver though is changing from the fallout in the international stock market towards the underlying weakness in the balance of payments and deteriorating local confidence. While possible USD weakness, an international market recovery, and the oversold nature of the ZAR offer scope for ZAR gains in the short term, upside on USD/ZAR through the year is much more likely. For now we maintain our 7.7 year-end view but continue to see the risks seriously biased to the upside. (Page 2) INTERNATIONAL MACROECONOMY: GLOBAL GROWTH TO SLOW (PAGE 3) Figure 1: We maintain our bearish view on the ZAR USD/ZAR 14. Actual Forecast We share the IMF s view that global economic growth will decelerate markedly this year. With downward growth revisions in the developed world raising the risk of spillovers into emerging markets and commodity prices. DOMESTIC ECONOMY: PEAK IN RATES AS THE ECONOMY SLOWS (PAGE 4) Apart from a sharp slowdown in global growth, electricity outages introduce an additional downside risk to our already below potential growth estimate of 4 for 28. While inflation can still push higher in the short term we see the next move in policy rates down, probably as early as 4Q8., RMB FM Research Table 1: ZAR forecasts (end period) Quarterly 1Q8 2Q8 3Q8 4Q8 USD/ZAR EUR/ZAR GBP/ZAR ZAR/JPY Annual USD/ZAR EUR/ZAR GBP/ZAR ZAR/JPY DOMESTIC ECONOMY: HIGHER INFLATION EXPECTED IN THE LONGER-TERM (PAGE 5) Despite a favourable short-term outlook, the long-term inflation outlook has deteriorated. Factors that have caused us to become more concerned include: politics, Eskom tariffs, electricity constraints, the weakness in the ZAR, and the growing openness of economy. Rand Merchant Bank and First National Bank are divisions of FirstRand Bank Limited John Cairns john.cairns@rmb.co.za +27 () Please see the last page for your local Treasury contacts

2 MAINTAINING OUR BEARISH ZAR VIEW We maintain our bearish view on the ZAR. The driver though is changing from the fallout in the international stock market towards the underlying weakness in the balance of payments and deteriorating local confidence. While possible USD weakness, an international market recovery, and the oversold nature of the ZAR offer scope for ZAR gains in the short-term, upside on USD/ZAR through the year is much more likely. For now we maintain our 7.7 year-end view but continue to see the risks seriously biased to the upside. THE USD AND RISK CHANNELS SUBSIDING As we have set out before the US economic problems have fed through primarily via two channels. The first of these, weakness in the USD, dominated in Q3 and Q4. As expected, the second, the risk channel, has dominated more recently. Both will of course impact further but arguable most of the adjustments have already been seen. The USD exemplifies this theme; after sharp falls from July onwards it has essentially traded flat since end-november. Deteriorating US fundamentals and the aggressive Fed rate cuts still offer scope for USD weakness, and hence USD/ZAR downside, and its interesting that the extremely short USD positions of recent months, which may have restricted further USD moves, have now been cleaned out. There have though been some suggestions that the market will start punishing currencies where actions aren t being taken to stimulate growth. The EUR stands out here, and some see it as only a matter of time before the ECB follows the Fed. Whether global stocks have fallen far enough is more questionable. Some US banks are suggesting another 8 1 decline in the S&P but others are way more bullish. Whatever the case, volatility is likely to remain extreme and any hope that the ZAR could decouple is now long gone. STRUCTURAL BOP NEGATIVES We have noted for some time that portfolio inflows have abated. January flows though took this to a new record with almost R12bn of net outflows, mostly out of equities but also partly out of the bond market, the worst figures ever. In fact, given these lack of flows it s not entirely clear how the ZAR has managed to hold up as well as it has. Partly this may be that the trade account deficit was low in both November and December, purely a temporary seasonal effect. Flows associated with the Standard Bank/IBCB deal have also come through the market seeing as they haven t been reflected explicitly in reserves. High rates may also have helped, although with currency volatility as it is its hard to see carry trades being put on. There are signs at least that the current account may be stabilising; we look for an around 8 deficit this year. This still needs to be funded though and it s not entirely clear where this will come from. Figure 2: ZAR followed the Dow weaker but is now on its own 7.5 USD/ZAR Dow Index Futures (RHS) 12, ,5 13, 13,5 14, 14,5 Jul-7 Oct-7 Jan-8 Figure 3: Record net selling of local and bonds equities by foreigners Rm 15, 1, 5, -5, -1, Source: I-Net, RMB FM Research RAND MERCHANT BANK page 2

3 INTERNATIONAL MACROECONOMY: GLOBAL GROWTH TO SLOW We share the IMF s view that global growth will decelerate markedly this year, with the major catalyst for the downward growth revisions coming from weaker activity in the developed world. The risk of carryover into emerging markets and commodity prices has increased. The IMF s World Economic Outlook Update published earlier this week forecasts that global growth will slow to the lowest level in fours years (4.1 in 28). While growth in the US is expected to moderate further this year to 1.5, the deceleration in the developed economies has become more broadbased, with growth in the euro area now expected to ease to 1.6. The softening of domestic demand conditions in the developed world poses downside risks to the outlook for emerging market growth, especially commodity exporters. In this environment, countries that are heavily reliant on capital inflows to fund domestic savings shortfalls are especially at risk. Although US inflation should eventually moderate in line with slowing economic growth, it will remain a concern in the interim given fears of further food and oil price increases. This will probably prevent policy rates from falling as far as they did during previous sharp US downturns. Barring a further significant deterioration in the labour market, it is unlikely that we will see a repeat of the post-21 period of sharply negative US real rates. The Fed would also try and prevent short rates from falling substantially below inflation as it could cause future problems by boosting asset price inflation. A Fed funds rate of 2.25 would represent a significant loosening of monetary policy. Timed with substantial fiscal relief (where an estimated $15bn worth of personal and company tax cuts are expected), this should provide sufficient stimulus for real growth in the US economy to return to positive territory in 2H8. Combined, significant monetary and fiscal policy relief should go some way to restoring investor confidence later in the year and we expect pressure on EM spreads to subside once growth in the US starts to recover. The bold action taken by the Fed over the past two weeks will have put pressure on other central banks to follow their lead by cutting rates more aggressively than initially anticipated. For example, the Bank of Canada also cut as an emergency measure against weakening economic growth. Meanwhile, in response to a housing-led slowdown in consumer expenditure, the BoE should continue to lower rates whether the Fed eases policy further or not. Given deteriorating economic activity in the US (and UK), it is only a matter of time before the EU will follow suit. Figure 4: US inflation remains concern, at least in the short-term y/y US CPI Figure 5: US growth worries driving EM spreads wider bp EMBI+ spread Figure 6: Other major central banks expected to follow the Fed 7.5 Fed ECB BoE BoJ RAND MERCHANT BANK page 3

4 DOMESTIC ECONOMY: PEAK IN RATES AS THE ECONOMY SLOWS Apart from a sharp slowdown in global growth, electricity outages introduce an additional downside risk to our already below potential growth estimate of 4 for 28. With the CPIX peak in sight, this strengthens our conviction that the next move in policy rates is down. Figure 7: Economic growth to decelerate in 28 q/q annualised y/y After four years of expanding at a rate in excess of 5, we expect real GDP growth to slow to 4 in 28. The anticipated slowdown will be concentrated in sectors in which output is driven by consumer expenditure i.e. wholesale/retail trade and financial services (which as a group accounts for 4 of GDP). Aside from government infrastructure investment, which should remain strong, weaker household expenditure coupled with softer global demand is expected to see real growth in private sector fixed investment slow (from 14 in 27 to around 11 in 28). Recent economic data support our view of a consumer-led slowdown. Real growth in retail sales weakened from a recent high of 6.5 y/y in August to only.2 in November, driven lower by falling sales of furniture and household appliances. In addition, after stabilising in 3Q7, real growth in new vehicle sales has worsened again, contracting by as much as 18.1 y/y in December. There is also evidence that the slowdown is broadening beyond just the retail and motor sectors: in constant prices, total building plans passed contracted by 2.7 y/y in the period between January and November, while in real terms house prices have stopped rising. Sharply lower discretionary spending could see real growth in household spending halve to around 4 in 28. What was initially only a warning about electricity shortages is fast turning into reality. Production losses are being incurred and, if sustained, have the potential to substantially erode GDP growth. In addition, outages have hit at the worst possible time. Led by the US, global growth prospects are rapidly deteriorating and a wide range of interest rate sensitive sectors are clearly already under pressure, with the full impact of the 4bp of tightening since mid-26 still to be felt. It is still too early to estimate the potential negative impact on growth from current outages. However, even if shortages are temporary, they represent a downside risk to our GDP forecasts. A prospective negative output gap combined with CPIX inflation topping out leaves scope for a first rate cut in 4Q8. However, where the MPC could previously afford to lower rates aggressively as inflation fell sharply, one should keep in mind that during those periods, the current account balance was either in surplus or in a small deficit. Neither of these conditions is expected this time around: rising food, petrol and related energy costs should see inflation coming down only gradually, while strong government fixed investment and rising income payments stand to keep the current account deficit large. We therefore expect rates to fall only gradually Source: Stats SA, RMB FM Research Figure 8: Consumer sectors taking strain y/y y/y 15 Retail Sales (LHS) New Vehicle Sales (RHS) Source: Stats SA, I-Net Bridge Figure 9: Lower inflation to lead to monetary policy easing in late 28 Target Area Repo rate CPIX Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Source: SARB, Stats SA, RMB FM Research RAND MERCHANT BANK page 4

5 DOMESTIC ECONOMY: HIGHER INFLATION EX- PECTED IN THE LONGER TERM Despite a favourable short-term outlook, the long-term inflation outlook has deteriorated. Factors that have caused us to become more concerned include: politics, Eskom tariffs, electricity constraints, the weakness in the ZAR, and the growing openness of economy. Figure 1: Cyclical fall in inflation expected y/y CPIX Forecast GROWING CONCERNS OVER STRUCTURAL INFLATION Despite a favourable short-term outlook, the long-term inflation outlook has deteriorated. While we still view the trend inflation rate to be around 5.5, there are a few factors that have caused us to become more concerned and which have added to an increasing uncertainty premium. These factors include: The change in ANC leadership has raised concern over the political will to maintain the current monetary policy framework of inflation targeting; The fact that Eskom has requested electricity tariff increases of 2 per annum over the next five years raises inflation concerns not only from the direct impact but also from the more crucial potential secondround effects; The downside risks to potential growth arising from the electricity constraints places upside risks to inflation. This is especially the case considering the potential negative impact on productivity growth and the concomitant increase in unit labour costs; and Our currency strategist expecting the rand to weaken moderately to USD/ZAR7.7 by year-end, with a 25 probability of it reaching 9.. While steady currency depreciation should not be too alarming, the growing risk of a sharp currency depreciation could have dire consequences for the inflation outlook, especially considering how much more open the economy has become over the past few years Source: Stats SA, RMB FM Research Figure 11: Increasingly open economy raises currency/ inflation risk Imports/GDP Source: SARB, RMB FM Research RAND MERCHANT BANK page 5

6 CUSTOMER DEALING RMB CORPORATE Spencer Robus RMB COMMERCIAL Anthony Grant RMB CAPE TOWN Louis Koen RMB DURBAN John Gaughran RMB PORT ELIZABETH Jacky Buys CURRENCY SOLUTIONS Raveen Ramlakan FIRST NATIONAL BANK BOTSWANA Pauline Motswagae FIRST NATIONAL BANK NAMIBIA Phillip Shiimi FIRST NATIONAL BANK SWAZILAND Khetsiwe Dlamini FIRSTRAND UK Martin Richardson Jan Sluis-Cremer Sylvia Kenny +44 () Reuters: FRBL RMB FINANCIAL MARKETS RESEARCH FIXED INCOME RESEARCH Theuns de Wet Bulent Badsha ECONOMIC RESEARCH Ettienne le Roux Kay Muller CURRENCY RESEARCH John Cairns CREDIT RESEARCH Jana Kershaw Elena Ilkova DATA ANALYST Raymond Sithole DISCLAIMER This research has been written by the financial markets research team at FirstRand Bank Limited (acting through its Rand Merchant Bank division) ( the Bank ). Whilst all care has been taken by the Bank in the preparation of the opinions and forecasts and provision of the information contained in this report, the Bank does not make any representations or give any warranties as to their correctness, accuracy or completeness, nor does the Bank assume liability for any losses arising from errors or omissions in the opinions, forecasts or information irrespective of whether there has been any negligence by the Bank, its affiliates or any officers or employees of the Bank, and whether such losses be direct or consequential. Nothing contained in this document is to be construed as guidance, a proposal or a recommendation or advice to enter into, or to refrain from entering into any transaction. This research contains information which is confidential and may be subject to legal privilege. It is for intended recipients only. If you are not the intended recipient you must not copy, distribute, publish, rely on or otherwise use it without our consent. Some of our communications may contain confidential information which it could be a criminal offence for you to disclose or use without authority. If you have received this communication in error, please notify us at the address below and destroy the communication immediately. This communication is not intended to nor should it be taken to create any legal relations or contractual relationships. The Bank is an Authorised Financial Service Provider under South African law but is not authorised and regulated by the Financial Services Authority in the UK ( the FSA ). Any protection afforded by the rules of the FSA does therefore not apply. FirstRand (UK) Limited is a co-subsidiary of the Bank. Both companies are owned by FirstRand Limited, a company listed on the Johannesburg Stock Exchange in South RAND MERCHANT BANK page 6

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