Offshore Allocations Mitigate Domestic Growth And Currency Risks.

By Alexander Forbes Investments on Sep 19, 2018 in Market and Economic Commentary

Bottom-line: Portfolios have been positioned to mitigate domestic growth and currency risks. That said, we are more constructive on the currency at cheaper valuations. Opportunities to capitalise on the weaker rand will emerge for our major accumulation portfolios.

Emerging market contagion into South Africa

In recent months South African bonds, equities and the rand were largely caught in a storm of emerging market volatility. Troubles in Turkey and Argentina created fear that other emerging markets would be similarly impacted by the stronger US dollar and higher US interest rates. The troubles in Turkey were detailed by Executive Chief Economist Isaah Mhlanga in the note, “Implications of Turkish debt and currency crisis on South Africa’s asset class returns”.

Recession turns the focus towards South Africa

In contrast to the emerging market contagion impact on South Africa, the second quarter gross domestic product (GDP) data pulled South Africa closer to the top of emerging market headlines in September. Second quarter GDP growth contracted by 0.7% q/q annualised. We estimate that growth for 2018 will be about 1.0% at best. The USD-ZAR exchange rate rose as high as 15.70 following the weak second quarter GDP data, which took South Africa into a technical recession. After gaining versus its emerging market currency peers earlier this year, the rand lost ground in June, July and August, showing the underperformance that has crept in.

While the technical recession was unexpected, the weak economic conditions were not. South African economic growth has been under pressure relative to other emerging markets for an extended period. This weak domestic growth theme was one of the factors motivating offshore exposure within our Living*Investing risk management framework. Offshore exposure allows portfolios to take advantage of the global investment opportunity set and the pockets of growth available outside South Africa.

Offshore allocations mitigate domestic growth risks

Following the decision to use the 30% offshore limit in the second quarter, our major accumulation portfolios fared well through the recent financial market volatility. Offshore allocations are not the only strategy to mitigate local growth risks and currency volatility. The domestic private equity programme has also managed to produce good returns historically during weak economic conditions. Additionally, hedge fund managers can trade both long and short, which can generate returns during tough times. Year-to-date both Performer and High Growth are ahead of benchmark. In fact, offshore assets have been the top performers year-to-date, highlighting the degree to which the rand has driven returns. The rand has now weakened substantially relative to levels associated with fair value. Fair value is not a good short-term predictor of rand performance, but it indicates that the rand losses are probably a little overdone.

South African Reserve Bank (SARB) differentiates South Africa from Argentina, Turkey and Venezuela

Another great way to assess this relative currency valuation theme is to compare South Africa to our troubled peers in Turkey and Argentina. The troubles in those countries are complex, but a simple way to view the short-sightedness of the economic policies implemented there is depicted in the graph above. Authorities in Argentina and Turkey allowed money supply to grow substantially in the hope this would stimulate economic activity. In reality, real economic prosperity is always a combination of sound spending, quality investment, efficient production and a clear focus on long-term goals. If money creation was a sound approach to economic prosperity, then Venezuela would have been a resounding success rather than troubled with hyperinflation. For context, if Venezuela’s money supply were added to the emerging market comparison chart, it would completely dwarf its peers. Venezuela’s money supply grew approximately 10000 times since Jan 2010, compared to Argentina’s nine times.

While extreme, the examples of Venezuela, Argentina and Turkey provide confirmation that money creation is merely inflation, which is not a sustainable economic strategy. South Africans can be grateful the current SARB leadership understands these dynamics and isn’t caving into populist demands to ease monetary policy.

Alexander Forbes Investments

Alexander Forbes Investments

Alexander Forbes Investments was established in 1997. We are a forward-thinking and trusted global investment provider, with roots in Africa. In pursuit of certainty we set out to understand our retail and institutional clients’ circumstances and risk tolerance to set clear goals. Our adaptive investment approach, called Living*Investing allows us to maximise opportunity and minimise risk at every stage of the investment cycle.

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