Welcome Money Makers,
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With that being said, let’s look at what “Investing for currency risk means”
Global Investing
It goes without saying that it’s obvious at this stage that some offshore exposure is warranted, especially for those of you living in south Africa or in other sovereigns that have volatility and risk in their domestic currencies.
Dated: 15th January 2024, at 8pm (USD/ZAR) at 18.67
The South African Rand is extremely liquid, if not the most liquid emerging market currency, making it prone to global economic disturbances, shifts in perceptions, and general speculation. Moreover, with these external forces contributing to the volatility of the ZAR, you are also faced with internal politics and economic stagflation.
Stagflation is when the economy has low growth and high unemployment while prices (inflation) stay relatively high.
I’ll touch on why the South African Economy experiences stagflation in another article, but for this article, I want to highlight the importance of global investing and managing currency risk when it comes to managing your investments.
Take a look at these historical figures of the Rand’s annual performance against the dollar:
It is evident from the two pictures above of what type of regime this is, it is an inflationary regime that looks for growth at the expense of the currency, which is also a contributor to this stagflation environment South Africa finds itself in.
Operating Under a Known Regime
If it is established that South Africa operates within this particular regime, it is crucial to recognize that a prolonged depreciation of the South African Rand (ZAR) is inherently ingrained in the longer-term perspective. I’d argue and say it is even by design.
While there may be instances of ZAR strengthening due to factors mentioned earlier, such as the susceptibility to global macroeconomic trends and shifts in perception, it pays to remember that ZAR strength is temporary.
It is also worth noting that during periods of heightened fear or excessive optimism, the ZAR may deviate significantly in both directions, either appreciating or depreciating beyond its fundamental value.
That means ZAR strength is happening because of two reasons:
It is strengthening because it overshot to the downside
There is excessive optimism and the global economy is risk-on
There can be a third, which is improved economics.
Inflation and Return
We then should invest accordingly and understand that our investments denominated in Rand can be an illusion if the currency is weakening.
Let me give an example of this subtle illusion:
As I write this, we wait for the December inflation print to be released, but as it stands, inflation for 2023, for the first 11 months of the year, on average, sits at 5.98%
For simplicity sake, we can extrapolate this data from above and then discount (predict) what the final average inflation for 2023 will be by taking the 3 preceding months and dividing by 3. Therefore, (5.4 + 5.9 + 5.5/3) = 5.6%. With this we can assume that December’s print comes in slightly higher than November at 5.6%.
Sidenote:
Predicting the future isn’t a guarantee, and one should leave room for error, similarly to a margin of safety when investing. South Africa’s GDP contracted in Q3 of 2023, so that could easily contribute to signs of a slowing economy, giving relief to December’s inflation print, but then we would also consider that December is high season and people spend more.
For simplicity sake, we will stick with 5.6% as December’s inflation. Meaning 2023’s average inflation comes in at 5.95% for the year.
Inflation Adjusted Return
When it comes to investing your capital, the idea would be to grow it above the rate of inflation. That means if you earned 11% in 2023 and inflation came in at 5.95%, your real local return would be:
From our example above:
(1 + Stock Return) / (1 + Inflation) - 1 =
(1.11 / 1.0595) - 1 *100 = 4.766 %
Since inflation and returns compound, geometric calculations are better to capture the compounding effects, rather than a simple linear subtraction of 11% - 5.95%.
That means, adjusted for inflation, in ZAR terms, one would have earned a real return of 4.77%.
Currency Adjusted Return
We have considered an inflation-adjusted-return above, but we have not included a currency-adjusted-return.
We use this to benchmark our purchasing power in dollars in real terms, to give us a better understanding of where best to put our capital. As a global investor who searches for yield and weighs up the risk-reward of each investment, these adjusted calculations are important.
That's why I mention that the returns in Rand can be deceiving. Even though our money is increasing in Rand, when you look at the global perspective and in terms of dollars, you might be losing value. As a result, people who decide where to invest globally might avoid certain countries or investments until the situation improves or the cycle changes again.
Here is the Corrected Formula for currency adjusted returns:
What this implies is that even if I gained 11% in ZAR terms, considering the local inflation at 5.95% in 2023 and a 7.7% depreciation of the currency against the dollar that year, my actual adjusted return would be -3.30% when measured in dollars
If someone is deciding to allocate capital and choosing whether to invest money in South Africa, they might hold off until the economic conditions improve, or as mentioned, wait for the cycle to turn in their favor.
In certain situations, countries or assets may need to readjust their prices downward before attracting that capital or new investments. This is to ensure that future potential returns make sense and the risk is worth it. (cycles)
Others may decide to only offset their 11% local nominal return by the 7.7% currency deprecation, and then work out their real return, but I prefer to include local inflation too. This gives me a safety of margin when taking all things into consideration, and looking for South African assets that will yield me above 17% annually. (cyclical stocks)
It is also important to remember that inflation is embedded in other currencies/countries too. So you could use Dollar inflation rate instead. The formulas don’t change only the inputs.
South Africa as an Investment Case
This analysis looks at a one-year cycle, so it doesn't automatically suggest moving away from investments in ZAR and going international because you may end up doing so at the point the cycle turns.
In the second year, the ZAR might strengthen, offsetting these losses and potentially providing higher returns along with a stronger currency.
That's the reason why many individuals have made and will continue to make the error of shifting their investments offshore when the currency has already depreciated, consequently overlooking the cycle's reversal as it returns to its fundamental range.
Longer Term
As previously noted, the ZAR tends to fall below and rise above its usual levels as we navigate through these cycles. The market consistently attempts to assess risk, considering various external and internal factors. It's important to bear in mind that these cycles are driven by the risk appetite and aversion of both local and global investors. In the long run, ZAR weakness is certainly based on fundamentals, but in the short-term, capital is likely to return in pursuit of higher yields.
Understanding this, then being patient is key because you will get an opportunity again to offload ZAR into yield chasers. Meaning, as the ZAR pulls back and strengthens, it gives you an opportunity to buy more dollars at a lower cost and increase your long-term offshore position. But it’s also important to still have some denominated ZAR investments to ride that wave and to maintain your ZAR denominated bills.
Looking into 2024
If you go back to the second picture at the start of the article, you will see that the ZAR has depreciated for 4 years in a row now, and this is partially because of global macro movements, risk-off sentiment, and rising interest rates over the last few chaotic years.
As we enter into 2024 and look ahead, the question on my mind is to what degree did external factors contribute to the weakening of the ZAR, and did fear lead it to decline more than necessary?
While internal problems do persist, the key consideration is how much of these challenges are already reflected in the ZAR's value (priced in), and where does its actual worth stand? I estimate between R16.90 -R18.30
After four consecutive years of depreciation, there's a possibility that the ZAR might strengthen this year or next as it aligns more closely with its actual fundamental worth. If this doesn't happen, it could indicate a broader issue in the global economy, and/or it may mean investors are saying goodbye to South Africa for good.
Closing Thoughts
In the coming articles, I will explore different investment cases and which South African companies I think may do well. I will also give you a look at the inside of my own portfolio and how I am managing my own money.
The key point to grasp is that over the long run, the ZAR is getting weaker and dealing with growth challenges. The market recognizes this, explaining the somewhat uninspiring performance.
Consequently, specific industries and companies might be more promising than the overall index. This is because, with significant currency risk upon us, you can't afford to be too comfortable with your investments. It's crucial to aim for real returns, and many companies overly tied to the ZAR may struggle to maintain growth or provide satisfactory returns for investors. (hence we’ve seen a struggling market)
We’ll end here for today, but it isn’t the last you’ve heard from me.
Keep safe, and chat soon.
Dave :)