South African Rand: Out Of Fear, Emerges Alpha

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Includes: AFK, EZA
by: Macro Bruin

Summary

The Rand is a risk asset with an attractive risk profile at its present valuation.

The South African currency is fundamentally undervalued.

If you expect Armageddon, or otherwise more turbulent markets than expectations, the Rand probably isn't a position you should put on.

After Brexit, the world quickly witnessed a precipitous decline in risk appetite and consequently in the valuation of risk assets. Emerging market assets, such as those in South Africa, consequently sold off because, their high yields (which during times of calm, are attractive) are the consequence of greater cash flow uncertainty than, say, Bunds, Gilts, and T-Bills--and certainty carries a high premium during big dislocations.

Thus, the South African Rand is a good proxy for global capital market risk aversion. Below is a regression of USDZAR and VIX:

Note all that red! The correlation coefficient is, except for one flareup, consistently negative. That means that when VIX rises (an admittedly rough approximation of investor uncertainty), the Rand falls.

After the results of the referendum were released, there was pervasive risk-off sentiment in response to both the surprise (yes, basically no market participants widely expected this outcome) and the associated uncertainty about the real economy. Below is a chart of ZARUSD showing performance over the past month:

As you can see, there was a huge sell-off in the Rand once the results were released, but presumably, there were some savvy macro speculators who picked it up and established long positions, realizing that the currency wasn't inherently worth 8% less even in light of the referendum.*

This realization was perhaps spurred by the fact that the real exchange rate is low--like way low.

First, I'll give you the 'scientific' estimate. In the below graph are the BIS's (yellow) and IMF's (green) Real Economic Exchange Rate (OTC:REER) estimates for South Africa. The REER is basically a gauge of relative price levels. If the REER = 100, that means that a South African good/service costs the same, in real terms (i.e. priced as a portion of a basket of goods or services, rather than a fiat currency), as an equivalent good/service of the representative South African trade partner... if you don't have an economics background, my (in hindsight, very convoluted) description probably didn't just help you! Try this IMF link for an elementary background.

Then again, you don't really need to understand REER's to get my thesis here. All you need to know is that:

  • REER < 100 means base currency is undervalued in long run (in this case, ZAR) relative to representative trade partner (i.e. the trade-weighted average of price levels of trade partner countries)
  • REER = 100 means perfectly equivalent price levels ('par')
  • REER > 100 means base currency is overvalued in long run

Click to enlarge

So as you can see, South African goods/services are comparatively cheap! The 100 mark for par is so far above the actual line that I didn't put it on the graph--the undervaluation is extreme! Incidentally, if economic theory were fully applicable to reality, this would not be a possible outcome because of a silly construct known as the 'law of one price.' But macroeconomic theory does, in this case, help us to understand the likely course of ZARUSD. Because South African, for lack of a better word, stuff, is comparatively cheap when priced in Rand, we should expect, over the long run (I'm talking potentially 10+ years, here) that demand for the currency will rise as people opt at the margin to buy their 'stuff' in South Africa.

Here's The Economist's Big Mac Index (which I'm sure you've heard of, but if not, is here). Note that by this (fun, but still instructive) metric, the South African Rand is undervalued by 64.08%! (official REER numbers say it's more like ~30%)

Click to enlarge

The primary risk factor in going long the South African Rand to exploit this undervaluation is that the market may experience more turbulence than expected.

Note the wording: market volatility/turbulence, which induce risk aversion, will not on their own diminish the value of the Rand relative to the USD, or other cross currencies. Present market expectations are already priced into the value of the Rand (if you disagree, just look at how much the currency has slipped in recent years!), so the only impact that macro volatility will have on the Rand will be if the volatility is significantly greater than the markets currently expect...

So an important question for each potential Rand investor (or more likely, speculator) to answer is that of whether they expect more or less market turbulence than the rest of the world.

Less? The Rand may be a good bet for you.

More? Probably time to look somewhere else (like 3x Inverse VIX ETF's--just kidding, please do not do that).

Even if you disagree with my tentatively bullish sentiment, the Rand is an interesting situation nonetheless!

*I wonder who those intrepid speculators were who picked up on the big Brexit overshoot in EM's... ;)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.