This will be a slightly more technical piece. I will attempt to keep the concepts simple in the interests of our non-financial readers. Please reach out should you require a more technical engagement.

What’s the ‘fair value’ of an emerging market currency – it’s the tracks on a rollercoaster ride

When you live in or are invested in an emerging market economy, discussions around the currency often become key. As a consumer, it informs what you pay for imported goods and fuel. As a business, it informs the cost of capital and what you can expect on exported goods.

The value of a currency is often seen as the ‘share price’ of an economy. Simplistically, when it strengthens, it is perceived that the economy is doing better and vice versa. The problem is that currency markets are often nuanced and depend highly on several interrelated global factors.

Economic theory suggests that interest rate and inflation parity relationships should hold over time. This means that countries with higher inflation and interest rates tend to have weaker currencies relative to their peers.

However, in the short term, global liquidity conditions, risk appetite and foreign portfolio flows are but some of the considerations which can lead a currency far from its perceived fair value.

Emerging markets also exhibit political idiosyncratic risk and macroeconomic (fiscal and monetary) risks which must get factored in as risk premia. Hence, if you ask 5 economists what the fair value of the currency is, you will get at least 6 answers!

I promised to update my view on the dollar and the rand in my earlier piece this week. I will attempt to simplify this for the general reader so as not to bore you with the process. I will also look specifically at the USDZAR cross although one could conduct this for any cross rate and/or basket of currencies.  

If you would like more detail on the numbers and would like to discuss strategy, please reach out here for a consultation.

 
What does Fair value look like in the long term?

I always say that fair value on a currency is an academic construct. The only times you will get to fair value is on your way ‘through it’, either up or down. The chart compares the monthly fair value of the South African rand vs. the US dollar (USDZAR).


Source: Moe-Knows.com

The blue line (actual USDZAR) is ‘smoothed’ to remove the intramonth volatility. The grey and orange lines represent a fair value with and without a risk premium respectively.

A ‘High Beta’ Currency – What does that mean?
A ‘risk off’ environment (signaling high global risk) sees the rand sells off resulting in a higher cost in Rands for each dollar. The rand tends to move A LOT in both risk on and risk off environments. This is what is meant when you hear comments like “The rand is a ‘high beta’ currency”.

What is evident is that the fair value acts as a ‘magnet’ for the currency. Times like 2001, 2009, 2016 and 2020 illustrate ‘peaks’ which correspond with specific event risks. These were the ‘dotcom bubble’, global financial crisis, ‘Nenegate’ and COVID respectively.But after each of these peaks, a period of relative calm returns and ‘pulls’ the rand back to its fundamentals. These are the proverbial ‘tracks on the roller coaster ride’ that I referred to above.

The other point which is evident is the upward slope to the rand. This is because, as mentioned above, South Africa exhibits higher inflation and interest rates than the US. As such, it is logical that the currency will depreciate over time.

At present, this model suggests that the fair value for the rand is R15.71. The model can also be used to make projections and forecasts of fair value and these act as a guide for where the tracks may be – but the car sometimes does ‘leave the track’.

The value of these long term projections are that it assists businesses in planning their business cases and investment projects. But like a map is to a driver, it charts the course but the driver still has to look for the bumps in the road.
 
The Loop Gap Roller Coaster: YouTube Geek Week Commercial – CoasterCritic
 
 
But what about right now?
The long term is fine but how do we deal with quick and sharp dislocations in the dynamic world of financial markets? At the time of writing, the USDZAR is R15.63 after an intraday low R15.20. Wow, this market does move fast.

The chart below maps our fitted financial conditions macro model against higher frequency data. The model incorporates inputs like the dollar index, global liquidity, commodity prices,etc. At present, it suggests that the rand could in fact be trading above R17.00/$. In fact, at present levels, the rand is about 1 SD stronger than the model suggests.
 
 

 Source: Moe-Knows.com

What does this all mean?
If your eyes have glazed over by now, I apologize. Let’s distill what this means RIGHT NOW!

Readers are generally familiar with the concepts of equity markets so lets use the exchange rate as a stock price. At current levels of R15.63/$, valuation models suggest that the rand is priced fairly. However, remember that this fair value is not static and depreciates over time.

The long term value of the stock will depend on whether the next few years see the US runs higher inflation and if SA manages to keep its own inflation in check. It will depend on how the country is run.

In the short term, the rand has corrected significantly from the massively oversold levels following the COVID crisis market scare and it remains vulnerable to some weakness. At present it is over 1 standard deviation stronger than its short term fair value suggesting that some short term weakness is more likely than not.

My Strategy
As such, the strategy I follow myself is that I watch these fair value estimates closely. When opportunity presents itself, I am not greedy. I do not wait for the currency to push the limits of its short term strength before looking at hard currency exposure again. The reason is that the long term value is depreciating and as such, I maintain a long USD vs. ZAR bias over time.  

This would only change if we see a structural change in how inflation relatives behave and the overall trend in the US dollar.

In the short term, moves of 1-2 standard deviations stronger than the model suggests starts to look enticing. I have always staggered my trades (much like an equity investor staggers their stock purchases). Can we go lower, sure. But do you have the risk appetite to hold on if it doesn’t?

At levels below R15.50, the rand looks expensive to me. In the R16.00’s may be more neutral and in the R17.00’s I would say it looks quite full.  

If we know where the roller coaster is taking us, and we take the precautions and strap in, we could enjoy the ride, regardless of the ups and downs. Here’s wishing you a safe and fun ride!

“ Stay in your seat come times of trouble. Its only people who jump off the roller coaster who get hurt.” 
Paul Harvey
 
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Disclaimer 

Our content is intended to be used and must be used for informational purposes only. You must do your own analysis before executing any investments or strategic decisions, based on your own circumstances. We do not provide personalised recommendations or views as to whether an investment approach or corporate strategy is suited to the needs of a specific individual or entity.

You should take independent financial advice from a suitably qualified individual who gives due regard to your personal circumstances.

Whilst every care is taken, we accept no responsibility or liability for any errors or omissions in any of our content.

The views, thoughts and opinions expressed in our content belong solely to the author or quoted individuals and/or entities, and not necessarily to the author’s employer, organisation, committee or other group or individual, or any of our affiliates or brand partners. 

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Disclaimer 

Our content is intended to be used and must be used for informational purposes only. You must do your own analysis before executing any investments or strategic decisions, based on your own circumstances. We do not provide personalised recommendations or views as to whether an investment approach or corporate strategy is suited to the needs of a specific individual or entity. You should take independent financial advice from a suitably qualified individual who gives due regard to your personal circumstances. Whilst every care is taken, we accept no responsibility or liability for any errors or omissions in any of our content. The views, thoughts and opinions expressed in our content belong solely to the author or quoted individuals and/or entities, and not necessarily to the author’s employer, organisation, committee or other group or individual, or any of our affiliates or brand partners.

Moe Knows © Copyright 2021. All Rights Reserved.

MK White

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