Rand Volatility: Potential Impact on Investment Returns
The depreciation in the Rand has to a degree been caused by the risk-off environment and given the distress in Argentina and Turkey, an increase in risk premiums associated with emerging economies across the board. More recently the Rand has been influenced by local factors. Politics around land expropriation without compensation and the second consecutive quarter with a negative GDP growth rate – a technical recession – have further resulted in capital outflows and a depreciating Rand.
Looking back in history, South Africans have understandingly tended to panic when the Rand suddenly loses value in a short space of time, bringing about the urge to take money offshore. Giving into emotion without considering market valuations and increasing your offshore exposure can have major negative effects on future returns. We have analysed three distinctive periods where the Rand has experienced a significant depreciation to the US dollar.
Economic theory dictates that on a purchasing power parity (PPP) basis, the Rand is expected to depreciate by the inflation differential between South Africa and its main trading partners. The chart below illustrates the implied PPP represented by the light blue dotted line, overlaid with the historical Rand/Dollar exchange rate. If the Rand/Dollar exchange rate rises above the implied PPP line, we can say the Rand is undervalued where the opposite is true when the Rand/Dollar exchange rate falls below the implied PPP. The shaded area can be considered the potential range which the Rand can trade in during the majority of instances. Of late the Rand has suffered a significant loss in value and is currently highly undervalued. However, history has shown that the Rand can fairly quickly revert to fair value from such points of extreme stress.
Late 2001 shows the Rand at an extremely undervalued position. Assuming the investor decided at this particular point in time to move his entire portfolio offshore, would the investor have been better or worse off? Our analysis focuses around investing in global equities (FTSE World) over a five-year period.
After five years, the investor would have seen a cumulative return of 53% in USD, however in ZAR the return would have been -10% because the Rand had reverted back to a fair value position over the subsequent five years. In addition, if the client had remained invested in the local equity market (All Share Index), their cumulative return in Rands would have been 139%. This is one example where Rand appreciation, following a strong depreciation and an emotional externalisation of assets, would have resulted in the client being in a substantially worse position than had they remained invested in the local market.
The Global Financial Crisis of 2007/08 was a time filled with uncertainty and concern causing a rapid depreciation in the Rand against the US dollar. If an investor again gave into fear and decided move their portfolio from local equities to global equities, they would have seen their investment grow over five years by a cumulative amount of 83% in USD. In this example, converting this return into ZAR would have given the investor a cumulative return of 85%, hence a small benefit of 2%. However, if they had remained invested in the ALSI for this period their cumulative return would have been improved to 112%.
The rampant depreciation in the Rand seen during December 2015 is the third example and was the result of local politics which saw the firing of the then finance minister Nhlanhla Nene. During Nenegate the Rand reached levels far beyond those of the Global Financial Crisis. Had an investor decided then to take money offshore, they would have achieved an approximate return of 26% in US Dollars over two years. However, in ZAR the return was 2% for the period. Once again, if the investor had stayed in the local equity market, they would have been better off, though only marginally with a 6% return.
In the chart below, the shaded areas highlight the three periods analysed. Also depicted are the returns of the FTSE World index both in USD (orange curve) and in ZAR (black curve), with the returns of the JSE All Share index represented by the blue curve. These are all overlaid against the ZAR/USD exchange rate represented by the green dotted line.
The exchange rate effect can erode the returns of an investor’s portfolio if managed incorrectly. As illustrated in the table below, in these three examples had the investor not acted on emotion and held their position within the local market, they would have achieved higher returns, placing them in a better financial position.
One cannot predict if the current weakness in the Rand will dissipate to more “normal” levels and market circumstances are always different. We have not considered market valuations in these three examples and this obviously has a major effect on subsequent returns. Diversifying one’s portfolio with offshore assets is highly recommended, but this should be proactive process not a reactive one.
It is important for an investor to seek the advice of a financial advisor to develop a long-term plan that will allow them to achieve their investment objectives. The performance of the Rand affects your investment returns and your financial advisor should be cognisant of when they allocate money offshore. Offshore investments assist in portfolio diversification however, the volatility of the currency can more than offset any benefit provided by the global market in certain instances. The investor should stick to their planned asset allocation and not allow themselves to be influenced by knee-jerk reactions which could result in detrimental long-term outcomes.
Need to discuss your investment choices then give me a call Warren Basel on 082 490 5182 or email warrenb@oracelbrokers.com
