Only time will tell if foreign pastures are greener than ours. Many South Africans have, however, already taken this view, moving their savings (or lives) offshore. Others are still considering their options; the content in this piece is for both parties.
The success of your decision to take money offshore will depend on two things; 1) the rand weakening against the offshore currency you choose to invest in, and 2) the asset you buy offshore performing well. Both are vitally important if you don’t want to lose money.
The latter question (which equities or bonds to buy) is too big to solve in this piece. What we can do is offer insight on which offshore currencies you may want to consider (and which to avoid) based on valuation.
When Rome is burning, it’s difficult to take your eyes off the buildings. But the surprising reality is that the rand has held up among the flames.
And because of its resilience, you can still ship money offshore without having to worry that you’ve missed the boat.
By looking at where the rand sits from a valuation perspective – using purchasing power parity (PPP) analysis – we can pinpoint which hard currencies we can buy the most of with our rands.
As will be the case for all the PPP charts that follow, the bold red line is the fair value of the rand against the offshore currency in question. Against first world currencies, this line will normally rise over time (indicating depreciation) because we have a structurally higher inflation rate.
If the black line is below the red line, the rand is overvalued, meaning that you can buy more of that hard currency than would normally be the case. It is critical to realise that selling the rand for foreign currency is best done below the solid red line because this is when it’s overvalued and has the most potential to weaken.
The reverse also applies; selling the rand when it’s undervalued means you run the risk of it strengthening. If you’re planning on diving the Great Barrier Reef soon, then the first currency we’re analysing should put a much-needed spring in your step.
You can get a nice slab of Australian dollars with your rand right now. The ZAR has moved from very undervalued, to very overvalued against the Ozzie since the beginning of 2016.
What makes this trade even more interesting is that in periods of weak global growth – denoted by the black arrows – the rand has historically been undervalued against the AUD, i.e. trading above the red line. Today we have similar soft growth conditions and yet the rand is strong against the Ozzie, a break from the historical correlation.
Should you wish to buy Aussie dollars with your rands (just don’t tell them), the valuation is unquestionably in your favour. In addition, the rand has the potential to weaken substantially, especially if global growth continues to soften.
The rand is also marginally overvalued against the British pound. Let’s round-up and call it fair value. We’re all aware of the uncertainty around Sterling — Blustery Borris versus the Empirical Europeans and all that. But gun to our head, we’d say that post any resolution to Brexit, the risk to the pound is to the upside.
As is often the case in financial markets, the uncertainty of an outcome is worse than the worst-case scenario. So yes, you can still get a fair number of Sterling for your rands, but don’t convert when buying a pint in a London pub. Whether you can deal with Borris at Number 10 is another matter entirely.
The euro is also another viable option. Again, the rand has been remarkably stable against the single currency.
A challenge for the euro is that many of the countries in the block are heavily dependent on their exports — we’ll show you just how reliant they are in a later graphic. So, with global trade dwindling, the euro constituents will struggle to shake the current manufacturing recession they find themselves in, which may leash the euro.
You can buy the euro – it’s at fair value – but it may have more cyclical headwinds in the near-term compared to the Ozzie and Sterling.
The greenback is the only currency we’d be weary of buying. Remember that the rand is undervalued above the red line, which means, on the balance of probability, it is prone to appreciation against the US dollar
Can it weaken further? Of course it can. PPP analysis, like much in the world of investing, is not an exact science. But the magnitude of further devaluation has historically been constrained by the gravity that the red line exerts on the rand, particularly from these levels of undervaluation.
Because the USD is such an important currency to get to grips with, we include another chart on it to further the debate.
The blue line is the greenback relative to the currencies of its major trading partners. The higher the line, the more expensive the US dollar is compared to its counterparts.
The conclusion is like that of the previous chart – the American buck is expensive. Of the currencies discussed, the USD has the greatest risk of losing value against the ZAR.
One of the most important things to grasp when taking money offshore is that currencies tend to weaken or strengthen over multi-year periods. This is because they are driven by fundamental forces that are cyclical in nature, not sporadic and random.
Why is this distinction important? Because it highlights the folly of using short-term, idiosyncratic factors when forming a view on the direction of the rand. More specifically, you shouldn’t be taking money offshore based on political instability, ratings downgrades, or fanciful health programs, as hard as that may be to digest.
When you hear the media saying the rand is weaker because Ace has been seen drinking milk from stolen dairy cows, just remember the correlation in the next chart. In blue we have the rand/dollar exchange rate, and in red we have an index of other emerging market currencies, both based to 100.
The message here is that the direction of the rand is determined by the big forces that drive all emerging market currencies, and not by our idiosyncratic propensity to score own goals.
To be sure, there exists a breaking point for all currencies, just ask Zimbabwe or Venezuela. But we’re not there yet. So, what should we be looking at right now?
When the world’s biggest economies are simultaneously growing at a healthy clip, the peripheral
economies (read emerging markets) benefit most because they are essentially geared plays on global growth. Rising demand for their assets bolsters their currencies, a trend in which the rand would usually participate.
This is illustrated nicely in the graphic below. In red we have the Obsidian Global Economic Indicator – a barometer for global growth – and in blue we have the real effective exchange rate (REER) of the rand against the USD.
When the red line trends upwards growth is accelerating. The blue line usually follows suit, which indicates a strengthening rand in real terms. It follows that slowing growth would be bad for the rand, and since Q4 2018, that’s exactly what we’ve had.
What we must get our heads around now is whether we’re at a cyclical bottom, ala 2012 and 2015 – consult the red line above – or whether we’re about to enter a more severe contraction ala 2008/2009?
This is an extremely difficult question to answer with conviction. But if you’re looking for the rand to weaken further, then a continued fall in the red line above is one way to achieve that; EM currencies don’t usually hold up in global recessions. The big money question is whether there is evidence to support the recessionary case?
Maybe the shock is already here
Recessions don’t happen slowly; they need to be catalysed but something, a shock needs to hit the system. Those taking the view that this slowdown is just another cyclical dip don’t believe that such a shock is imminent.
But what if the economic gremlin is already here in the form of the trade war? Can Trump’s industrial-sized spanner do enough damage to the global machine to cause a recession? The next graphic illustrates who is most vulnerable to a slowdown in global trade.
If more than 80% of your GDP comes from your exports, it makes sense that a quasi-moratorium on global trade could seriously derail your economy.
The countries that populate the top of the horizontal bar chart above are of this ilk. And they are material contributors to the global economy. If they were to experience recessionary conditions, they would likely pull down many of the periphery economies (ahem, like us) that rely on their activity.
Somewhat surprisingly, the Chinese economy is now much less dependent on its exports, reducing the percentage contribution to GDP from about 65% in the mid-2000’s, to below 40% by 2017. If that trajectory is still intact, the percentage could well be lower today.
If Trump wants a strong S&P 500 to finger when he’s up for re-election, he better start dealing because the Chinese may find his hair scarier than his tariff stick.
Beware the emerging market King
Another lever that China can use to circumvent the tariffs is their currency. By letting it devalue against the US dollar they earn more from their exports. The problem for the rand is that if the yuan devalues, other emerging market currencies are likely to move in sympathy.
Shortly after the first China-specific tariffs were implemented, the yuan began depreciating. The correlation of the rand to the yuan since then (next graph) has been uncanny. In blue we have the rand/dollar exchange rate (inverted) and in red is the yuan/dollar (also inverted).
If the trade war continues, the Chinese may take a few more fingers off the wheel steering the yuan, its depreciation dragging other EM currencies with it.
The world’s horse
The US economy is the other obvious element that needs to be discussed because recessionary conditions in the USA would perpetuate significant contagion.
Whatever your position on the likelihood of a US slowdown, you cannot ignore the warning signs:
The bull market is long in duration; yield curves have inverted; consumer confidence is at record highs; unemployment at record lows; and corporate profitability is elevated.
History tells us that risk assets (like the rand) will struggle to hold ground if the US does experience a period of contraction. From a shorter-term perspective, the rally of the S&P 500 that we’ve seen this year looks anomalous when you consider the next illustration.
The red line is again the Obsidian Global Economic Indicator, while the blue line is the price to dividend per share ratio of the S&P 500; an upward sloping blue line indicates a strong equity market and a bullish outlook on future dividends.
But if the red line continues to fall, their expectations are unrealistic. Should these two lines re-establish their long-term fundamental correlation, the S&P 500 could easily give up its 2019 gains. Watch the recessionary whispers turn into screams then. Of course, if the red line rebounds then you’d have to flip the script.
Why is the US equity market important in the context of the rand? Well, when US equity falls, most other equity markets follow suit. Equity losses make people feel poorer, their confidence about the future wanes, and they look for security at the expense of risk assets. And voila, you’ve got a weaker rand.
Living that charmed life
If you’ve followed us for a while, you’ll know that we vigorously consult the outlook for commodity prices — particularly of the metals that we export — when forming a view of the rand. With slowing global growth, one would expect commodity prices to have fallen, and the rand along with them.
Fortuitously though, the specific metals that we mine, and ship, have seen their prices rise on the back of idiosyncratic supply side shortages. You can see how our commodity basket (platinum, palladium, rhodium, iron ore, and gold) has been powering higher in the graph below.
A rising blue line means the rand is strengthening. Yes, it should have been stronger given the rising commodity prices. But should those prices fall, the rand will lose a fundamental support and will likely depreciate in a, sharper, more sustainable fashion.
If you want to take money offshore there are still hard currency options where valuation is on your side.
In order of attractiveness, on a PPP basis, these currencies are the Australian dollar, British pound and the euro. The valuation of the greenback is not on your side, but that doesn’t mean the rand can’t weaken further against it, especially under a recessionary environment.
If global growth continues to fall, exacerbated by the trade war, then the commodity prices of the metals we export would likely fall. That would likely cause an acceleration of the rand’s depreciation. Rather than focusing on all the noise happening at home (yes, very difficult), it is these global forces that should be informing your decision to take money offshore.
Whatever you decide, it is very important to understand the valuation of the rand versus the offshore currency you want to buy. Buying foreign currency at the wrong time can offset even the healthiest gains from the equity or bonds that you buy in foreign markets. And then you could have saved yourself the hassle and stayed local.