Running the Rand race? Best you put away your timer if you are…

It’s interesting how the value of the rand can influence our perception of the value of our country. A strong rand, when compared to the dollar, often makes us feel better about the state of affairs in South Africa. When the value of the rand climbs, so does our optimism about the growth and recovery of the country, while a weak currency fires up all the negative sentiment we read about in the press.

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. In the following article, we discuss the different factors that can influence the value of our local currency.

In recent years, the South African rand has been on the back foot against major currencies, with investors being extra cautious due to the many headwinds and political infighting that frequently dominates news headlines. Investors simply can’t ignore that the country has subdued growth, a weak fiscal outlook, rising industrial and social tensions, and external vulnerabilities associated with the current account deficit, all of which support a weaker currency.1

A research report2 was written by the International Monetary Fund (IMF) wherein it looked at the main drivers that impact the Rand/Dollar exchange rate since the onset of the global financial crisis and the results are very interesting.

Rand volatility could be attributed to global macro-economic factors

The IMF’s research showed that the main driver behind the movement of the rand relates to global factors and macro-economic events in the U.S. In other words, the level/value of the rand is often influenced and determined by dollar movement (strength and/or weakness). Roughly 30% of all rand volatility could be attributed to global macro-economic factors which influenced the US dollar and hence the rand.

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. This can often lead to the rand depreciating.

1 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.
2 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.

Commodity price volatility is a key factor

A second finding was that commodity price volatility was a key factor that influenced rand/dollar volatility. Roughly 30% of the volatility of our currency was a result of commodity price volatility. Over the past year, we have seen a sharp rise in commodity prices of which South Africa has been a beneficiary.

South Africa is a net exporter of resources, and 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.

South Africa also imported a lot less in 2020, which has impacted our current account balance positively which, in turn, has been a factor causing the recent Rand strength.

Impact of domestic factors on the rand

The IMF’s research also looked at the impact of domestic factors on the currency. They found that neither domestic macro-economic surprises nor those originating from other emerging markets are statistically related to rand volatility. However, they did find that local political uncertainty is positively associated with rand volatility.

Purchasing Power Parity’s part

Of the many metrics used to determine the valuation of the rand against other major currencies, is the Purchasing Power Parity Index (PPP). PPP is an economic theory that compares the different currencies from countries across the globe through a “basket of goods” approach.

In 1986, The Economist created the Big Mac Index 3 to create a lighthearted way of showing PPP and whether currencies were cheap or expensive. The Big Mac Index uses a price of a Big Mac burger in the US (as a base) and then compares the price of a Big Mac burger in every other country (in its native currency) and then looks at the price differential.

According to the latest Big Mac Index data, the rand is very cheap compared to the US dollar. A Big Mac costs R33.50 rand in South Africa and US$5.66 in the United States. The implied exchange rate is 5.92. The difference between this and the actual exchange rate, 15.52, which suggests the South African rand is 61.9% undervalued.4

With that being said – it should also be pointed out that we do not believe the Rand to be 62% undervalued – this is merely a fun way of looking at relative currency strength or weakness versus the US dollar.

3 https://www.economist.com/big-mac-index
4 https://www.economist.com/big-mac-index

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. 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.

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 that 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.

As can be seen in the below graph, the rand is currently undervalued on a Purchasing Power Parity basis.

Work done by the capital markets team at Morningstar supports the view that the Rand remains undervalued compared to the US dollar. It is also worth remembering that the rand never really trades at fair value. Historically, the rand moved in big swings from being expensive to being cheap and each time shooting through fair value.

Where does that leave us?

While the rand (at roughly R14/$) is undervalued/cheap, we don’t believe the economic data supports a materially stronger rand. Over time the inflation and growth differentials between South Africa and our developed counterparts support a depreciating currency. While the commodity cycle and US economic factors favour a firmer rand for now, we do expect that in a 10-year horizon the rand is likely to depreciate from these levels.

We are often asked the question, “Is this the time to be taking money offshore given where the Rand is?” and the best way to answer that is to quote Howard Marks who said, “This is not the time but it is a time”. The decision to invest offshore should be based on the investment opportunity. While the value of the currency does play a factor, we would encourage investors not to try to time the currency.

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.

In Conclusion

Over decades of evidence and through the investment literature there is one golden thread –time in the market remains superior to timing the market.

Ask yourself this: “Given where I am now, what actions move me closer to my long-term goals?” “Would an investment change align with the original investment plan for reaching well-defined goals?” These are different questions than, “What do I wish I had done last month?”.

We believe that investing is a long-term pursuit, patiently allocating to assets that will help you achieve your investment goals.

Victoria Reuvers

Managing Director

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.

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.