Daily Equity Report
Seed Weekly - Currency Valuation
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 of 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 guide our tactical asset allocation decisions, where we under- or overweight certain asset classes in the short term, compared to our longer term target weights.
When evaluating global asset classes for our funds, we try to separate the currency decision from the underlying asset class valuation. Practically, this means that if global equities show a lot of value, we might allocate even when the rand is weak. Although currency volatility might overshadow our asset class decisions in the short term, investing at attractive valuations pays off over the long term.
We look at both the trend exchange rate of the Trade Weighted Basket of currencies and the well-known Purchasing Power Parity (PPP) relationship against each of the majors on a monthly basis.
The Trade Weighted exchange rate of the rand is based on trade in and consumption of manufactured goods between South Africa and its most important trading partners, incorporating twenty different currencies. Presently, the five major currencies in the basket are the Euro (29%), Chinese yuan (20%), US dollar (14%), Japanese yen (6%) and British pound (6%).
The graph below illustrates that the rand is around 20% undervalued given the long term trend in the Trade Weighted basket of currencies:
Source: Seed Investments 26 July 2016
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. In SA, with local annual inflation running at 6.1%, a consumer will see his purchasing power eroded a lot quicker than in the US, where inflation is 1.0%. Therefore, a SA consumer needs to be “rewarded” with more rand per US dollar each year - resulting in rand depreciation - if this relationship holds.
Theoretically, PPP implies that SA’s 5% higher inflation should result in around 5% depreciation per annum against the dollar. In practice, actual exchange rates can deviate from the calculated PPP estimate for extended periods. Over the last 10 years, SA inflation has been running at 6.3%, with US inflation at 1.8%, while the rand has weakened by 7.5%, quite a bit more than the expected 4.5%.
The graph below illustrates that, at a market rate of R 14.70 as at end June, the rand is around 37% undervalued vs. the calculated PPP rate of R 10.69.
Source: Seed Investments 26 June 2016
In the wake of the Nenegate sage in December last year, the rand has been exceptionally volatile, prompting many investors to re-evaluate their global exposure. At Seed, we have not traded on the short term volatility, but have maintained our global allocations at close to 25% for our multi asset class funds and model portfolios.
Cor van Deventer
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Wed, 27 Jul 2016- 09:15