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Takeaway: Consistent w/ our outlook for EM asset prices, we see 15-20% downside in the EZA amid a myriad of idiosyncratic structural & cyclical risks.

Our Dour Outlook for EM Asset Prices Remains Firmly Intact

At Hedgeye, we like to go both ways – particularly when it comes to emerging markets. Recall that we authored the 2013 bear thesis back in April of last year, as well as the 2014 bull thesis in February/March of this year.

We are now overtly negative on the EM space going forward,  a research view we outlined in great detail in our September 23rd note titled, “EMERGING MARKETS: THE EM RELIEF RALLY IS LIKELY OVER”. In that note, we closed all of our active long ideas across EM, as well as introduced the Vanguard FTSE Emerging Market ETF (VWO) on the short side. We highly encourage you to review that note to the extent you haven’t already.

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - Idea Flow Monitor

Since then:

  • The WisdomTree India Earnings Fund (EPI) – a former long idea – has dropped another -2%
  • The iShares China Large-Cap ETF (FXI) – a former long idea – has dropped another -2.1%
  • The iShares MSCI Indonesia ETF (EIDO) – a former long idea – has dropped another -3.1%
  • The Vanguard FTSE Emerging Market ETF (VWO) – a former long idea – has dropped another -3.3%
  • The iShares JPMorgan USD Emerging Markets Bond ETF (EMB) – a former long idea – has dropped -0.8%

Those equity ETF declines compare to a -1.3% decline in the MSCI All-Country World Index over that time frame and the near one percent drop in the EMB ETF compares to a +0.1% increase in the Barclays Aggregate Bond Index since then.

As you can probably tell, booking gains at the appropriate juncture and minimizing losses remains a core focus of our fundamental research efforts, as most recently highlighted by our decision to book gains on the long side of Brazil (EWZ), which has dropped -5.6% since we booked an +11.2% gain in this bullish research recommendation on June 3rd and on the short side of Japan (DXJ), which has risen +10.9% since we booked a +0.1% gain in this bearish research recommendation on May 28th. Moreover, we’ve been implicitly negative on the former since our July 14th note titled, “SELL BRAZIL?”; the EWZ ETF has plunged -12.2% since then.

#ResearchAlpha…

As part of our nascent quest to populate our idea list with emerging market short ideas, we walk through why we think South Africa is a prime candidate in the sections below.

Our Model Suggests South Africa Has the Greatest Degree of Structural Economic Risk Among Emerging Market Economies

Unfortunately, we continue to lack a crystal ball, magic wand or rabbit’s foot with respect to making calls on emerging markets. That being said, however, we do possess what we continue to believe is the most robust model for quantifying risk across emerging market economies (i.e. our EM Crisis Risk Index).

And on this model, South Africa scores most poorly at the current juncture:

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - EXPLANATION TABLE

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - AGGREGATED RISK

South Africa’s key risks are concentrated in Pillar I (i.e. external sector risks) and Pillar IV (i.e. political and regulatory risks):

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - SUMMARY TABLE

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - PILLAR I

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - PILLAR IV

One of South Africa’s key issues is the fact that policymakers have failed to respond to ~18M of consensus expectations for [and actual] US monetary and fiscal policy tightening with credible tightening of their own. The current account deficit is actually wider now as a percentage of GDP versus its TTM average (-6.2% and -5.6%, respectively), while the sovereign budget deficit is little changed as a percentage of GDP versus its TTM average (-4.9% and -5.1%, respectively).

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - CURRENT ACCOUNT BALANCE

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - BUDGET BALANCE

Now, the country is at risk of meaningful capital outflows, while at the same time seeing reduced current account inflows from falling commodity prices. It’s worth noting that raw materials account for over half of South African exports (55%), with the slowing Chinese economy being its key export market at 14% of the total.

In light of the aforementioned dynamics, it’s no surprise to see the South African rand (ZAR) has dropped -5.2% vs. the USD over the past month; that’s the third worst spot return of the 24 EM currencies tracked by Bloomberg. We anticipate further downside over the intermediate term.

Our Model Suggests Cyclical Risks Are Mounting As Well In South Africa

The South African Reserve Bank (SARB) finds itself in quite the policy conundrum. On one hand, the Monetary Policy Committee (MPC) is projecting full-year growth in a range of +1.5-1.7%, which would be the slowest pace since 2009. On the other hand, inflation has exceed their +3-6% target for the past five months.

Layer on the fact that the SARB needs to find a replacement for Governor Gill Marcus who is stepping down from her post in November after just one term, and we clearly have a central bank that is squarely under pressure from both an economic and political standpoint. Pressure bursts pipes in emerging markets.

One key overhang on South African growth specifically are “managed” blackouts that are weighing heavily upon Industrial Production growth and Business Confidence trends. The state-owned Eskom Holdings SOC Ltd, which provides 95% of the country’s electricity, is facing a 225B ZAR ($20B) funding shortfall through 2018, which is forcing it to ration power during peak periods. Its 33.2 gigawatts of daily available capacity in the YTD is a mere 4% above estimated peak demand of 31.8 gigawatts, which is well shy of the 15% international norm. The current blackouts are eerily reminiscent of the 2008 blackouts that forced mine closures and were declared a national emergency.

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - INDUSTRIAL PRODUCTION

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - BUSINESS CONFIDENCE

This net result of these economic factors is that we see the South African economy mired in the stagflationary scenario that is Quad #3 on our GIP model for the balance of the year.

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - SOUTH AFRICA

Investment Conclusion: Short the EZA

Our Tactical Asset Class Rotation Model (TACRM) is generating a “SELL” signal for the iShares MSCI South Africa ETF (EZA). Moreover, TACRM is also generating “high-conviction SELL” signals for both EM Equities and Commodities, as well as a “low-conviction SELL” signal for Foreign Exchange. All three of these primary asset class signals corroborate the aforementioned “SELL” signal being generated for South African equities.

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - TACRM Heat Map

HUNTING FOR SHORT IDEAS IN THE EM SPACE? LOOK NO FURTHER THAN SOUTH AFRICA - TACRM Summary Table

In the context of these quantitative signals and the fundamental risks highlighted above, we believe South African equities are great short opportunity at current prices. We see probable downside to at least the 2013 lows of $53.61 (-16.2%) over the intermediate term.

Have a great night,

DD

Darius Dale

Associate: Macro Team