(Bloomberg) -- The rand will be one of the few South African assets trading through the country’s general election Wednesday, as investor optimism that drove a five-week rally gives way to caution over the risk of a surprise outcome.

While reliable forecasts of the results won’t be available until early Thursday, the rand could respond to this newfound nervousness after a 5.1% advance since late April that was the second-best performance in emerging markets. Options traders are already pricing in turbulence in the currency, sending its one-month implied volatility to the highest level since October. For the rand’s post-election outlook, investors may have to wait until next week as the final tally is expected only by Sunday.

South African markets rallied in May amid expectations the next government will be headed by the ruling African National Congress, with a market-friendly coalition partner, thus signaling policy continuity. Less than a quarter of respondents in a Bloomberg survey were underweight the assets despite opinion polls signaling a generational change — ANC potentially denied majority for the first time in the post-Apartheid era.

Traders may have failed to price in the “tail risks” of either the Leftist Economic Freedom Fighters or former President Jacob Zuma’s uMkhonto weSizwe forming part of a new coalition government, said Eimear Daly, EM strategist at NatWest Markets. That will go against a survey finding that showed Wall Street favoring an ANC partnership with Democratic Alliance.

“The rand seems dangerously complacent to these risks,” she said. “While my base case is an ANC coalition with smaller political parties, prolonged coalition negotiations or civil unrest could give investors a wake-up call to what’s truly at stake in this election.”

Bloomberg Terminal clients can click on ELEC ZA for more on South Africa’s elections.

 

Election day is a public holiday in South Africa, and the nation’s stock and bond markets are closed. The rand was trading little changed as of 8:33 a.m. in Johannesburg at 18.3348 per dollar.

Here are how markets are stacked up as voters head to the polls:

Stocks

South Africa’s benchmark stock index has risen 3.4% in local-currency terms this month, beating more than 60 national benchmarks worldwide. Higher commodity prices fueled the gains, and investors started pricing in a positive election outcome. 

Different possible results would create different winners and losers, according to Andrew Kingston, the head of equities for active management at Sanlam Investments in Cape Town. If the ANC partners with smaller parties, sectors such as financial, consumer goods, and local manufacturing could benefit from increased economic stability and potential interest-rate cuts, he said.

“Conversely, shares exposed to international economies would benefit if the election results lead to increased political uncertainty and economic instability,“ he added.

But if the ANC forms a coalition with larger populist parties, significant currency depreciation and inflationary pressures could hurt local shares, particularly those in the retail and real estate sectors that rely heavily on the domestic market.

Rand

The rand is bracing for volatility at least in the short term.

The cost of hedging against currency declines over the next week is at pandemic-era highs, though the prognosis based on longer tenors is more favorable. The 12-month risk reversal, while still skewed in favor of the dollar, is well below the five-year average.

 

Carry traders have earned 5.4% in the past weeks by shorting the US dollar and investing in rand-denominated assets.

“The rand has benefited from a resurgence in global carry trades, which may have blinded investors to the domestic political risks,” Daly said.

Bonds

Both the nation’s local-currency bonds and dollar debt have outperformed the average returns in emerging markets in May. South African debt trades on one of the steepest curves in the developing world, partly due to high interest costs as a percentage of gross domestic product, said Bhumika Gupta, a strategist at Citigroup Inc. 

 

“This makes South African assets appear undervalued, with potential for a reduction in risk premiums, particularly at the long end, as global yields decline and South Africa remains hawkish,” she said.

“However, for investors to be truly attracted, South Africa needs to show better currency stability, growth and sustained structural reforms.”

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