Despite US economic growth slowing and recession fears mounting, the currency of that country continues to surge. In our view, the US dollar is now materially overvalued at close to two standard deviations firmer than our estimate of purchasing power parity (PPP) – a theoretical line we use to calculate the value of a currency.
What explains the sustained strength of the US currency? In part, in an environment of heightened uncertainty in financial markets, the flight-to-safety factor must be in play. Even though there has been some diversification away from the US dollar by central banks around the world in recent years, it remains the world’s reserve currency.
WAR IN UKRAINE
More specifically, the current US dollar strength relative to the euro is probably best explained by the war in Ukraine. There is little to suggest that de-escalation of the conflict is imminent. Rather, the opposite appears to be true as countries in Western Europe increase armaments spending while imposing rigid economic sanctions on Russia.
In retaliation, Russia has cut natural gas exports to those European economies that refused to accede to its demand to be paid in rubles. Maintenance on the Nord Stream 1 pipeline has also restricted supply. Gas prices have spiked, contributing to a rapid increase in the cost of living in the European Union, which relied on Russia for around 40% of its gas consumption before the conflict started.
Concern is growing that Russia could cut gas supplies to Europe completely during the upcoming winter months. If this happens, the consequences for economic activity in Europe would be dire. Already, due to supply chain disruption and high prices, Germany’s industrial production is weak, while the country recorded its first trade deficit in three decades in May 2022.
FRAGMENTATION RISK
At the same time, fragmentation risk is back on the agenda in the euro area, as reflected in, for example, higher bond yields in Italy relative to Germany. Recall the European debt crisis and its associated fragmentation risk, which began with the global financial crisis in 2008. At the time, the US dollar strengthened from close to €/US$1.6 in mid-2008 to about €/US$1.2 by late 2014.
It appears relative US dollar strength is likely to be maintained until Europe can address these concerns. The European Central Bank (ECB) has indicated that the introduction of a new instrument to address this problem is imminent. However, the consequences of the Ukraine conflict will take time to resolve.
Note too, while fragmentation risk lingers, the ECB is likely to adopt a relatively cautious approach to tightening monetary policy. The interest rate differential has already increased firmly in favour of the US dollar.
THE FED MATTERS
Higher US interest rates and the relative strength of the US dollar have underpinned tightening global financial conditions, with significant implications for emerging market economies, including South Africa. The US Federal Reserve (the Fed) matters!
Despite elevated export commodity prices, the rand has depreciated against the US dollar since mid-2021. This coincided with the June 2021 US Federal Open Market Committee (FOMC) meeting when the Fed pulled forward its projected path for US interest rate hikes and emphasised its commitment to maintaining inflation at a low level over time.
Recently, a combination of falling export commodity prices amid still-high oil prices imply downward pressure on South Africa’s terms of trade and, by extension, the rand (although the spike in export coal prices helps to a degree).
In addition, relative rand weakness has been accentuated by electricity load shedding, which must be weighing heavily on production, especially mining and, hence, export volumes.
MOVING PARTS
There are, therefore, a lot of moving parts and forecasting in the current environment is perilous. However, we can note that lower inflation in South Africa relative to the US has firmed the estimated ‘fair value’ for the rand relative to the US dollar significantly over the past year. Currently, we estimate the rand is trading at more than two standard deviations weaker than its estimated PPP level of firmer than US$/R14.
Historically, the rand has tracked its PPP level over time, although shocks do cause deviations that could last years. If the Ukraine conflict escalates or export commodity prices fall further, the rand may weaken further. Even so, we believe in the current situation, a (hoped for) return to stable electricity supply would likely make a significant difference.
All of that said, however, a key requirement is that the South African Reserve Bank (SARB) keeps inflation and inflation expectations well anchored at a relatively low level. We trust it will. If it does, the rand should navigate its way back towards PPP over time (noting that looking forward the PPP level adjusts in line with inflation differentials).
This nonetheless implies we likely have some way to go in the interest rate hiking cycle to ensure second-round inflation effects do not take hold in South Africa.
Commentary by Alwyn van der Merwe, Director of Investments:
It’s clear from Arthur’s analysis that determining the direction of travel of one currency relative to another over the short term amounts to, at best, an educated guess. Usually, each currency has its own set of drivers, ranging from variables that influence investor sentiment to factors such as the direction of interest rates and inflation differentials.
When it comes to the rand, however, in our experience sentiment towards the currency can be the dominant determinant for sustained periods given the uncertainty of economic policy in South Africa and our rather precarious fiscal position. Our analysis has revealed the rand tends to oscillate around its theoretical value (our adjusted PPP value) over the longer term. This pattern is likely to be sustained, provided the SARB continues to independently formulate monetary policy to protect the long-term purchasing power of the rand.
When sentiment against our fragile currency turns negative, however, our thesis provides cold comfort – and it tests patience and resolve. We currently find ourselves in such a period, where sentiment has turned decidedly negative amid the economic and political woes our country is grappling with, not least of which is the lack of reliable electricity supply.
In our construction of multi-asset retirement portfolios, we have favoured local assets over offshore exposure. Although the Regulation 28 offshore limit of 30% on these portfolios has recently been upwardly adjusted to 45%, we have not increased offshore exposure – a decision that has been vindicated by the outperformance of South African assets relative to their offshore peers.
However, following the material sell-off in global equities, we’d like to use the relative valuation adjustment to the benefit of our clients, and increase the offshore exposure in these portfolios. The weaker rand over the past three months has thus far kept us from doing so. Given the undervalued local currency, we’ll do what we always do: wait for a more attractive US dollar price before we effect the switch. This waiting process is again likely to test our resolve and that of our clients, but we believe it will add value over the longer term to enter this transaction at a more attractive price point.
