Up until the current standoff between Finance Minister Pravin Gordhan and the Hawks, the biggest eye-opener in South African financial markets since the start of the year was not the fact that the rand strengthened against most major currencies. Instead, it was the extent and speed of these gains. After falling by more than 25% in 2015, especially in the last quarter, our currency appreciated to levels last seen around 10 months ago.
What were the reasons for this resurgence? An important factor was a global search for yield, especially over the past three months. Emerging markets have come back into favour. South African bonds are providing an attractive yield to foreigners, and some of our equities are trading at quite an attractive dividend yield. Investor sentiment improved immediately following the outcome of the local government elections. The recovery in commodity prices from low levels recorded earlier in the year also played a role.
Could we have forecast such a sharp appreciation? No. But were we surprised? No. In our view the price of the currency was simply too cheap, and over the long term, the prices of financial assets like currencies also tend to migrate back to fair value. We argued during 2015 that emotive investment behaviour drove the price of the rand materially below a value that we regarded as fair.
In December, the announcement of the axing of our then Finance Minister Nhlanhla Nene sent shock waves through financial markets. The rand, which was already on a slippery slide, lost 10% to the dollar in less than a week following the announcement. We’ve always said the best time to invest offshore is when the rand is strong, but investors panicked, and rushed to get their currency offshore. As with the current debacle, which has seen the rand take yet another nosedive, it was decidedly challenging in the face of rattled investor confidence to convince our clients to stay the course and wait for a return to fair value.
How do we measure this fair value? We believe strongly that in an ideal world, the currency should track purchasing power parity (PPP). This method of calculating the value of a currency simply suggests that the value of the currency should track the inflation differential of the home currency versus that of its most important trading partners. In December, PPP calculations indicated that the rand was severely oversold. Despite the fact that many investors justified this extreme move following the political events, it’s not uncommon for the currency to strengthen or migrate back to its fair value once the dust has settled.
It’s important to remember that a currency can deviate from the theoretical line for extended periods of time. These deviations are caused by real shocks, for example, political events such as Nenegate and the current Gordhan/Hawks saga, but also commodity price and productivity shocks. Last year was a bad year for commodity prices in South Africa, and in recent years productivity shocks have also been prominent.
Up until the most recent attempts by the Hawks to investigate alleged irregularities committed by Gordhan, we believed the currency might continue to strengthen gradually. It has now become apparent, however, that it would be unrealistic to expect it to return to fair value given the ruling party’s current lack of policy direction. The way in which the Hawks have handled the allegations against our Finance Minister, the response by the Presidency, and our President positioning himself to oversee state-owned enterprises, have all severely dented investor confidence. Given the current uncertainty it would be naïve to think the rand will revert to the mean over the short term.
There are also other short-term obstacles that may sour sentiment and drive the rand down, not least of which could be a US Federal Reserve interest rate hike, which is starting to appear more likely.
Another important factor is the looming threat of a ratings downgrade when the three top ratings agencies return to South Africa in December, and Gordhangate is of course not helping. However, we believe the potential impact of a downward adjustment in our credit rating should not be overestimated. Our government’s rand-denominated debt is rated higher than its foreign currency debt and therefore has a lower chance of losing its investment-grade status. The rand debt rating is also more relevant, as only 10% of government debt is denominated in foreign currency. Of course, the better than expected economic growth numbers – off a low base – are at least a step in the right direction.
So what is the bottom line for investors considering when to go offshore? As we’ve said, price is crucial, which is why we’ll continue with our phased approach, waiting for bouts of rand strength to increase our clients’ offshore exposure. As we’ve seen, things can change very quickly, but there will always be upward lurches in the cycle and we’ll make full use of these opportunities to expand our clients’ offshore portfolios.
