- Since the last report in March, the ZAR appears to have consolidated its undervaluation against all currencies barring the JPY. A significant number of risks have played out and undermined the performance of the ZAR, including SOE failures, SA’s greylisting, persistent load shedding and the changes to Reg 28 that allow funds to invest a greater proportion of funds abroad. Funds have sought to diversify their portfolios away from SA’s failures, shield their portfolios against currency volatility and expose clients to a wider selection of companies and markets.
- The result is a strong outflow of funds from both equities and bonds. The strong correlation between these portfolio outflows and the performance of the ZAR once again highlights how the markets will hold the government to account for poor policymaking. Until such time as investors have taken their natural fill of investments abroad, the ZAR will perform poorly against most currencies and will need to offer foreign investors a deeper discount or higher incentive to invest in SA.
The poor performance of the ZAR reflects the country’s higher risk profile and the lack of appetite to expose portfolios to SA’s “failing state” despite the high and very attractive interest rates. The discount offered to foreign investors is increasing, but while the market searches for that equilibrium to stabilise the ZAR, it will continue to prod weaker and weaker levels until it does. That does not change expectations for a ZAR recovery later this year as the Fed turns its monetary policy and the USD starts to lose some ground.
As the USD liquidity tide goes out, volatility may ensue
Every now and then, it is useful to pull back the lens and reflect on where we find ourselves. Often we get so caught up in the near-term noisiness of markets that we forget to gain a healthy perspective on what the background conditions look like. One barometer ETM has often used to create such context is the USD liquidity cycle, reflected in the chart above.
It should be considered a tidal chart. When USD liquidity washes through the global economy, asset prices rise, credit cycles strengthen, and risk appetite improves. The opposite also holds true, and that will hold implications for riskier asset classes. As the red line drops to reflect a tightening liquidity environment, investors will become more judicious in where they place their funds. It will also prompt the Fed to act differently, holding a different set of implications for the ZAR.
For example, will the USD respond negatively to the fact that the overall business cycle has softened, inflation is declining, and interest rates can fall? Or will the USD surge on the back of expectations of a global financial market meltdown? If the latter, that could imply a shift back to the USD as a safe haven.
USD overvaluation still stretched, Fed policy reversal could be key
How the USD performs in the next few months will be very telling. In the coming months, the Fed is expected to reach for the pause button and start to prepare the market for a turn in the monetary policy cycle towards rate cuts. Given the role that rate hikes have played in bolstering the performance of the USD, the expectation of rate cuts could well do the opposite.
What makes this more complicated than just working out the monetary policy cycle, is the response of financial markets to the economic backdrop at the time. If rates in the US are declining due to a Fed response to a severe downturn that is affecting asset prices, the USD may not lose as much as first anticipated. However, should the Fed cut rates in what is essentially a more benign backdrop where financial market stress is not acute, then the USD could lose a lot of ground and revert back to more normalised levels.
At this point, that is unclear, so the next 3-6 months will likely dictate how the USD performs over the next year and whether the ZAR will gain the opportunity to stage a solid recovery vs the USD.
ZAR performance undermined by the exodus of funds
In the past month, not much has changed. On a trade-weighted basis, the ZAR remains heavily oversold by at least 13% and is showing no distinct signs of recovering. Yet, history has shown us that levels of undervaluation this extreme, have not been sustained for very long.
In the two preceding periods, where the ZAR slipped to even more undervalued levels, the recovery was impressive. Such levels of undervaluation raise the degree of attraction of SA assets, although one would have to balance such a comment against the plethora of risks SA faces at the moment.
For a sub-investment grade country faced with malfunctioning SOEs, structurally weak growth and a constrained tax base, the greylisting on top of the raising of the Reg 28 offshore prudential limits for funds has tilted the balance against the ZAR. Significant outflows have emerged this year, which have undermined the performance of the ZAR. How much more pressure those outflows will exert is anyone’s guess, but a lot of funds have already found their way abroad. The exodus of funds has its limits.
Output of updated valuation calculations:
- Not much has changed through the course of the past month. The ZAR remains undervalued vs the USD by approximately 17% and although there appears to be reluctance to weaken the ZAR much further, there are also no clear signs of a recovery.
- Suffice to say that such undervalued levels have not been sustained historically and investors would be hard-pressed to argue for a substantial depreciation of the ZAR from current levels.
- Instead, one could argue that the balance of forces has turned more asymmetrically in favour of a ZAR recovery, whether that be driven by a weaker USD, or improved ZAR.
- Similarly, against the GBP there has not been much change through the course of the past month. The ZAR remains approximately 7% undervalued against the GBP on a seven-year cyclically adjusted PPP valuation model.
- There is much more room for the ZAR to depreciate against the GBP. However, there is also good reason not to be overly optimistic on the GBP given all the economic headwinds that the UK economy faces at the moment.
- High inflation is keeping the BoE cautious and hawkish. However, that is unlikely to last particularly long. On the contrary, as the economic and credit cycles subside, the GBP may respond negatively to a BoE which softens its stance.
- In the past month, the degree of undervaluation of the ZAR vs the EUR has extended to an even deeper extreme, approaching levels of some 30% undervaluation.
- The ECB has retained a hawkish stance and remains committed to reducing inflation through tighter monetary policy.
- Whether that is sustainable given the effects of rate hikes that have yet to filter through is debatable.
- While the ZAR has depreciated against the EUR, it makes sense that it would lose ground against the CHF as well. Even though the SNB plays an active role in keeping the CHF from appreciating, the ZAR has still lost ground and now finds itself some 7% undervalued.
- Compared with valuation levels at the start of 2022, the ZAR has lost more than 20% of its purchasing power vs the CHF, just as it has done against the EUR over that same timeframe.
- While the ZAR may have lost some 25% since the start of 2022, it now appears to have stabilised somewhat at levels approaching fair value.
- As risk aversion has climbed more recently, so investors have scaled back some carry trades and repatriated some of their funds back to Japan.
- However, ZAR can still lose more to the JPY on the basis of pure valuation, but that might be difficult while the SARB continues to tighten monetary policy and the BoJ remains ultra-accommodative.
- Compared with last month’s report, the ZAR has not lost any more ground to the CNY, against which it remains some 7% undervalued.
- That offers some competitive advantage on the trade front and may assist in propping up the trade account to SA’s single biggest trading partner.
- Nonetheless, the ZAR remains undervalued, just as it does against most other currencies to round off a relatively weak performance by the ZAR which goes some way to explaining the buoyant inflation at the moment.