By Glacier Research, 31 May 2013
The performance of the rand affects your investment returns and your portfolio manager should be cognisant of when he/she allocates money offshore for a rand denominated fund. This is important because, as offshore investments assist in portfolio diversification, the volatility of the rand can introduce volatility in the fund’s performance in the shorter term. For most portfolio managers, valuation remains the most important factor but understanding the currency risks when offshore assets are introduced into a fund is important.
The risk-on risk-off environment has played a role in the rand’s devaluation to a degree but the depreciation of the rand can mainly be attributed to government policy, labour unrest as well as a deterioration of the structural factors of the economy. These include budget deficits, trade balance and debt to GDP levels. A combination of these factors has led to the manifestation of negative sentiment. The chart below highlights some of the major factors that have affected the rand’s depreciation recently.
An example last year was the government’s inability to quash murmurings around mine nationalisation. This caused investor uncertainty and repelled potential investment. Another example is labour unrest, which increased negative sentiment abroad and turned away potential investors. It highlighted the breakdown between labour unions and their members which led to difficult labour relationships with employers.
In Table 1 we can see what happened from Q3 to Q4 2012 in terms of the drastic decline in both Direct Investment as well as Portfolio Investment. Portfolio Investments (chart 3) which are flows into our bond and equity markets have supported the rand for a period of time. This is not as sustainable because it can be influenced by the vagaries of short-term sentiment. Conversely, Direct Investment - which includes infrastructure development - is sticky money but this had declined sharply towards the end of Q4 2012.
A deteriorating trade deficit is a structural factor. We are importing more than we are exporting. In order to import, buyers would have to sell rands to purchase other currencies. Fuel is one of the largest products that are imported. It represents 24%1 of total imports. An increased oil price and a weakening rand exacerbates the trade deficit. Chart 5 illustrates South Africa’s trade balance as a percentage of Gross Domestic Product (GDP). Important to note is that the rate of GDP growth has slowed and under previous policies was not able to grow at a higher rate.
Another factor that may impact the currency is the spending requirements of the government. If government’s tax receipts are less than what was budgeted for, the government needs to borrow to fill the gap. South Africa’s budget deficit (currently 5.2% of GDP, previously 4.8%, Chart 1) as a percentage of GDP has increased with many market commentators saying that a large proportion of the deficit has gone to pay wages and not enough to improve the productive capacity of the economy. The government’s increased borrowing has led the proportion of Debt-to-GDP to ratchet upwards. It currently stands at 41.2%2 compared to 27.4% in 2009. Therefore government policy is an important tool that investors use to gauge the investment environment and eschew opportunities where government policy is not clear or not sound.
The rand has depreciated – relative to the US dollar - the most when compared to selected emerging market peers. Over the last 12 months the rand has depreciated 20.67%, the Mexican Peso depreciated 9.40% while the Brazilian Real appreciated 0.88% relative to the US dollar. Earlier in the article we noted some of the factors at play distinguished between short-term (market sentiment) and long-term (structural) factors. Over the last year, although negative sentiment played and continues to play a key role in the rand’s depreciation, structural factors have become more pronounced.
In table 2, I’ve used different indices as proxies for investable world markets. The MSCI ACWI, FTSE World and FTSE/JSE All Share Index are equity indices while the Barclays Global Aggregate is a global bond index. As a South African domiciled investor, had you been invested in a fund similar to that of the MSCI ACWI Index, your fund would have achieved a one-year return in the region of 28.60% in rand terms compared to a similar US investor, whose fund would have returned 6.78% in USD terms. The enhanced return in rands is due to the depreciation of the currency. But this could work against you too. Had the rand appreciated relative to the investing currency, the returns in Rands would have been diminished.
Therefore, with the afore-mentioned factors affecting the rand, you, the investor can understand what may drive the currency in the longer term and how this might impact you. Short-term volatility is difficult to predict but on a structural basis, portfolio managers who look at these factors understand the interplay between them. They make decisions based on the underlying security valuation and the longer term.
Towards the end of 2011 there was a widely held view that the rand was overvalued and a number of funds with an offshore allowance decided to gradually increase their allocation. Consensus views were that the rand should have been trading around R8.50/dollar.
The rand could continue to be affected by the risk-on risk-off trade that abounds globally. The liquidity of the rand makes it susceptible to sudden and volatile changes. Looking longer term, SA needs a ratings upgrade and for this to happen, government policy needs to be clear and focused towards increasing the productive capacity in the long run. We require higher domestic savings which would place less of a burden on borrowing requirements. The government needs to be aware that they are accumulating debt faster than before (although SA’s government finances are much healthier than some of the more established developed countries). So we could continue seeing a volatile rand impacted by foreign flows in the future.
From one point of view, currency strength talks to the perceived health of a country’s financial position. As an investor you should be aware of the factors affecting the rand and whether they are the result of short-term sentiment or longer-term structural factors.