Despite the high level of political risk associated with South Africa – given an unwelcome boost by the recent Cabinet reshuffle and two credit rating downgrades – the relative strength of our fragile rand has continued to surprise many investors. Contrary to some expectations, the currency has firmed marginally against the US dollar since the start of the year. Why has the rand seen such a sturdy recovery – even taking into account the wobbles of the past few weeks – and what are investors to make of it?
Nenegate, which sent shockwaves through financial markets in December 2015, resulted in the rand blowing out to R16.73 against the US dollar. Just before the credit downgrades in March this year, however, it was trading on a significantly firmer footing at R12.50.
In our view, there were three main reasons for the rand’s resurgence:
- At the time of Nenegate, the price of the currency was simply too cheap, with emotive investment behaviour driving it materially below a value that we regarded as fair. Over the long term, it’s not uncommon for the prices of financial assets like currencies to migrate back to fair value once the dust has settled.
- A global hunt for yield led to emerging markets coming back into favour. International capital flows to emerging markets increased, with South Africa’s bond market a leading beneficiary of the trend.
- Since the start of 2016, there has been a strong correlation between commodity prices and the direction of our currency. Commodity prices picked up significantly and stabilised towards the end of the year. As a result, the terms of trade strengthened, providing support for the rand.
Although the credit downgrades did result in some currency depreciation and bond yields kicked higher, the rand recovered again shortly afterwards. It’s important to remember that while credit ratings are assessed on local fundamentals, global rhetoric and capital flows can dictate market momentum in the near term. The flows into global emerging market government bonds undoubtedly supported the local currency despite the negative impact of the credit downgrades.
However, the obvious risk is a change in emerging market investor sentiment, which is likely to result in sharp foreign outflows, since South Africa is at the lower end of the spectrum in terms of credit risk, growth and political stability. We’re likely to bear much of the brunt should a sell-off ensue.
So what impact is further action from the three main rating agencies likely to have? We believe Moody’s may downgrade our local and foreign currency credit ratings by one notch in August. This will keep both above investment grade, with a negative outlook.
This is premised on all the usual factors:
- elevated political risk
- lack of structural reform implementation
- a shift in focus to radical economic transformation and a push for nuclear energy – both of which may worsen fiscal metrics
- rising contingent liabilities, which would place a greater burden on state resources
- deteriorating growth metrics, confidence levels and private sector investment.
Standard & Poor’s (S&P) is due to release its rating review on 2 June. Although the consensus view is that the agency will maintain its current local currency rating to one notch above sub-investment grade (our long-term foreign currency debt has been relegated to ‘junk’), the rand may well respond – either positively or negatively – to any surprises when S&P next visits our shores.
In our view, the most important factor investors need to consider is whether or not the rand is trading at or close to what is regarded as its fair value. How do we measure this? In an ideal world, the currency should track purchasing power parity (PPP). This method of calculating the value of a currency should track the inflation differential of the home currency versus that of its most important trading partners. The currency could deviate wildly around the theoretical line for extended periods, especially in a cyclical economy such as South Africa where political uncertainty has a marked impact over the shorter term.
The theoretical value of the rand is now around R12.50, so at its current level of R13.08 to the US dollar the currency is trading in ‘no man’s land’. The current price reaction is muted in statistical terms when compared to the Nenegate debacle.
Over the near term our currency is likely to respond to the following forces:
- change in commodity prices – if commodity prices stabilise at current levels, the rand will receive support
- continuation of the global hunt for yield or the end of the theme
- actions of credit rating agencies
- a charged local political environment as party leaders jockey for position, with statements and actions that may well shock the markets.
We’ve always believed however, that short-term financial market volatility – of which we may see a lot in the coming months – should never alter our clients’ longer term investment objectives. As professionals, we know that in times like these, the most prudent response is to ‘stay the distance’ with our investment approach, which has proven its worth through turbulent times and investment cycles.
