Paul Hutchinson, Sales Manager, Ninety One

 

Timing the currency seems to be a national sport in South Africa, with the purchasing power parity (PPP) model being the most used methodology to determine the relative strength or weakness of the rand. Simply put, PPP is based on the law of one price i.e., if there are no transaction costs or barriers for a particular good, then the price for that good should be the same in each country.

 

The Economist Magazine’s Big Mac Index is a widely quoted, lighthearted variation of the PPP-model – the idea being that a Big Mac should cost roughly the same in any country. Therefore, where the price of a Big Mac is higher in one country than in another (when converted to a common currency, usually the US dollar), then it suggests that the currency in the first country is overvalued. Clearly the Big Mac Index is not a perfect measure of currency values but is an entertaining guide.

 

At Ninety One we also use a PPP-model as one input into our view on the long-term trajectory for the rand. The following chart shows our calculation of fair value for the rand over time, versus where it has traded.

 

Figure 1: The long-term trajectory of the rand

Source: I-Net Bridge, Bloomberg & Ninety One as of 2 June 2023; log Scale

 

It is important to observe though just how seldom the rand trades at our calculation of fair value to the dollar; and at times the rand is either materially (two standard deviations) expensive or cheap relative to the dollar and can remain so for lengthy periods of time.

 

So, while this PPP-model provides insight into the direction of the rand over time, we argue that it should not be used in isolation when valuing the currency.

 

Compelling Forces Framework™

 

The Ninety One Compelling Forces methodology is a consistent framework that can be applied to investments, where the best opportunities score well on all three of the following metrics:

 

• Valuation: Is the investment cheap, expensive, or trading at fair value?
• Fundamentals: Do the facts underlying the investment support its case?
• Market price behaviour: Are investors buying the investment or likely to start buying it i.e., what is the market sentiment towards it?

 

As illustrated above, our PPP-model currently shows the rand as oversold, and by our calculations the rand should therefore depreciate marginally over the next 10 years to return to fair value. But what of the fundamentals and sentiment as they relate to the rand?

 

Fundamentals: a summary

 

Unfortunately, there is no clear steer when analysing fundamentals as they relate to the rand currently.

 

Positive:

 

The Monetary Policy Committee of the South African Reserve Bank has raised interest rates by 475 basis points since it started tightening monetary policy in November 2021 (more than doubling the repo rate in only 20 months, from 3.5% to 7.75%). While placing the consumer and economy under significant pressure, this action has maintained a relatively attractive interest rate differential with many first-world economies, which has supported continued capital inflows into South Africa attracted by the relatively high interest rates available in our market.

 

Neutral:

 

While not at the same levels as last year, commodity prices are generally holding up. This is important as commodities are mostly priced in dollars and falling dollar commodity prices result in downward pressure on the rand.

 

Negative:

 

The poor absolute and relative growth rate of the South African economy, coupled with the deteriorating Eskom and Transnet infrastructure, is negative for the rand. This is exacerbated by the deteriorating global economic growth outlook. It is broadly understood that the rand, while highly liquid, and therefore volatile, is a risk- on / risk-off currency i.e., the rand is a cyclical asset: when the global economy is strong and global equities are in a bull market phase, the rand tends to appreciate against the dollar and other developed market currencies, and vice versa when the global economy is weak.

 

Market price behaviour: a summary

 

Sentiment has turned negative towards, and within South Africa. Political risk is elevated following the ‘Lady R’ – did we or did we not load arms onto the Russian ship in Simonstown? – fiasco, and by the increasing political rhetoric leading up to the 2024 national elections.

 

In the financial markets, sentiment was not helped when the Financial Action Task Force grey-listed South Africa earlier this year, making it more onerous to execute global financial transactions. At the same time, the changes to Regulation 28 of the Pension Funds Act, which increased the allowable offshore exposure of a Regulation 28-compliant investment from 30% (excluding the additional 5% to Africa) to 45%, has seen continued selling pressure on South African assets as investment managers upweighted their offshore exposure.

 

And finally, there is increased global risk aversion, adding to selling pressure on emerging market assets. All this adds pressure on the rand.

 

A forward-looking view on the rand

 

Bringing these three compelling forces together then, the PPP-model is showing that the rand has sold off too much and is therefore offering value at these levels. Unfortunately, however, both the fundamentals and sentiment are against the rand in the short term. In the very short term, however, there does appear to be some improvement in sentiment. The fact that these three forces are currently (and often) not in synch adds to the rand’s volatility, making timing the currency incredibly difficult.

 

Take a long-term view when investing offshore

 

For those South Africans looking to diversify their investment offshore into a longer-term growth investment, it is worth noting that our analysis[1] shows that the rand / dollar exchange rate at the time of the investment matters far less than the value at which they purchase the offshore growth investment. Simplistically this is because in a risk-on environment, investors switch exposure from developed market (DM) assets to emerging market (EM) assets, depressing DM asset prices and strengthening EM asset prices, and currencies like the rand. In a risk-off environment, the reverse is true, with investors reversing their allocation back to DM assets, resulting in a weakening rand, which then acts as a ‘shock absorber’ for an offshore investment.

 

So, what the rand may give you in terms of a potential offshore investment entry point, offshore asset valuations (and asset price momentum) tend to take away, and vice versa.

 

 

ENDS

[1] Does the exchange rate really matter when investing offshore for the longer term? See link: https://ninetyone.com/en/south-africa/insights/taking-stock-summer-2023/does-the-exchange-rate-really-matter-when-investing-offshore-for-the-longer-term