A broad review of recent market commentary shows that many local asset managers believe the rand is overvalued and have positioned their portfolios accordingly. However, not all fund managers consider this a foregone conclusion.
“We do not make currency forecasts and don’t build our portfolios on a directional rand view. As such, we do not believe investors should rule out the possibility that the rand could be stronger than anticipated for a sustained period,” says Lyle Sankar, fund manager of the PSG Money Market Fund.
“Current rand strength is partly attributed to ‘Ramaphoria’,” he continues. “Many therefore argue that after the sharp re-pricing of South African assets since November, bonds and domestic equities are unattractive and rand hedges are the way to go.”
With this in mind, many investors are being advised to increase their allocations to offshore investments.
“While we consider global investments an essential building block for most domestic portfolios, we do not believe that offshore allocations should be based on currency predictions,” says Sankar. “In addition, we are mindful that there is a scenario under which the rand may remain stronger than expected, for longer than expected.
“We are still of the view that South African government bonds and cheap domestic equities provide an opportunity for attractive long-term returns at relatively low levels of risk.”
Based on PPP, the rand is undervalued
While the shortcomings of using purchasing power parity (PPP) as a predictive tool for currencies have been well documented, it still gives pause for thought.
“Based on our PPP model, the rand is undervalued,” says Sankar.
“Market participants tend to extrapolate recent experiences, and we think many may be 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, which is the longest period of successive weakness over the last 25 years.
“The sharp appreciation of the rand since November could thus be viewed as a partial reversal of fundamental undervaluation,” says Sankar.
“Contrary to popular perception, the rand has actually been strong relative to PPP value for 60% of the time since democracy, and this has generally been during periods of synchronised global economic growth, such as 2005 to 2007 and 2010 to 2012. “We are currently seeing similar global economic conditions.”
Rand weakness is not a necessary precursor to local growth
Many believe 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.
“The period in which South Africa experienced the strongest sustained GDP growth over the past two decades was between 2004 and 2007 – and this period coincides with a strong rand,” says Sankar. “This was a period of synchronised global growth and low levels of South African inflation.”
The medium-term inflation outlook is favourable
“The South African Reserve Bank has been highly successful 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,” says Sankar.
“CPI is currently at 4.5% and, given the SARB’s credible inflation targeting track record, we expect benign medium-term domestic inflationary pressure. Combined with a favourable global economic backdrop, this could lead to further interest rate cuts, which could provide a meaningful boost to our economy and potentially keep the rand stronger for longer,” Sankar adds.
“While we do not deem a stronger rand a certainty, we therefore believe it prudent to account for the possibility. We would caution against building portfolios that will only do well if the rand weakens.”