Commentary: Jeremy Squier
In South Africa we are often subjected to periods of Rand weakness relative to major First World currencies and individual investors often take a largely emotionally based approach to deciding when to take funds out of SA and diversify internationally. The reality is that the Rand is one of the most liquid currencies in the World and so external forces of demand and supply drive the currency far more than do local politics and emotions. The following narrative is a modified extract of an article on valuing the Rand by Nolan Wapenaar of Anchor Capital.
Below we introduce a fair value gauge of the Rand against the US Dollar. Forecasting the Rand is a fool’s errand. No model is able to predict this and we must accept that actual USD/ZAR will be different from the modelled value for long periods of time. We have settled for a Purchasing Power Parity model which depreciates the Rand by the inflation differential between South Africa and the United States. This model has been shown to have an R2 of 76% over time (meaning it explains about 76% of the move).
We know that on average the Rand has traded within a R2.50 range from strongest to weakest over a year. In this context, we have put a R2.00 band around our PPP fair value. When the Rand is within that range, then to us it is fair. When it is above the range it is cheap and conversely it is expensive when it is below the range. This also means that at least once a year, we would expect the currency to trade outside of our range.
We have discussed a number of times that the challenge with the PPP model is that your starting point determines your outcome. This is true, however, by looking a range of possible outcomes rather than trying to predict spot, we deal with this to a degree.
In the context of rising global interest rates, a strong US dollar and negativity towards the emerging markets it is natural to expect that the Rand would be on the cheap side of fair. This is clearly evident in the graph. In early October at R14.70 it was just outside of fair value range and it has traded much further away from fair in 2002, 2010 and 2016. As of midday on Wednesday 21st November, the Rand had regained some ground and was trading at 13.94 which is within the fair value range indicator.
We have seen some work on the amount of time that the currency is outside of the fair range. When it pushes too high or too low versus our model, it has on average remained that way for just over two years. This means that while the rand is a little on the cheap side of fair right now, it could very reasonably remain so for the next two years.
The fair value of the Rand is date dependent under the PPP model. Therefore, while midpoint of the fair value range is 12.80 right now, this might have pushed out to 13.40 at 30 September next year. Based on this fair range, we can graph the PPP versus spot and we can also create a gauge which shows when the Rand is outside of our range and how extreme this is from a statistical perspective. Perhaps what Anchor CEO Peter Armitage often says is most important, “In ten years’ time, the fair value of the Rand is likely to be well over R20 to the dollar. So, when looking to take long term cash out of South Africa, it doesn’t really matter if we do it at R13.00, R14.00 or even R15.00 to the USD. The outcome is highly likely to be good in the long run.”
This methodology is likely to be more productive than using fear as the gauge on when to externalise funds, but it comes with the strong caveat that often the Rand can remain weak for unexpected periods of time but can then also strengthen, seemingly against all odds at times when it seems the most unlikely.