By Michael Kruger, CFA, Investment Analyst, Morningstar Investment Management South Africa.
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.