By Cornelius Zeeman,
Fairtree Portfolio Manager
Volatility of the Rand exchange rate.
The South African Rand is one of the most volatile currencies globally compared to advanced economies and emerging market peers. Only the Russian Rouble and Argentinian Peso have been more volatile in the last decade. South Africa’s rand is traded in large volumes globally and is seen as a proxy for emerging market investment. It makes the currency highly exposed to external shocks and, thus, highly volatile. It is in most people’s best interests to diversify and invest in offshore equities, but trying to time the investment can be very nerve-wracking, even more so if it is your role to advise someone or do it on their behalf. What if the Rand strengthens and the investment loses value in Rand terms?
The good news is that if you look at the last 25 years, it is rare for the exchange rate movement to dominate the equity returns. Equities and Emerging Market currencies, like the Rand, are assets that perform well in risk-on environments. It is, therefore, unusual for the Rand to strengthen when global equities sell off. If you were unlucky or panicked at the four points in history (green dotted lines in Graph 1 below) where the Rand was extremely undervalued, you would have ended with a positive return in Rand terms in three instances. The Rand strengthened by 23-53% over these four periods, while Global Equities rallied 22-68%.
Graph 1: Rand Exchange Rate vs. Global Equities
Source: Fairtree, Bloomberg (as at 25 August 2023)
Clearly, investing offshore before the Rand strengthens by more than 20% is not optimal, but it is not a disaster. You also need to consider the alternative if you are trying to time the exchange rate. Do you wait in cash, which generally offers a low real return, or will you deploy the money in local equities? Investing in the local equity market would have been a better decision over all four periods. Investing in equities with such a short time horizon is usually not advisable.
Graph 2: Relative Equity Returns
Source: Fairtree, Bloomberg
The South African Rand is undervalued.
If we look at the latest Big Mac Index from July, a Big Mac costs R49.90 in South Africa and $5.58 in the United States. The implied exchange rate is 8.94. The difference between this and the actual exchange rate at the time, R17.78, suggests the South African Rand was 49.7% undervalued – this looks extreme, and you would not find any economists calling for the Rand to strengthen to this level.
The Rand has always screened as undervalued in the Big Mac Index. Due to our lack of sufficient electricity supply and Logistics capacity, our economy cannot react to exploit this Rand weakness by ramping up production for exports.
This is evidenced by our trade balance (see Graph 4 below), which swung back into deficit in June. Our trade balance was supported by robust commodity prices over the last three years. This export tailwind has now faded.
Graph 3: Big Mac Index – Historic relative cost in South Africa versus the United States
Source: The Economist (downloaded on 29 August 2023 from https://www.economist.com/big-mac-index)
Graph 4: South African Trade Balance (R’bn)
Source: Fairtree, Bloomberg (as at 30 June 2023)
Looking at South Africa’s rising debt/GDP and debt service costs, our fiscal situation is precarious. When looking at year-to-date tax collections versus the budget in Graph 5 below, our fiscus is in a worse position than planned – this means foreigners remain net sellers of our government bonds. The relaxation of Regulation 28 has meant that locals have been net sellers of South African equities over the last year. These portfolio flows have led to further pressures on the Rand. Fortunately, this headwind should fade going forward or even turn positive.
Graph 5: Gross tax undershooting Treasury’s full-year forecast growth as VAT refunds overshoot and company income taxes collapse
Source: Treasury, Standard Bank Research (dated 31 July 2023)
The Rand is undervalued at R18.53, but no clear catalysts are on the horizon for it to strengthen significantly. It is difficult to time equity markets and exchange rates, so it is often best to stick to your strategic asset allocation unless we are at extreme levels. If that requires you to invest in offshore equities, it probably does not help to worry too much about getting the optimal Rand exchange exit point because it might mean you are foregoing equity returns.
Fairtree Asset Management (Pty) Ltd is an authorised financial services provider (FSP 25917). Please note that there are risks involved in buying or selling any financial product, and past performance is not necessarily a guide to future performance. The past performance is relevant to the financial services being rendered. The value of financial products can increase as well as decrease over time, depending on the value of the underlying securities and market conditions.