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Forecasting the Volatile Rand

Audio Version

The Rand is staying true to form – very volatile. However, the long-term outlook remains very negative. We provide an analysis on forecasting the Rand with some key decision points and how to incorporate an offshore strategy into your investment portfolio.

Forecasting the Rand

The Rand continues to be the most difficult asset class to forecast in the short term (1 to 3 years). And currently, it remains true to form, exceptionally volatile. We explain what mostly drives the Rand in the shorter term and investigate the best way to forecast the Rand for the long term.

Main short-term drivers of the Rand

Emerging Market Investment Flows

Emerging Market Investment Flows zar-usd

Global flows in and out of Emerging Markets (EM) are a major driver of the Rand. These flows are driven by global economic changes and geopolitical uncertainties.

Over the last three months, there has been a rotation of funds flow to EM from Developed Markets (DM), largely due to the announcement of  a successful vaccine being produced and a resurgence in COVID-19 in the USA and Europe.

Equity funds EM vs DM

Surplus trade flows are currently supporting the Rand

Monthly net trade flows

Monthly net trade flows

Over the last four months, there has been a large trade surplus, which is a net inflow of money into the country, creating more demand for the Rand. The surplus is driven by a surge in commodity exports (platinum group metals being the largest contributor), and a decline in imports as local consumer demand has decreased with the economic slump.

Per the graph above, these trade flows swing significantly from surplus to deficit in a few months, which is likely to remove the current trade support for the Rand.

The trend is your friend

The graph below is the R/$ 200-day moving average, which clearly shows the Rand’s retreat after each spike. Now that the Rand has retreated, if it follows the trend, the retreat is close to being completed. This means that further major strengthening is unlikely.

Rand spot spread 200 day moving average

Forecasting the Rand / Dollar

Like any other asset class (equity, bonds, property, etc) the fundamental value will determine its price over the long term (+5 years). The Rand/Dollar purchasing power parity (PPP) driven by the inflation differential between SA and the USA is the most popular fundamental valuation method. The PPP is effectively the number of Rands that are needed to buy the equivalent of 1 US Dollar of goods.

Per the graph above, the fundamental value of the Rand or PPP is 13.4, represented by the blue line. But this is where it gets complicated because the investment market prices in the risk of this theoretical fundamental value changing in the future. Thus, the actual R/$ is not tracking the real effective exchange rate (PPP).

The graph below is the difference between the actual R/$ price and the PPP value. This difference is commonly called the “sovereign risk premium”. It is the perceived economic stability of the country. Barring global shocks to the Rand, this risk premium has steadily increased over the last 8 years (averaging 20%) as the country’s economy has deteriorated and the political landscape has weakened.

Rand Dollar Risk Premium

Given South Africa’s fragile financial position with government debt shooting-up to 82% of GDP and a projected weak economic recovery of 3.5% and 2.4% in 2021 and 2022 respectively, after this year’s -8% decline, the risk premium should continue to increase to + 25% as government debt spirals out of control. This values the Rand/Dollar at 17.80.

Government Debt to GDP

Government Gross Debt to GDP Trajectory

In October, the Government revised its debt to GDP outlook, which is the grey line. We believe this is not achievable without meaningful economic policy changes, which are not taking place. The risk is that the green line materialises, which is far more likely as explained below:

Government Budget Deficit

To reduce debt, revenue needs to exceed expenditure. Per the graph below, the expenditure gap over revenue has widened over the last 8 years and ballooned this year as the economy has collapsed with the lockdown.

SA National Treasury Rolling 12 month Revenue, Expenditure and Deficit

Government’s strategy to eliminate the deficit, is to cut government expenditure and grow the economy.

Cutting government spending (if it materialises) is a short-term measure, but ultimately, we need growth to increase revenue. However, this requires more debt to be invested into income-producing assets, such as infrastructure. But, with our high debt, junk status and government’s poor delivery track record, funding is expensive and private investment is difficult to attract.

However, the biggest constraint to growth, is government’s lack of skills to execute investments productively. We believe this will not be rectified under the current government.

Therefore, without this execution capability, debt to GDP will exceed 100% by 2024, which will likely require funding from foreign sources (such as the IMF). This will put significant strain on government finances and ultimately lead to a further weakening of the Rand.

Other funding is in the form of a prescribed asset policy, which we believe is unlikely. But government may resort to using government pensions to fund “expenditure”.

How much should I invest offshore?

The degree of offshore exposure that you have in your investment portfolio should vary depending on your investment objectives, risk tolerance and personal circumstances. Everyone is different. In theory, you should match your % offshore investments to your % offshore spending to protect against an erosion of local purchasing power.

There will also be times in the short term where the Rand may be under- or over-valued against the US Dollar, which provides short-term opportunities.

A general industry guideline of the percentage of your money that should be exposed to foreign currency is:

  • Aggressive or (+10-year investments) 50% to 100%
  • Moderate or (5 to 10-year investments) 30% to 50%
  • Conservative or (3 to 5-year investments) 10% to 30%
  • Retirement savings are restricted to 30% offshore and 10% in Africa (ex SA).

The reason that these percentages differ based on risk profiles, is that foreign currency is a volatile asset class and is therefore not suitable for all types of investors.

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