Pro emerging market assets
We entered 2017 with the view that EM currencies would continue to show strength on the back of improving global trade. These stronger currencies should reduce inflation and provide support for their interest rate sensitive assets in particular. The rand and the SA consumer price index (CPI) followed this trend through 2016, running well ahead of its emerging market peer group. As a result, we diversified our domestic interest rate sensitive (IRS) bet into other EM territories whose currencies (and IRS assets) had lagged the rand. That said, we believed the rand would continue to thrive on the prevailing global cyclical rally, cognisant of the fact that it was now fair value against most hard currencies. As a consequence, we still held a significant portion of SA interest rate sensitive equity and long-dated SA Government bonds. Because of our belief in resurgent global growth, we also remained positive about our domestic cyclical equity and therefore maintained our exposure to select counters.

Then came the reshuffle
The continuation of our pro-domestic stance going into 2017 speaks to our thinking around the possibility of an irreversible capture of the Treasury - either Zuma didn’t have the power to remove Gordhan, or if he tried, he himself would be extricated. When it became clear that neither of these outcomes would eventuate, we tempered our domestic IRS bet, allocating the proceeds to offshore assets (in addition to the EM exposure we had already established). This was a very difficult decision to make as we have previously discounted the impact of political events on the fundamental relationships we believe to be the drivers of asset class returns. However, Zuma’s latest triumph (and his country’s largest tragedy) likely signals an end to our previously disciplined fiscal behavior, and further denudes our state institutions of their thinning corruption armour. We believe our decision to reduce our SA Inc. exposure under this scenario was prudent.

Our burning question
The most important question to answer now is does the rand dislocate from its fundamental drivers (namely commodity prices) because of the pending onslaught on the fiscus, or does it re-establish the pre-shuffle trajectory thanks to an overwhelming flow of assets into emerging market economies? The market reaction to Gordhan’s removal was subdued compared to Nene-gate. We believe the prevailing emerging market favour has cushioned the blow to some extent. But the ability of the rand to continue benefitting from the general EM rally comes into question when the case of Turkey is examined; the lira has decoupled from the commodity price index since the attempted coup.

Our SA Government Bond position
We are still willing to maintain our exposure to SA Government Bonds (albeit smaller after the reshuffle). In a previous investment piece we put forward the notion that sovereign downgrades to junk rarely impact bond returns over the medium to long term. Rather, it is inflation that drives their performance. We concede that there is now an upside risk to our inflation numbers, especially if the rand unhinges from its fundamental driver, namely commodity prices. But given the capital flows that emerging markets are currently enjoying, we don’t yet believe that SA CPI is going to blow out. In addition, our bond yields are relatively attractive to other emerging market bonds given the respective levels of inflation.

Conclusion
We believe the macro theme that supports EM currencies and their interest rate sensitive assets is still in play. However, the uncertainty of how the rand will behave post a political event imbued with lasting consequences warranted a reduction in our local interest rate sensitive bet. Due to the rand hedge nature of our domestic commodity players, we have largely maintained our exposure to our select cyclical counters.