Why investors should steer clear of the South African rand exchange rat race

Discussions regarding the rand exchange rate have been known to lead to many emotionally charged debates. Many South African citizens use the exchange rate against major developed markets (such as the United States and the United Kingdom) as an indicator of the state of the country. When the rand does well, South Africans tend to reflect this sentiment as they feel more secure and positive about the country’s outlook. The opposite is also true, in that when the rand struggles, we often become pessimistic about the state of the country.

Negative sentiment has, unfortunately, grabbed hold and sentiment is quite possibly at an all-time low. The country is facing a plethora of challenges, such as Eskom bailouts, political infighting, a potential credit downgrade from Moody’s (to sub-investment grade), the unemployment rate being at an 11-year high (at 29%), subdued GDP growth…and the list goes on. It’s no surprise that South Africans are weighed down by the ongoing stream of negative headlines. With that said, it’s not all doom and gloom and South Africans can find some reprieve in knowing that the value of our currency is only partially affected by South African specific factors.

 

As a small, open, emerging market that makes up less than 1% of the world economy, we are more likely to be affected by what is happening globally rather than in our own country. This is further exacerbated by the fact that the rand is one of the most liquid and tradeable currencies when compared to other emerging market currencies globally. Often when there is global risk aversion (better known as a “risk-off trade”) and investors flock to safe-haven assets, the rand acts as a proxy for all assets perceived to be risky by global investors (the recent issues in Argentina and Turkey come to mind). This can often lead to the rand depreciating in value.

 

A sharp depreciation in the value of the rand can be painful. Imported goods and services become more expensive, making it more expensive for South Africans to purchase everyday items such as fuel, machinery, electronics and vehicles. Stay-cations become the order of the day, as overseas travel becomes more expensive. Many of us are all too accustomed to the shock of converting the price of a coffee in New York back into rand.

 

It is worth keeping in mind, however, that rand depreciation also benefits some parties. Local exporters benefit from the rand weakness in that it makes the goods and services that we produce cheaper for foreigners and more attractive when compared to the goods and services available in other markets. One of South Africa’s largest sources of income is its tourism industry. When the rand is weak, South Africa becomes more appealing to tourists as a holiday destination as they can get more bang for their buck. For every eight tourists that visit our country, it is estimated that one permanent job is created in South Africa.

 

So how should we go about working out a fair value for the rand? Currencies can deviate significantly from fair value over time, however, over the long-term, movements between currencies should reflect inflation differentials between two countries. This is known as purchasing power parity (PPP). Due to the relatively higher inflation environment in South Africa (especially compared to most developed markets), we would expect the rand to depreciate against most developed currencies in the long-term.

 

The United States Federal Reserve (Fed), which is responsible for setting monetary policy in the US, targets an inflation level of 2%. The South African Reserve Bank (SARB), which is responsible for setting monetary policy in South Africa, targets an inflation level of 4.5%. As a simple example, if the US manages to maintain inflation at 2% per year and South Africa maintains inflation at 5% per year, we would expect the rand to depreciate against the US dollar by 3% per year over the long-term.

 

Currencies can frequently deviate from purchasing power parity over time. Extreme examples include the height of the commodities boom in 2005 and 2006 when the rand reached R6 to the US dollar. Following the removal of previous Finance Minister Nhlanhla Nene (in late 2015 and early 2016) the rand reached around R17 to the US dollar.

 

What should be apparent, however, is the movement in the exchange rate following these events. In almost all cases, the exchange rate moved back to a value which would be regarded as fair when judged according to PPP. That is not to say that currencies do not stay cheap or expensive for long periods of time. Idiosyncratic events may cause currencies to deviate from fair value for extended periods, however, currencies tend to move back to levels reflective of inflation differentials in the long-term.

 

So how should one approach portfolio construction when considering the value of the currency? By building portfolios holistically. In so doing, you can take advantage of offshore allocations to sectors or geographic locations that are underrepresented in the local market. Thereby, diversifying away from South African specific risk by allocating money to global markets which have a low correlation to our economy. You can also take advantage of allocations to foreign currencies that benefit from rand depreciation. There will be times when the currency appreciates, and global exposures detract from portfolio performance. Similarly, there will be times when the rand depreciates, and global exposures contribute to portfolio performance. Nevertheless, over the long-term, we expect exchange rate movements to compensate investors accordingly for investments in global markets.

 

The above factors once again emphasise the need for investors to remain patient, stay the course and avoid making investment decisions in a panic due to gloomy news headlines. This would include articles forecasting which direction the rand is heading. Previous experience has taught us that these forecasts are seldom accurate. It is during these challenging investment times that we should remove emotions from our investment decision-making process and focus on the fundamentals. As Nobel Prize winner Harry Markowitz said: “Diversification is the only free lunch in investing”.

 

At Morningstar, we continue to follow a valuation drive approach when allocating capital. This includes taking a holistic approach to portfolio construction, by allocating to unloved and cheap assets with a wide margin of safety. It is often during times when these assets are completely out of favour that the best opportunities for future returns present themselves.

Michael Kruger, CFA

Investment Analyst, Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

 

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

Is now really a good time to invest?

The fear of an impending recession, low interest rates, U.S. strength, South Africa’s weak economy, and the negative implications of the ongoing trade war (to name but a few), have left quite a few investors at an impasse. Many investors are battling with the question “is now really a good time to invest?”. Despite all these concerns, we believe that now is a great time to invest – provided you follow a tried and tested investment process

At Morningstar Investment Management, we follow a valuation driven investment approach. This investment philosophy aims to identify cheap asset classes to invest in and limits exposure to expensive asset classes. Many factors are considered in understanding the valuation of asset classes. Evidence points, such as longer-term valuation, is evaluated as a key determinant of future returns. To avoid value traps, fundamental risk is also considered to ensure that we do not invest our client’s capital into asset classes that are cheap for the wrong reasons (as these assets will likely remain cheap).

 

If we consider the CAPE ratio (Cyclically Adjusted Price to Earnings ratio) think of it as an inflation-adjusted measure of how much you are paying for each unit of future earnings. Therefore, the higher the value, the more you are paying for further earnings. Currently, assets with a high CAPE value include US largecap tech stocks such as Apple, Alphabet and Amazon, to name but a few. In this instance, investors are assuming that the growth achieved by these companies over the last couple of years will remain intact for the foreseeable future. They are also therefore willing to pay more for the future earnings of the asset.

 

As illustrated in the graph below, and if history is anything to go by, expensive asset classes tend to underperform their cheaper peers. If we were to rank all asset classes into expensive (Q5) and cheap (Q1) and measure the returns over the next 10 years, we can see that cheaper asset classes tend to outperform their more expensive peers.

 

 

By creating a portfolio of asset classes that have lower CAPE ratio’s, it creates the possibility of such a portfolio to outperform in the foreseeable future. But what happens if there is a market sell-off and all asset classes decline in value? If we consider what happens to these assets in the event of a significant risk-off trade (in other words, the large sell-off of equities), the more expensive asset classes (Q5) sell-off more than their cheaper peers (Q1). The cheaper asset classes will inevitably lose some value as well but a portfolio with a 10% drawdown will recover meaningfully faster than a portfolio that lost more than 50% of its value.

 

 

So, where are we seeing opportunities and how are the Morningstar portfolios positioned currently? In global markets, U.S. large caps are relatively expensive when compared to other asset classes (Q5). Areas such as the UK, Japan and Emerging Markets (Q1) are presenting better opportunities.

 

Locally, we’re seeing opportunity in S.A. bonds and the S.A. industrial sector. Our analysis indicates that S.A listed properties are still facing significant headwinds due to an oversupply of both retail and office space.

 

What does this mean for clients and ultimately their investment goals? Thankfully, lower interest rates have supported most asset classes in recent years. Going forward, it would be advisable to place more focus on expected future returns and risk management. It is no secret that risk has increased of late, but we remain confident that our investment approach will deliver positive outcomes for your clients -irrespective of market outcomes.

Eugene Visagie

Portfolio Specialist, Morningstar Investment Management South Africa

Risk Warnings

This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management South Africa (Pty) Ltd makes no warranty, express or implied regarding such information. The information presented herein will be deemed to be superseded by any subsequent versions of this commentary. Except as otherwise required by law, Morningstar Investment Management South Africa (Pty) Ltd shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.

This document may contain certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.

 

Morningstar Investment Management South Africa Disclosure

The Morningstar Investment Management group comprises Morningstar Inc.’s registered entities worldwide, including South Africa. Morningstar Investment Management South Africa (Pty) Ltd is an authorised financial services provider (FSP 45679) regulated by the Financial Sector Conduct Authority and is the entity providing the advisory/discretionary management services.

When selling, what about capital gains tax?

In a recent article1 we made the point that while investors are encouraged to remain invested through the cycle, there are several warning signals that should trigger the re-evaluation of their investment in consultation with their financial advisor. The article generated much interest, with advisors identifying the following additional triggers:

Significant cashflows

Significant cashflows in either direction over a short period of time may impact a portfolio manager’s ability to implement his investment philosophy. Monitoring cashflows is therefore important. In this regard, it is also important to understand how concentrated the ‘ownership’ of the fund is, as a fund with a few large investors could be materially impacted should one or more decide to exit.

Assets under management

Certain investment philosophies’ ability to deliver outperformance reduces as assets under management grow and portfolios become unwieldy. It is crucial that the asset manager has the discipline to close to new investments and not succumb to greed.

Offshore capability

With managers now able to invest up to 30% offshore and a further 10% to Africa ex-South Africa (in respect of Regulation 28-compliant funds and funds classified by ASISA as South African portfolios2) it is essential that the managers demonstrate excellent, fully integrated investment capabilities, with local and offshore assets managed holistically. While some managers may outsource the offshore holdings in their South African portfolio, we believe it vital they are managed with full oversight by the South African fund’s portfolio manager(s), rather than as a bolt-on portfolio of vanilla assets benchmarked to a global index. Bolt-on, at best, does not enhance the risk/return tradeoff and at worst leads to unintended positions within the fund.

1 Viewpoint: When to sell? – September 2019.

2 ASISA Standard on Fund Classifi cation for South African Regulated Collective Investment Scheme Portfolios, 30.10.18.

The impact of capital gains tax (CGT), often overlooked

For discretionary investors, even if a warning signal has triggered, a further consideration is the early payment of CGT when making portfolio changes. Or is it? While often considered, the CGT impact is seldom quantified. However, this is an important exercise because when an investor disinvests intra-term and pays CGT there is the compounding opportunity cost of the tax paid. Simply put, an investor in the maximum marginal tax bracket who realises a capital gain of a R100 000 pays CGT of R18 000 (if he has already used his annual capital gains exclusion of R40 000). The opportunity cost to the investor is then the difference between the future growth on the full R100 000 (if he did not realise the investment) versus the growth on only R82 000. This opportunity cost is often missed in the investment planning process because the CGT on a portfolio rebalance is generally paid later in the year, and often from an investor’s other liquid assets.

 

Quantifying the CGT cost of portfolio changes

Now that we understand that the early payment of CGT may carry an opportunity cost, we have tried to answer the following question; “If an investor switches out of fund A and into fund B at some point during their investment term, what additional return is required from fund B to compensate the investor for the early payment of CGT?”

 

The answer to this question is not straightforward and depends on multiple factors, which include the returns and profile thereof delivered by fund A and B, the investor’s investment time horizon and at which point in the investment time horizon the investor decides to switch.

 

As an example, let’s compare the experience of two investors, Jack and Jill who invest a similar amount in fund A at the same time, and have an investment time horizon of 10 years. Fund A delivers a consistent return of 10% p.a. and Jack remains invested for the full 10 years, at which time he disinvests and pays his CGT liability. Jill, on the other hand, identifies one of the triggers detailed above and decides to switch out of fund A after 5 years. After paying CGT, Jill invests the remainder of her proceeds into fund B. Table 1 sets out the excess return per annum that fund B must deliver over the following five years so that Jill has the same fund value as Jack at the end of the 10-year term.

 

Table 1: Excess return required from fund B

The table above shows that, for an annual return of 10% p.a. from fund A, fund B needs to produce an additional 0.60% p.a. so that Jack and Jill finish on the same fund value after 10 years. This difference in return represents the opportunity cost of paying CGT after 5 years.

 

Fairly intuitively, our analysis indicates that:

• The required additional return from fund B increases as the return from fund A increases (as seen in the table)

• The longer the investment time horizon the greater the additional return required from fund B (e.g. doubling the investment term to 20 years increases the excess return required on fund B from 0.60% p.a. to 0.81% p.a.)

• The earlier into the investment time horizon you switch, the lower the additional return required from fund B and vice versa

Conclusion

The CGT impact of making changes to an investment portfolio should be carefully considered and quantified. The CGT impact can set a portfolio back and should therefore be evaluated against the expected benefit of the portfolio change. Given the multiple factors that will affect this decision, we strongly recommend that you consult with a qualified financial advisor and seek expert tax advice, as required.

 

For longer-term, higher marginal tax-paying investors it may prove beneficial to hold their underlying local investments in the Investec IMS Access sinking fund policy and for offshore investments in the Investec GlobalSelect Access sinking fund policy, as they will benefit from the lower CGT effective rate of 12% (for maximum marginal taxpaying investors).

Important information

All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund. The fund is a sub-fund in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act.

This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Issued by Investec Asset Management, September 2019.

Focus on the Facts

I am tired as an investor. I am tired as an individual. I know that I am not alone. On the investment side, Darryl Hannington, Anchor’s head of portfolio management, spoke to equity fatigue and the various options available to investors in his article entitled, Invest(ing) in the other 99% published in the 3Q19 Navigator. Obviously, all the facts, figures and suggestions he made, makes sense. However, sometimes, as human beings, we might not necessarily.

In my previous article for the Navigator entitled Three money memories, I spoke about how financial behaviour tends to be more emotional than rational and that our financial behaviour, as with the rest of our actions, is a deep-rooted expression of our internal psychology.

 

The problem, though, is that, as human beings, there are numerous behavioural biases which impede our ability to reason if we don’t understand these inclinations and make a conscious effort to work around them. In this note, I want to talk about one of the options available to us as individuals to manage our mental health and, as a consequence, our financial health.

 

We are tired because we are constantly being bombarded by a seemingly never- ending stream of negative news. And, unfortunately, we are hard-wired on an evolutionary level to focus more on the bad news than (admittedly, the harder-to-find) good news. This is a psychological phenomenon known as the negativity bias.

 

A couple of years ago, I read a book by Rick Hanson, a neuroscientist and psychologist, called Buddha’s Brain. In this book, he simply explains our focus on negativity. Our ancestors needed to be alert to danger because it was a matter of life or death for them. We inherited these genes and, as such, we are inherently negative. In addition, not only does our brain’s “alarm bell” use more capacity (two-thirds) to look for bad news, but this bad news imprints far more quickly and lingers longer in our memory (in contrast to positive events and experiences, which are usually only held in our consciousness for a dozen or so seconds). There is positive-negative asymmetry.

 

Thanks to evolution, our biological and chemical make-up, we register and recall the negative over the positive. Did you really have a bad day, or did you only have a bad ten to twenty minutes during the day? Have you found yourself fixating on past mistakes or insults but rarely take note of your achievements or the compliments which you receive? Does it cause you more pain to lose money than the pleasure of gaining an equivalent amount?

 

This last one is an example of another behavioural bias called loss aversion as explained by prospect theory and explored in detail in the book Thinking, Fast and Slow and other works by Daniel Kahneman, a Nobel prize-winning economist. Kahneman did extensive research and writing in applying psychological insights to economic theory, especially with regards to making judgements and decision making.

 

So, not only are we subjected to bad news more regularly and easily, we also tend to focus on this more. Unfortunately, we cannot do much about the way in which news is reported since sensationalism sells. However, what we can do, is change the news that we actively seek out, and our subsequent interpretation thereof.

 

One of the best gifts I received last Christmas was a book (books always make for the best gifts). Unfortunately, I only started reading it recently. Although, in retrospect, maybe I started reading it at exactly the right time. I am an inherently positive person, but the past few months I have felt myself being weighed down by negativity.

 

“It is easy to be aware of all the bad things happening in the world. It’s harder to know about the good things; billions of improvements that are never reported.”

 

The book I received and I am reading, which I think every single individual, and investor should read, is called Factfulness by Hans Rosling. This (Factfulness) is the one option available to all of us as individuals to manage our own mental and financial health. Factfulness is the stress-reducing habit of only carrying opinions for which you have strong supporting facts.

 

As a working example from the very document that you are reading, I would highlight Peter Armitage’s contribution to the Navigator entitled, SA’s corporate meltdown: Billions of rand vaporised. You could read just the title and assume the worst, or you could delve deeper into the details of the piece and understand the facts being explained. As he writes in his opening paragraph: “The temptation is to jump to the conclusion that SA business is fraught with malfeasance, but this analysis seeks to illustrate that, while there has no doubt been unethical behaviour, the majority of failures have been through a combination of bad luck, tough market conditions, one-off unanticipated events and poor judgement.” Similarly, Glen Baker’s contribution, SA Property: Light at the end of the tunnel? demonstrates that, even though the property sector is not immune to economic conditions, there may well be a structural change in the way investors value property and SA-listed property is now trending towards an equity-like profile, which is in-line with property sectors across US, European and Asian markets.

 

In addition, as he explains, there are some mitigating fundamentals being ignored which present valuations that make for a compelling investment case. Both of these articles should be read in their entirety for the whole message to be properly understood and this also applies to almost any information we consume, albeit research, news, books etc. Of course, there are articles and news reports which are not even based on facts so it’s always important to curate what you consume and not only how you consume it.

 

The sub-heading of Factfulness is Ten reasons we’re wrong about the world – and why things are better than you think. Hans and his collaborators, Ola Rosling and Anna Rosling Rönnlund, offer a radical new explanation of why we are wrong about the world and why it is better than we think. They reveal ten instincts that distort our perspective and how to overcome these behavioural biases. His second reason, and Chapter Two explains the negativity bias, “our tendency to notice the bad more than the good”, as referred to earlier. There are numerous examples and stories and, most importantly, facts. In summary, we are negative because we misremember the past, are exposed to selective reporting by journalists and activists and a part of us feels heartless to say that things are getting better when some things are still bad (even if they are improving).

 

 

It is easy to be aware of all the bad things happening in the world. It’s harder to know about the good things.

On page 7 in the first few paragraphs of our Strategy and Asset Allocation section, we speak to the latter – we acknowledge that, even given the work that needs to be done locally and globally, we are pleased to see that the direction of change is improving. We need to recognise when we get negative news and remember that bad news is far more likely to reach us, and stay with us, than good news. Nick Dennis’s article entitled, Investing in uncertain times: What would Peter do? speaks to this wisdom and Nick quotes Peter Lynch who echoes this sentiment throughout. He summarises by noting that often we are our own biggest hurdle due to all the (usually negative) noise, but highlights that if we focus on companies (the facts) and maintain an optimistic outlook we will reach “nirvana”.

 

The world is constantly changing, and it is important for us as investors and individuals to update our knowledge and worldview accordingly. In my previous article for the Navigator, I wrote that financial integrity encompasses understanding why you manage money in the way that you do and if you are feeling competent to either continue in that manner, or to make the necessary changes. In this article, I want to encourage you to understand the type of information you are consuming and to make sure that you are making your decisions based on FACTS and not on your primordial negativity instinct. If you are not, make the necessary changes or allow us to assist you. Seeking out positive facts and factual news will not only improve your mental health but, as a result, your financial health as well.

by Tamzin Nel, Portfolio Management, Anchor Capital