Bottom Line:

  • Assisted by another strange turn of geopolitical events, the ZAR has extended its period of resilience by capitalising on the strength of the latest commodity cycle. Although it remains undervalued on a trade-weighted basis, it has performed reasonably well through the past quarter and made back significant ground lost in the final quarter of 2021.
  • The war in Ukraine has ironically helped the ZAR despite raising overall levels of risk aversion. Commodity prices were driven higher by anticipated scarcities, and SA’s terms of trade once again surged. Although they have since reversed, partly due to the rise in oil prices, terms of trade remain firmly in the ZAR’s favour.
  • Although the ZAR’s discount to foreigners has evaporated, the ZAR cannot be regarded as expensive at these levels. The ZAR’s valuation is not a good reason to argue for a substantially weaker ZAR. It offers an interesting opportunity in carry attractiveness terms as it doubles up as a proxy for the commodity supercycle. One could even argue that the ZAR’s resilience will persist for at least another quarter, possibly two.

Baseline View:

There are good reasons to argue for the ZAR to depreciate over the longer term and importers may well see value at current levels, but the current valuation of the ZAR shows that the ZAR still holds the potential to appreciate further. ZAR is currently not trading at levels one could regard as a screaming USD buy.

SA’s trade balance remains a cornerstone to ZAR resilience

A trade balance on its own is interesting but lacks context. A trade balance relative to the size of the economy is more relevant and offers a better perspective on the surplus and whether it is out of synch with the economy.

The accompanying chart, a smoothed version of the trade balance as a % of GDP, makes for interesting reading. The effects of the Covid pandemic and the supply chain disruptions have played an important role in creating scarcities that have boosted commodity prices.

This two-year surplus has provided an unexpected boon for SA, helping to plug the fiscal hole that SA had experienced after the hard lockdowns. It also helped provide some support to the ZAR, which unexpectedly did not sell off aggressively but gained some resilience instead.

SA has lived within its means, has required no funding from foreigners and even offered investors a proxy to speculate on the commodity supercycle.

Terms of trade remain ZAR supportive

In the last two years, SA’s terms of trade have risen impressively. It has been the single biggest driver of the trade surplus and continues to support the economy, the ZAR, and has mitigated inflationary pressures.

And just as the pandemic induced commodity cycle was ending, the outbreak of war in Ukraine boosted prices again. It has extended the terms-of-trade bonus that SA has enjoyed and assisted the ZAR to make back more lost ground.

That too has reversed in the past week, but the terms of trade remain materially better than they were pre-pandemic. It ultimately means that the commodity price environment remains supportive of the ZAR and that the ZAR’s impressive performance so far this could extend for a while longer.

The biggest threat to the commodity cycle will be the rapid normalisation of monetary policies by the world’s leading central banks. Expansive monetary policy has underpinned the rapid growth in consumer demand post the hard COVID-19 lockdowns.

ZAR Performance in line with EMs

Cyclically adjusting the valuation model for a seven-year cycle shows that the ZAR is trading slightly above its fair value mean on the trade weighted real-effective exchange rate. By this measure, the overvaluation has risen to 2.5%, which reflects the recent surge in the ZAR.

One could argue strongly that the ZAR needs to trade at a discount to compensate foreign investors for placing their funds in South Africa, although interest rates are attractive and the current account is currently in surplus.

SA’s problem is not the immediate future but the general trajectory of the economy that appears to be steadily de-industrialising.

In the short-term, factors such as the performance of the USD, commodity prices, QE and others could influence the performance of the ZAR. Over the longer term, unless the government addresses the issues eroding the sustainability of the fiscus and restricting GDP growth, the probability is high that the ZAR will revert to trading at a discount in the foreseeable future.

Output of updated valuation calculations

  • Since the Last report run in December, the ZAR first depreciated against the USD and then appreciated over the past three months to reduce the undervaluation to less than 3% on a rolling 7yr cycle.
  • Much of this undervaluation is due to the overvaluation of the USD, implying that the ZAR might be trading even stronger if that overvaluation had to unwind.
  • Given the inversion of the risk of the US yield curve inverting and raising fears of a recession, the prospect of the USD losing ground should not yet be ruled out, even though the Fed will be the most aggressive developed economy central bank when normalizing monetary policy.

  • Against the GBP, the last three months have seen the ZAR trade from fair value to a firmly overvalued position of roughly 9% on a rolling 7yr mean.
  • Britain’s ongoing concerns over Brexit, as well as the proximity to Europe which currently has a significant exposure to the war in Ukraine is counting against sterling.
  • The central bank’s commitment to normalizing monetary policy will support the GBP at the margin, but it is also important to note that Britain’s largest trading partner is the EU and the EU is being heavily impacted by the war in Ukraine.
  • Difficulties in Europe will spill over into Britain which would go some way to softening the BoE’s approach to monetary tightening.

  • In the past three months, the EUR performed well and recovered off its lows against both the USD and the GBP. It has
    been more a function of how much has been priced in relative to underlying fundamentals as opposed to just focusing on the monetary policy disparity between the Fed and the ECB.
  • For the ZAR, a 6% undervaluation when adjusted for a risk premium implies ZAR is close to fair value in real terms.

  • Interventions by the SNB, verbal or otherwise have kept the CHF on the defensive and allowed a currency like the ZAR to appreciate into overvalued territory.
  • The CHF has lost ground against the EUR which leaves the ZAR 12% overvalued in what the SNB will regard as a successful effort to prevent the CHF from appreciating and undermining the country’s export initiatives that have contributed so much to GDP.

  • Overvaluation of the ZAR vs the JPY or has surged to over 20% in the strongest ZAR performance against the JPY in at least the past thirty years.
  • Japan retains its status as the world’s funding currency and its current performance only serves to reiterate this point. The only major factor to be concerned about, is that this data also suggests that the carry trade may be stretched and overdue a correction of sorts. Guessing what the catalyst might be is difficult.

  • Since Dec, the ZAR has made back some ground against the CNY, but thankfully has not turned overvalued, or SA’s trade balance with China might look worse.
  • With China now dealing with lockdowns and the fallout of the war with Ukraine, the potential exists for the ZAR to appreciate further.
  • Economically speaking, it is also important to note the slowdown in China that will keep the PBoC focused on reflating the economy and combating some of the headwinds.