Ride the rand’s ups and downs
Investors and financial planners should stop trying to forecast the short-term fortunes of the rand relative to other currencies and instead take advantage of misalignments in the medium-term valuation of the rand, David Knee, the head of fixed income at Prudential Portfolio Managers says.
The current relative strength of the rand, together with favourable valuations (prices relative to future earnings) of foreign shares, is a compelling case for investing in international equities, Knee says.
In addition to the robust hard currency returns that international equities are priced to deliver, the rand is expected to depreciate in the medium term, because it is widely regarded as overvalued on all the measures used by economists and analysts, he says.
(A hard currency is one in which investors have confidence.)
Although it is impossible to time currency moves, investing in offshore assets when the rand is overvalued will produce superior returns, because history shows that the rand will depreciate in the medium term, and you will then benefit from both the weaker currency and the return on the international asset held.
While the precise extent to which the rand needs to depreciate in order to return to its true value can be argued, should it move from its current level of overvaluation to being more fairly valued, this would entail it depreciating by five to six percent a year over the next few years, Knee says.
The difference between inflation rates in South Africa and the United States is often used as a gauge of how much the rand should depreciate against the US dollar to maintain purchasing power parity (to ensure that the cost of, for example, a hamburger here remains the same relative to the cost of a hamburger in the US over time), Knee says.
Since 2000, South African inflation has exceeded that of the US by 44 percent, while the rand has depreciated by just over 10 percent, which means that goods in South Africa are now over 30 percent more expensive for Americans than they were a decade ago. Knee says it is impossible to know when this difference will unwind, but he suggests it is reasonable to assume that it will unwind in every five-year period, and this would entail a depreciation in the rand-US dollar exchange rate of six percent a year.
Focusing on a single exchange rate, such as the rand to the US dollar, may sometimes be misleading, because South Africa has a number of trading partners and none of them accounts for more than 10 percent of total trade with South Africa, Knee says.
However, currently an analysis of the rand’s exchange rate to all the currencies of the country’s major trading partners also shows that the rand is overvalued to these currencies, he says.
The rand exchange rates and inflation differences of South Africa’s trading partners are combined in what is known as the real trade-weighted exchange rate. At the end of February, this exchange rate was 13 percent above its average since the end of 1995, Knee says.
While the strength of the rand seems to indicate that it should depreciate in the future, the fortunes of the rand in fact cannot be forecast, because the factors that drive the strengthening or the weakening of the rand are inconsistent over time, Knee says.
You cannot identify catalysts that will accurately predict what the rand will do, he says.
While you can always tell a compelling story for whether the rand should strengthen or weaken, the rand is one of the most volatile currencies in the world, and being subject to its fortunes is “bound to be a bumpy ride”, Knee says.
The best thing for investors is to have a plan on how to invest and to implement that plan on a consistent basis, Knee says.
History shows that you can decrease the volatility of your investments by having some exposure to offshore markets, Knee says.
While certain global events affect all investment markets, the magnitudes of the effects differ. When investors are spooked by these events and want to decrease their investment risk, they often buy US government bonds, which in turn boosts the dollar and the US bond market, he says.
Knee suggests that you step back from the high-frequency data about investment markets and economic conditions and learn to accept unpredictable episodes of rand strength or weakness. When they occur, use them to your advantage.
The strength of the rand can be used to your advantage if you need to increase your exposure to offshore assets, Knee says. You may be reluctant to do this, because the rand returns from offshore markets over the past 10 years have been very disappointing for local investors. But the returns of the past decade should not be a surprise given the valuations of the different asset classes 10 years ago, Knee says.
If you had invested R100 in January 2000 in global equities (as measured by the MSCI World index), at the end of last year your R100 would have been worth only about R115 – far less than you could have earned in local listed property, equities, bonds or even cash.
If you invested R100 in January 2000 in global bonds (as measured by the JP Morgan Global Government Bond index), at the end of last year your money would have doubled but you would still have under-performed local cash.
If you had invested in local bonds, you would have tripled your money (reaching R350), while inflation-linked bonds would have quadrupled your money (R400).
An investment in local equities would have turned your money into R560, but the shoot-the-lights-out asset class over the past 11 years was the local listed property sector. R100 invested in January 2000 in listed property as measured by the FTSE/JSE Listed Property index would have been worth R960 at the end of last year.
Knee says that the difference between what you earned from local equities and what you earned from foreign equities is not surprising, because the price-to-earnings (PE) ratio of global equities was so high at the start of the decade in 2000. The PE of the US equity market was 30 in January 2000, before the technology bubble of that year burst.
It is not the case that US companies have failed to deliver earnings growth over the past 11 years – in fact, they have doubled their earnings over the decade – but the valuations at which you buy shares initially make all the difference, Knee says.
Valuations on global equities are now cheap in comparison with their extremely expensive levels in 2000.
The PE ratio of the US market is now about 15, compared with double that a decade earlier. Knee says that investors are now paying half the price for future US company earnings than they were in 2000. This means that the prospective real yield (the return before adding inflation) from US equities is now over seven percent, whereas it was struggling to reach 3.5 percent 10 years ago.
Knee says that Prudential Portfolio Managers expects offshore developed market equities to be the best performing asset class over the next three to five years and to deliver an annual hard currency return in the region of 15 percent, while local equities will return little less than this.
In addition, should the rand weaken as expected, your rand returns from an offshore investment could be boosted by five percent a year, taking the prospective annual total return to about as much as 20 percent.
IS A STRONG RAND GOOD OR BAD?
A rand that is either very strong or very weak is not good for the country, David Knee says.
When the rand is strong, as it is currently, it has the effect of lowering inflation, which is good for consumers. This increases their disposable income and results in a higher consumption of goods, which in turn stimulates the economy, Knee says.
Lower inflation leads to lower interest rates and bond yields, which mean cheaper financing and lower debt servicing costs for the government, individuals and companies.
These are the valuable effects of a strong rand, but there are also undesirable effects, Knee says.
Principally, a strong rand has the effect of weakening export activity, because exports become more expensive, Knee says.
It also affects certain service industries. Notably it weakens tourism, because local goods and services appear more expensive, he says.
The overall impact of an overly strong currency tends to be somewhat less robust economic activity. This in turn implies more sluggish jobs growth, an area of intense concern for South Africa in the next decade, Knee says.
When the rand is strong, ultimately the current account deficit – the difference between imports and exports – will rise as imports become stronger, while exports become weaker.
The resulting shortfall of foreign currency needs to be financed, either by international investors buying South African financial assets or by foreign direct investment into local companies. This need to draw in foreign investment means that interest rates need to rise to make them more attractive relative to competing foreign rates. Higher interest rates, in turn, will slow economic growth, which eventually should restrain import demand and in time weaken the rand, Knee says.
ECONOMIC FACTORS THAT ARE DRIVEN BY THE RAND
The relative strength of the rand exchange rate to other major currencies is an important driver of inflation in South Africa, but inflation does not always move in tandem with the rand, David Knee says.
In general, a weakening rand relative to other major currencies tends to drive inflation higher, while a strengthening rand tends to result in lower inflation, he says. However, other drivers of inflation can dominate the impact of exchange rate moves, as occurred from 2004 to 2007. The rand was virtually unchanged over the period, but inflation rose steadily on the back of rising wages, low productivity and accelerating global commodity prices, Knee says.
At times, there may be a relationship between industrial production and the strength of the rand, but the rand is not the primary driver of industrial production, he says.
When a country’s currency is strong, companies that are export-driven are forced to become leaner and more efficient to compete on international markets, Knee says.
In South Africa, the problem has been that companies have struggled to reduce their labour costs, he says. Wage increases have consistently outstripped productivity growth, undermining local companies’ competitiveness.
While the impact of the rand on South Africa’s economy is important, other effects can dominate, Knee says. During the economic boom from 2004 to 2007, there was no rand effect, he says. Instead, he says, economic growth accelerated as a result of the boom in credit extension prior to the introduction of the National Credit Act.
The most important factors that affect economic growth in the long term are how wealthy consumers are and how competitive a country is globally, he says.
ECONOMIC FACTORS THAT DRIVE THE RAND
It is impossible to forecast the direction the rand will take or accurately to identify the catalysts of the rand’s fortunes, David Knee says.
Interest rates, the government’s current account and foreign investment may all at times affect the fortunes of the rand, but each one of these factors does not of itself cause the rand to strengthen or weaken relative to other major currencies, he says. (The current account is the difference between the country’s exports and its imports.)
There is not a clear cause-and-effect relationship between interest rates and the rand, Knee says.
In 2000, the rand weakened despite increases in interest rates. When rates started to decrease in 2003, the rand continued to strengthen from its 2001 lows. This indicates that something other than interest rates affected the rand, Knee says.
You would expect the level of the current account to affect the rand, but often this has not been the case, he says. The rand weakened sharply between 1995 and 2002, despite a current account which was almost balanced. Equally from 2002 to 2007, the current account moved into significant deficit while the rand strengthened sharply, Knee says.
Analysts often focus on foreign investment inflows as a driver of the rand. Knee says strong inflows in the second half of 2009 and 2010 coincided with significant rand strengthening. The same can not be said for 2003 to 2007 when strong inflows into South African investments, were less important in driving the currency, he says.
International investors often focus on global events outside of South Africa, and these events typically have a significant effect on the rand, because the rand is one of the most liquid emerging market currencies (it is easy to buy and sell), Knee says.
The rand is frequently used to reduce risk of adverse moves in other emerging market currencies, and this makes the rand very volatile, he says.
The fortunes of the rand are closely tied to those of other risk indicators such as the JP Morgan Emerging Market Bond index, which shows how much of a premium to the interest rates paid on United States bonds is demanded by investors who invest in emerging market bonds, Knee says. Unfortunately, it is impossible to forecast this index, he says, so it does not help to predict the rand’s fortunes.
Rather than trying to forecast the short-term moves in the currency, you should focus on the medium-term outlook. Plan to take advantage of cheaper international assets and the overvalued rand. Expect volatility and do not be spooked out of your investments in the face of unexpected market movements, because this will only lose you money in the long term, Knee says.