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Iran Nuclear Deal: Bad news for Inflation and Emerging Markets

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Oil and all of its associated products are key inputs into any economy, and fossil fuels remain the backbone. The current bullish developments in the oil price complex will have substantial impacts on inflation and currencies, especially for emerging markets having to import all of their oil. When the move is substantial and sustained, they face a double edged sword: oil prices rise and the local currency weakens, sending the import price even higher. This is bad news for inflation.
 
Currently, there are four key points driving developments in the oil market:
 

  1. The Iran nuclear deal. Trump delivered on his promise to pull out of the Iranian Nuclear Agreement, describing it as “horrible and one-sided”, and oil markets, unsurprisingly, have reacted in bullish fashion. Iran is OPEC’s third largest producer at 3.8 million barrels per day, yet the reaction has not been as significant as it could still prove to be with the market awaiting more detail on how the US withdrawal will affect other parties to the agreement. Tensions in the Middle East, particularly between Israel and Iran, have escalated sharply off the back of the announcement, with the two nations exchanging rockets and air strikes. The full effect of Trump’s withdrawal is only likely to be felt in six months, which is the deadline for companies operating in Iran to wind down their business there. Some respected oil market commentators are calling Brent Crude at $82.50 by the summer.  OPEC have stated that they will meet any shortfall that new US sanctions on Iran brings about, but the reality is that they, and in particular Saudi Arabia, require higher prices to balance their budget. 
     
  2. Possible further US sanctions against Russia. Trump backed off imposing further sanctions on Russia for supporting Syria’s chemical weapons attack on civilians. This does not mean that he will not extend sanctions further in the near future. This could cause 0.5 million barrels to be removed per day.
     
  3. Geopolitical risk in the Middle East. Instability continues to escalate and the war in Yemen rumbles on. Yemen is strategically important because of the Bab al-Mandab straight, a narrow waterway linking the Red Sea with the Gulf of Aden, through which much of the world’s oil shipments pass. It is also another potential point of contact between archenemies Saudi Arabia and Iran. Israel has been strengthening relations with Saudi Arabia who are keen to secure the nuclear deterrent offered by Israel as a possible defence against Iran and its nuclear aspirations. The risk of the Yemen war escalating and dragging in other parties is high, with Iran, Russia and Syria on the one side and Saudi Arabia, Israel and the US on the other.
     
  4. Venezuela’s oil industry crisis. The state owned oil company, PDVSA can barely stay afloat, forced to import light crude from the US to dilute the heavy oil it drills locally. Crude production has been falling for the last 25 months according to OPEC figures. They now produce half the oil they produced in the late 1990’s, 0.5m barrels per day have already been lost and supply is likely to decline further, with a high likelihood of a sharp collapse. Higher oil prices pose a risk to global growth, with inflation likely to rise in many countries. At the time of writing this report, July expiry ICE Brent was down 52 cents at $76.60 per barrel.

 
South Africa is an emerging market sure to be affected by these moves.
 
The recent change in the leadership of South Africa’s governing party - the ANC, has raised the country’s profile for foreign investment. The rising oil price, US steel tariffs and a rampant dollar all pose headwinds to the economy.
 
Wage pressures continue with the government’s latest offer of a 7% increase to unions against a demand of 12%. The government is walking a tightrope with elections looming in 2019 and they are likely to cave in on the high side, risking the fragile economic recovery. National Treasury is striving to reduce the budget deficit from the current 4.3% of GDP to 3.6% by March 2019. These figures exclude government guarantees to State Owned Entities. State wages constitute a whopping 35% of total state spending in fiscal 2018. The real solution is a downsizing of the public sector work force but this is not likely so close to an election. CPI is expected to average 4.9% for 2018 and printed at 3.8% in March.
 
GDP growth could still surprise on the higher side. Both the IMF and National Treasury have revised their forecast up to 1.5% for 2018, but Goldman Sachs stated in a research report earlier this month that they expect that the economic risks to be tilted to the upside. In January, they were predicting GDP growth of 2.4% but have seen little evidence of reform progress in key areas and will be monitoring four key areas: the mining sector, land reform, state owned enterprise policy and public sector negotiations. The ratings agencies will have similar views. SOE action is showing preliminary signs of the right policy shift but this is a huge task and requires changes in executive and buy-in of employees and management. Guarantees by the State in favour of SOEs pose the most significant fiscal risks to South Africa.
 
ZAR has endured a wild ride over the past week or so, hitting 12.75 off the back of Dollar gains and risk-off sentiment. This has since reversed with ZAR back at 12.23 following a lower than expected US inflation print.
 
South Africa’s mining and manufacturing industries contracted in March as policy uncertainty and lukewarm demand weighed on output, threatening to reverse a fragile economic recovery. Mining production suffered its worst fall in two years and, together with the manufacturing data, is signalling a poor Q1 growth, placing the GDP forecast for 2018 at risk. “Ramaphoria” is waning and the realities of his weak support base continue to plague his efforts to drive reforms and create a more business friendly environment. It will be interesting to see what progress his investment envoys make in the coming months as they attempt to raise $100 billion in direct foreign investment. The ANC remain deeply divided and Ramaphosa will need to step carefully in his attempts to make everyone happy. The ANC remain deeply divided and Ramaphosa will need to step carefully in his attempts to make everyone happy. Quite how he can marry the hugely divergent populist requirements of his elective base with the capitalist realities of the foreign investment community will make for interesting observation. I wish him all the best in his endeavours. 
 
Any businesses with currency, energy, commodity, or interest rate risk in South Africa should be looking at extending their hedging activities and ideally looking for optionality or participation to cater for the volatility to come.
 
Upcoming data releases
 
This is a data heavy week with EU GDP, EU CPI, ECB Current Account and EU Trade Balance proving direction for the euro and US Retail Sales, Manufacturing Production and Initial Jobless Claims providing dollar direction.

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