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An important part of Seed’s multi management process is performing monthly asset class valuations using our in-house quantitative models. This process covers all the local and global asset classes that are suitable for inclusion in our multi asset class funds and model portfolios. The output of these models guides our tactical asset allocation decisions, where we under- or overweight certain asset classes in the short term, compared to our longer-term target weights.
The most significant move in our asset class valuation models over the last year has been on the currency side. The 20% appreciation in the rand versus the US dollar, from R14.47 in mid-November last year to R 11.56 on 23 February 2018, has captured countless headlines. While many investors believe this is solely driven by the new sense of hope and optimism surrounding President Ramaphosa, the truth is that the USD has also been weaker versus the other majors over the last year.
The driver behind our currency valuation model is the well-known Purchasing Power Parity (PPP) relationship, which we calculate for each of the major currencies on a monthly basis. The PPP relationship is based on the law of one price, meaning a consumer should be able to pay the same price for a diversified basket of goods, no matter in which economy the purchase is made.
From January 1985 to January 2018, SA inflation came in at an annualised 8.3% and US inflation at 2.6%, resulting in a 5.7% inflation differential over this 33-year period. Therefore, an SA consumer will see his purchasing power eroded a lot quicker than in the US, and will be rewarded with more rand per US dollar each year.
Theoretically, PPP implies that SA’s higher inflation should result in around 5% – 6% depreciation per annum against the dollar. In practice, the chart below illustrates that the exchange rate has spent very little time around the PPP line, but has remained undervalued and overvalued for extended periods.
Chart 1: Purchasing Power Parity (PPP) – ZAR / USD
Source : Seed Investments (31/01/2018)
After the significant rand weakness over the last three months, investors are left with the question of how much stronger the rand can get from here?
Let’s take a look at how the recent cycle of rand weakness and recovery compares to two previous cycles (2001 and 2009), and focusing only on monthly data points.
Chart 2 : Major ZAR Cycles (2001, 2009, 2016)
Source : Seed Investments (31/01/2018)
The current cycle (blue line) peaked at 49% undervalued in January 2016, which is still modest compared to the 88% undervaluation we saw in December 2001. The 2009 cycle was more muted at 25% away from the PPP point, but was still a “trigger point” at more than one standard deviation away from the average.
In both 2001 and 2009 the rand continued to strengthen towards the PPP point and beyond, ending at around 20% overvalued in both cases. There is no reason to believe it cannot happen again.
How does this influence the global exposure in the Seed unit trust funds and model portfolios? As always, when looking at global asset classes, we try to separate the currency decision from the underlying asset class valuation. Practically, this means that even though the rand is at the most favourable point in the last 2 years to increase global exposure, we also have to consider the fundamentals of the global asset classes where we can invest out dollars. Global fixed income remains unattractive, with low yields on offer, and global equities remain expensive even after the recent correction.
The Seed Investments team will be keeping an eye out for further rand strength and any improvement in global asset class valuations to increase the global exposure in our unit trust funds and model portfolios.
Cor van Deventer