Stay abreast of COVID-19 information and developments here
Provided by the South African National Department of Health
Dollar dominance:
why it's not going away
After trading in a band of roughly €/US$1.1 to €/US$1.2 from early 2017 to early 2021, the US dollar has strengthened over the past year to around parity against the euro. Why is the US currency so strong, and is its dominance likely to continue? Importantly, what does this mean for portfolio construction?
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.
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.
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$1.2 by late 2014.
It appears relative US dollar strength is likely to be maintained until Europe can address these concerns. The European Central Bank (ECB) has indicated that the introduction of a new instrument to address this problem is imminent. However, the consequences of the Ukraine conflict will take time to resolve.
Note too, while fragmentation risk lingers, the ECB is likely to adopt a relatively cautious approach to tightening monetary policy. The interest rate differential has already increased firmly in favour of the US dollar.
Higher US interest rates and the relative strength of the US dollar have underpinned tightening global financial conditions, with significant implications for emerging market economies, including South Africa. The US Federal Reserve (the Fed) matters!
Despite elevated export commodity prices, the rand has depreciated against the US dollar since mid-2021. This coincided with the June 2021 US Federal Open Market Committee (FOMC) meeting when the Fed pulled forward its projected path for US interest rate hikes and emphasised its commitment to maintaining inflation at a low level over time.
Recently, a combination of falling export commodity prices amid still-high oil prices imply downward pressure on South Africa’s terms of trade and, by extension, the rand (although the spike in export coal prices helps to a degree).
In addition, relative rand weakness has been accentuated by electricity load shedding, which must be weighing heavily on production, especially mining and, hence, export volumes.
There are, therefore, a lot of moving parts and forecasting in the current environment is perilous. However, we can note that lower inflation in South Africa relative to the US has firmed the estimated ‘fair value’ for the rand relative to the US dollar significantly over the past year. Currently, we estimate the rand is trading at more than two standard deviations weaker than its estimated PPP level of firmer than US$/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.
Sanlam Private Wealth manages a comprehensive range of multi-asset (balanced) and equity portfolios across different risk categories.
Our team of world-class professionals can design a personalised offshore investment strategy to help diversify your portfolio.
Our customised Shariah portfolios combine our investment expertise with the wisdom of an independent Shariah board comprising senior Ulama.
We collaborate with third-party providers to offer collective investments, private equity, hedge funds and structured products.
We constantly challenge the norm. Our investment process is a thorough and diligent one.
Michael York has spent 21 years in Investment Management.
Have a question for Michael?
South Africa
South Africa Home Sanlam Investments Sanlam Private Wealth Glacier by Sanlam Sanlam BlueStarRest of Africa
Sanlam Namibia Sanlam Mozambique Sanlam Tanzania Sanlam Uganda Sanlam Swaziland Sanlam Kenya Sanlam Zambia Sanlam Private Wealth MauritiusGlobal
Global Investment SolutionsCopyright 2019 | All Rights Reserved by Sanlam Private Wealth | Terms of Use | Privacy Policy | Financial Advisory and Intermediary Services Act (FAIS) | Principles and Practices of Financial Management (PPFM). | Promotion of Access to Information Act (PAIA) | Conflicts of Interest Policy | Privacy Statement
Sanlam Private Wealth (Pty) Ltd, registration number 2000/023234/07, is a licensed Financial Services Provider (FSP 37473), a registered Credit Provider (NCRCP1867) and a member of the Johannesburg Stock Exchange (‘SPW’).
MANDATORY DISCLOSURE
All reasonable steps have been taken to ensure that the information on this website is accurate. The information does not constitute financial advice as contemplated in terms of FAIS. Professional financial advice should always be sought before making an investment decision.
INVESTMENT PORTFOLIOS
Participation in Sanlam Private Wealth Portfolios is a medium to long-term investment. The value of portfolios is subject to fluctuation and past performance is not a guide to future performance. Calculations are based on a lump sum investment with gross income reinvested on the ex-dividend date. The net of fee calculation assumes a 1.15% annual management charge and total trading costs of 1% (both inclusive of VAT) on the actual portfolio turnover. Actual investment performance will differ based on the fees applicable, the actual investment date and the date of reinvestment of income. A schedule of fees and maximum commissions is available upon request.
COLLECTIVE INVESTMENT SCHEMES
The Sanlam Group is a full member of the Association for Savings and Investment SA. Collective investment schemes are generally medium to long-term investments. Past performance is not a guide to future performance, and the value of investments / units / unit trusts may go down as well as up. A schedule of fees and charges and maximum commissions is available on request from the manager, Sanlam Collective Investments (RF) Pty Ltd, a registered and approved manager in collective investment schemes in securities (‘Manager’).
Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. The manager does not provide any guarantee either with respect to the capital or the return of a portfolio. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in a portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance of a portfolio and an investor will differ depending on the initial fees applicable, the actual investment date, date of reinvestment of income and dividend withholding tax. Forward pricing is used.
The performance of portfolios depend on the underlying assets and variable market factors. Performance is based on NAV to NAV calculations with income reinvestments done on the ex-dividend date. Portfolios may invest in other unit trusts which levy their own fees and may result is a higher fee structure for Sanlam Private Wealth’s portfolios.
All portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No. 45 of 2002. Funds may from time to time invest in foreign countries and may have risks regarding liquidity, the repatriation of funds, political and macroeconomic situations, foreign exchange, tax, settlement, and the availability of information. The manager may close any portfolio to new investors in order to ensure efficient management according to applicable mandates.
The management of portfolios may be outsourced to financial services providers authorised in terms of FAIS.
TREATING CUSTOMERS FAIRLY (TCF)
As a business, Sanlam Private Wealth is committed to the principles of TCF, practicing a specific business philosophy that is based on client-centricity and treating customers fairly. Clients can be confident that TCF is central to what Sanlam Private Wealth does and can be reassured that Sanlam Private Wealth has a holistic wealth management product offering that is tailored to clients’ needs, and service that is of a professional standard.