SA: Just another BRIC in the wall?

1 October 2018 | SA Views | Joani van Wyk
 


Brazil, Russia, India, China and South Africa collectively form the BRICS countries. These countries are characterised to be the world’s leading emerging countries and were formed with the aim to promote development between member countries and drive them forward.

When constructing a diversified portfolio there are many emerging countries to choose from. In this article, we have a look at the yields of the BRICS countries and how they compare with each other over the long and medium term. We will discuss the importance of timing when trading currency pairs as these trades can easily wipe out returns earned from a carry trade strategy. A carry trade involves borrowing in a country with low-interest rates, and investing in a country with high-interest rates. This strategy can earn a profit if the interest earned in the high-interest rate country exceeds the depreciation of that country’s currency relative to the currency that the capital was borrowed in.

As an example, consider borrowing at 2% in the UK and converting the pound sterling into rand, then investing the rand amount at an interest rate of 8% in South Africa. If the rand depreciates more than ~6% versus the pound over a year, then the carry trade results in a loss. Without any external factors (politics, market sentiment, etc.) the rand will theoretically in this example depreciate by ~6% so that an investor will be in the same final position whether he invested in the UK or SA. This is not the case in reality and an opportunity to benefit exists to make a carry trade if one currency is undervalued relative to another.

At the moment, emerging markets face numerous geopolitical risks from both EM and developed nations, the most predominant being the US-China trade war. However, there remains potential in these countries. When constructing a globally diversified portfolio, a money manager must make the decision of how much capital to allocate to emerging markets and which of those countries to allocate to. 

The money manager will consider the interest rate and assess the risk. This includes an assessment of the risks to interest rate changes as well as risks that could influence the exchange rate like politics and global market sentiment. Take South Africa’s land reform as an example, this is a politically driven event that is perceived negatively by the market and has been a factor in the rand’s depreciation in 2018.

Usually one would see a country’s currency appreciate when an interest rate hike is announced or expected since higher interest rates attract capital. With a carry trade strategy, you face the risk of that country’s currency depreciating relative to your local currency (and the value of your initial investment decreasing). In our carry trade example above we note that in theory, a country with higher interest rates should see its currency depreciate. Inflation plays a role in all of this so let’s have a look at this economic relation for the BRICS countries using real (after inflation) interest rates:

Currently, Brazil is offering the highest real yield on the 10-year horizon and Russia has the highest 2-year real yield and real policy rate. South Africa’s 2-year and 10-year yields are the second lowest after China with the SA real policy rate being the lowest. From a policy rate perspective, one’s first reaction might be to invest in Russia instead of South Africa. When looking at the possible currency movement for the rand, it appears that the rand should appreciate against these currencies in order for economics to hold. If this is true there should be no BRICS member providing a better return than the other. On the other hand, should the rand depreciate significantly, there would be a good profit opportunity when investing in higher yielding countries.

BRICS Countries Real Rates

(Click image to enlarge)image1

banner


joani

Joani van Wyk
Analyst

Joani van Wyk joined the asset management team in January 2017, responsible for quantitative research of equities across all industries. Joani completed her degree in Mathematical Science in 2015, as well as an Honours degree in Financial Risk Management in 2016, both at the University of Stellenbosch. She is currently a CFA candidate.


Disclaimer:
The information contained in this article is for informational purposes only and must not be regarded as a prospectus for any security, financial product or transaction. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial issue. Investors should consider this research/article as only a single factor in making their investment decision. We recommend you consult a financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs. The views and opinions (where expressed) in this article are those of the author and do not necessarily reflect the official policy or position of Sharenet.