The rand is generally deemed strong, and offshore investments more attractive than domestic options
A broad review of market commentary and portfolio positioning clearly shows a consensual view among local asset managers that the rand has overshot as a result of ‘Ramaphoria’ and finds itself overvalued. Furthermore, many argue that after a sharp re-pricing of South African assets since November, bonds are unattractive and domestic equities are pricing in excessive optimism. In contrast, rand hedges are deemed attractive. Many investors are being advised to take advantage of the increase in regulatory limits for offshore assets in prescribed funds (from 25% to 30%, excluding Africa) by using rand strength to immediately increase their allocations.
Investing globally offers many advantages but should not be based on currency views
We consider global investments an essential building block for most domestic portfolios. The JSE is small and the benefits of a wider universe, diversification and hard currency protection cannot be underestimated. Furthermore, market timing is always difficult (if not impossible) and it is better to be buying dollars at R12/$ as opposed to R16/$ – where the exchange rate was two years ago. However, we do not consider it a foregone conclusion that the rand must weaken from here. In fact, we think it is very possible that the rand could be stronger than anticipated for a sustained period. We also think it is advisable to pause and question whether building a portfolio based on a singular view that the rand is overvalued is appropriate. Lastly, we believe that both South African government bonds and cheap domestic equities continue to provide an opportunity for attractive long-term returns at relatively low levels of risk.
We do not make currency forecasts and do not build portfolios on a directional rand view
We are, however, cognisant of longer-term economic cycles – and in particular, how the dollar cycle impacts emerging markets. (We wrote about this in the third quarter of 2017). We take this into account when managing our portfolios and aim to ensure that our client outcomes will be satisfactory regardless of unpredictable short-term movements.
Based on purchasing power parity (PPP), the rand is undervalued
A review of PPP (which gives an indication of the fundamental value of an exchange rate between two countries) may offer an alternative perspective to the view that the rand is currently overvalued. In Graph 1, it is noticeable that the rand is still undervalued on this basis. In fact, based on PPP, its fair value is closer to R10.70/$
While PPP has its flaws as a predictive tool, it does give us pause for thought
The shortcomings of using PPP as a predictive tool for currencies have been well documented. Firstly, it is very sensitive to which starting point you use and can be heavily influenced by short swings in inflation. Secondly, the rand is the key driver of local inflation and a move in exchange rates can have a causal impact on inflation differentials (the difference between two countries’ inflation rates).
That said, Graph 1 is instructive in several ways. Market participants have a tendency to extrapolate recent experiences. We think many are likely guilty of extrapolating the experience of the later years of the Zuma era, when the rand traded at more than two standard deviations below PPP fair value on a sustained basis. In total, it has traded weaker than the PPP value for four years, the longest period of successive weakness over the last 25 years. It can therefore be argued that the sharp appreciation since November is in fact a partial reversal of fundamental undervaluation.
We also observe that the rand has been strong relative to a PPP value for 60% of the time since democracy, contrary to popular perception. Interestingly, this has generally been during periods of synchronised global economic growth (such as 2005 to 2007 and 2010 to 2012, circled in the graph). It is therefore important to note that we are currently witnessing such conditions – and that the rand has previously displayed sustained multi-year strength when the global growth stars were aligned.
Rand weakness is not a necessary precursor to local growth
Another widely held perception is that the South African economy needs a weak currency to grow, given that currency strength acts as a headwind for many of our primary industries. Here, it is worth noting that the period in which South Africa experienced the strongest sustained GDP growth (3% and over) over the past two decades was between 2004 and 2007 – a period that coincided with a strong rand. This was a time of synchronised global growth and low levels of South African inflation.
We believe the medium-term inflation outlook is favourable
We think that there is a broad under-appreciation of how successful the South African Reserve Bank (SARB) has been at anchoring inflation expectations within its targets over the past 15 years: it has managed to repeatedly drop inflation below the 6% upper limit despite adverse conditions and extended rand weakness, as Graph 2 shows.
CPI is currently at 4% and, given the SARB’s credible inflation targeting track record, we expect benign medium-term domestic inflationary pressure. This is an outcome that we do not think is priced into longer-dated South African government bonds, even after the rally of recent months. We continue to view real yields as attractive for this asset class and our clients retain exposure.
Strong global growth and low local inflation stand to benefit the local economy
The combination of a favourable global economic backdrop and benign domestic inflation could likely give impetus to further interest rate cuts, which should provide a meaningful boost to the domestic economy. When we consider the low base of consumer and business confidence levels and the improved outlook for governance at state-owned enterprises, we could be looking at further upward revisions to South African GDP over the years ahead. This would be an environment in which the rand is likely to be stronger for longer.
We do not believe portfolios should be positioned for a weaker rand
Given the consensual positioning of domestic portfolios for a weaker rand and the fondness for expensive rand hedges, this scenario could see lower investment returns than many investors have become used to. A strong rand will also act as a headwind for the offshore equities that our clients own, but we take comfort from the high dollar returns we expect from current valuation levels. Furthermore, our portfolios contain a number of higher-quality domestic stocks that remain very cheap and on low levels of earnings. These stocks have missed out on the re-pricing of ‘SA Inc’, which has largely been restricted to the widely held JSE large caps. They should therefore do especially well in an environment of improving South African confidence and a strengthening rand.