Let’s put it out there. We live in an emerging market country with deep structural imbalances and many challenges. Within this environment, the Rand serves as the barometer of health of South Africa – and as South Africans, whether we admit to it or not, we are all and always invested in the Rand.
Through this period of economic decay and political volatility it has been difficult to remain unemotional about the events that are affecting the country. If you don’t like stocks or bonds, you can sell them. But if you are South African, you are tied to the Rand and as such, it’s possible that you are listening only to your own version of the story.
Emotion is a powerful force – especially when it comes to investing. Through history we have seen that investors are likely to make poor investment decisions when driven by emotion rather than valuation and fundamentals. And the Rand is probably the most emotional trade of all.
Despite all the political instability the Rand has strengthened significantly since January 2016. So the question really is:
Is the Rand still fundamentally cheap?
The only way to answer this one – is to remove the skew of emotion. Let’s look at the numbers.
In January 2016 the Rand traded at its weakest levels ever. It averaged R16,32 per USD for the month and touched a level of R17,92/USD at its weakest point. The selloff started in December 2015 when Nhanhla Nene was fired as Finance Minister. The Rand regained some ground when Pravin Gordhan was appointed 4 days later. However, the incident had badly damaged confidence in South Africa so when 2016 started with a selloff in global markets, the Rand once again came under severe pressure.
From the weak levels of January 2016, the Rand has made a strong recovery. In spite of this, there were setbacks during the year as repeated attempts were made to unseat Pravin Gordhan through criminal charges and, expectedly, the Rand also reacted to the ratings downgrades which brought South Africa to junk status.
So why did the Rand recover?
Since January 2016, there has been continued political volatility, attacks on the Treasury, ratings downgrades and poor growth. President Zuma eventually managed to fire Pravin Ghordan and now exerts greater control over the Treasury through the appointment of Malusi Gigaba as Minister of Finance. Despite these headwinds, the Rand is now stronger than when Nene was fired.
We believe there are two key reasons for this.
1. The Rand was very cheap in January 2016.
In January 2016, the Rand was 35% undervalued. According to our fair value model, this was very cheap by historical standards. To explain: the market was already pricing in a very negative scenario. The firing of Nene was a massive shock to the market, but each subsequent attack on Treasury had a lesser impact. Once investors acclimatised to the noisy political environment and downgrade, cheap valuations pushed the Rand stronger.
2. A supportive global environment
Emerging Market (EM) flows were very strong in 2016 after several years of weakness. As we are still in an ultra-low global yield environment, investors remain hungry for yield; leading them to the relatively high yields of EM bonds. When the US Federal Reserve signalled that it was not going to raise rates aggressively, large flows into EM and South African supported both bond and currency markets.
Will the recovery continue?
Based on our fair value model, the Rand is still slightly undervalued today. At the R12.80 level it is currently 7% cheap relative to our fair value estimate of approximately R12. However, if one looks at history, the Rand tends to remain on the cheap side for extended periods when political risk is high and fundamentals are poor. Cheapness alone is not a sufficient reason to buy. We need to look at South Africa’s relative fundamentals in order to understand whether the Rand should continue to appreciate towards fair value.
The fundamentals of the South African economy are very weak on a relative basis. We focus on the key metrics of growth, fiscal balance and current account balance. On all three metrics South Africa stacks up poorly.
The prospects for all three metrics remain poor. Growth is constrained by political uncertainty and we will not get clarity on economic policy until we know who is going to lead the ANC after President Zuma. We will only know this after the ANC’s elective conference in December. On the fiscal deficit side government spending and debt levels have increased dramatically since 2008. The new finance minister is likely to be more accommodative towards government spending, in which case the fiscal position will worsen. While the current account deficit has narrowed due to lower imports and higher commodity prices, South Africa’s structural deficit remains one of the highest in the world.
So where does that leave us?
The recent cabinet reshuffle represented a fundamental shift in South Africa’s policy framework, but the reaction of the Rand has been muted. Consensus seems to be that President Zuma is under severe pressure and he will be removed in December. If there is a positive outcome at the ANC’s elective conference in December, South Africa should experience a sharp boost in confidence which will alter the growth outlook. Despite the market’s optimism, this positive outcome is far from guaranteed.
Fundamentals have not mattered in the shorter-term as emerging market bond funds have received record inflows. If the Fed follows through with rate hikes and normalises interest rates, EM flows will likely reverse and the Rand will weaken.
We are in a period where the Rand should trade somewhat cheaply relative to fair value in order to compensate for very poor (and deteriorating) fundamentals. With the Rand having strengthened significantly since the beginning of last year, we have looked to increase our exposure to offshore currency and assets.