The madness of crowds

Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr 

Once again, South Africa is the country that see-saws from one extreme emotion to another. Two weeks ago, the robustness of our rule of law was being celebrated. Now we are grieving the loss of many lives and widespread destruction and looting. This just as the devastating third wave of Covid-19 infections seems to have peaked. 

What just happened? 

What may have started out as a political protest – to the jailing of former president Jacob Zuma – quickly descended into widespread violence and pillaging on an unimaginable scale in KwaZulu-Natal and townships around Johannesburg. Perhaps because phone cameras are ubiquitous now, many harrowing images were circulated this week.  

The military has now been deployed and a semblance of order is returning. The next major challenge is to restore supply chains so that food, fuel and medicines remain accessible in affected areas.  

While we have never experienced anything on this scale before, South Africa does have a history of violence stretching back centuries, but particularly in the 1980s and early 1990s. Crime is rife in our society and there are frequent outbreaks of public violence. These range from violent strikes and service delivery protests to battles between rival taxi operators and xenophobic attacks against foreign nationals.  

Order needs to be restored and maintained, but the underlying issues and social ills also need to be addressed as a matter of urgency.  

Chart 1: SA unemployment rate 

Source: Refinitiv Datastream 

However, there is footage showing that it was not only desperately poor people who looted. Many of the stolen goods were loaded into upmarket vehicles. This unjustifiable lawlessness is deeply worrying and calls for serious soul-searching as a nation. 

Trust in the security services will have to be rebuilt, as well as trust in one another. There is no other alternative for people who want to stay in South Africa. As is always the case in our country, there was also good news amid the chaos. There were, for example, many encouraging scenes of communities standing together to protect shopping centres and neighbourhoods, and there was also no shortage of volunteers keen to help clean up and rebuild.   

Can the centre hold? 

South Africa has been on the brink many times, but somehow always managed to veer away from a descent into complete anarchy. It’s as if we are always peering over the edge, stepping back only at the last minute.  

This recalls Yeats’ Second Coming which former President Mbeki was fond of quoting: “Things fall apart; the centre cannot hold.” The events of the past few days will convince many that the country has finally spun out of control, its centrifugal forces no longer strong enough.  

But their pessimism is likely to be misplaced. What is crucial is that South Africa has a framework within which to rebuild social trust and repair the economy.  

The big philosophical questions of representative democracy have long been settled. What seemed like intractable conflict in the 1980s gave way to our constitutional order: all adults can vote, everyone is equal before the law, and our basic rights and freedoms are enshrined in the Constitution. The problems we are faced with today are largely practical, not conceptual or ideological. They are big, and we have failed to address many of them, but progress is possible.  

Failed states cannot even begin to address their problems because there is no consensus on the basic rules of the game. In contrast, most of South Africa’s 60 million citizens want peace. Most are fed up with crime and corruption. Most want shared prosperity and hope for all.  

So the centre can hold. It is held together by ordinary people and key institutions such as our free and fair elections, a parliament with opposition parties, our Reserve Bank, businesses and business organisations, civil society, trade unions, and of course the courts.  

What will the economic impact be? 

The combination of Level 4 lockdowns and the violence and looting means July is likely to see steep declines in economic activity across a number of sectors, and the third quarter as a whole could see negative GDP growth. The losses will run into billions, some of it insured, much of it not. Some smaller businesses therefore might have to close for good.  

The biggest impact will be on the retail sector, followed by transport and logistics, and manufacturing. Retail is an important sector at around 7% of GDP, but clearly an economy is much bigger than its shops and malls. South Africa is a R5 trillion economy, some of it informal and fragile, but much of it sophisticated, flexible and robust. 

Depending on how soon calm can be restored and shelves restocked, activity can rebound fairly quickly as we saw a year ago when the economy emerged from hard lockdown. People still need to buy food, clothing and other household items. The rebuilding and restocking efforts will add to economic activity, giving a boost to fourth quarter growth numbers. The exact timing is of course is up in the air at this stage.  

While it is easy to overstate the short-term damage, it is also possible to underestimate the long-term consequences. These are likely to extend well beyond the retail sector, dealing a blow to already fragile business and consumer confidence. The blow can be softened if government deals more decisively with the violence and also adapts its policies to boost the economy. 

As the looting intensified, the World Bank released a report highlighting some of the steps South Africa should take to grow the economy and create jobs. While important economic reforms have been announced – most notably the deregulation of electricity production – there is more that can be done to make it easier to do business. Listening to the expert economic advice of global institutions like the World Bank is an important start, just like the government has relied on expert advice in dealing with the pandemic. 

Crime and unrest have long impacted the economy negatively in a number of ways. Last week’s riots were in many respects an acute flare-up of a chronic condition. Injury and loss of life cost the economy billions (and unquantifiable anguish). Diverting scarce resources to security measures is extremely costly. Small businesses, particularly in townships, are very vulnerable to theft and often don’t survive as result. Stolen goods can be replaced, but it drives up insurance premiums, sometimes to unaffordable levels for informal entrepreneurs.  

What we can’t measure is the investment that does not take place because of crime and violence, when global businesses and investors overlook the country, or when locals decide to emigrate and take their skills and capital with them. Or simply when a business that wants to expand finds it impractical to do so (as was recently the case with Rio Tinto’s Richards Bay mineral sands operation).  

How did markets respond? 

The rand is the country’s financial pressure valve, and it lost about 2% against the US dollar in the past week. Neither local nor foreign investors like to see scenes of anarchy, but if short-lived they are unlikely to count as a dramatic event in the context of the currency’s history. Foreign investors are more likely to dump South African equities, bonds and the currency when they are concerned about global economic growth than in response to events on the ground here. In fact, some of the weakness in the rand was due to a stronger dollar in response to firmer US inflation.   

Chart 2: Rand dollar exchange rate 

Source: Refinitiv Datastream 

South Africa has long been better at attracting portfolio flows than foreign direct investment (FDI). In other words, foreigners are more likely to buy bonds and equities that they can quickly trade in and out of thanks to our sophisticated financial markets than buying businesses that they have to operate. There are substantial FDI flows, but portfolio flows are bigger. Portfolio investors also tend to have short memories and most often trade on global financial considerations    

Foreign investors in emerging markets accept that there is less social stability and weaker government control than in developed markets. It ends up being built into the valuations and the higher return expectations. Violent protests are not unique to South Africa. Just in the last year, Chile, Colombia, Brazil and Mexico have experienced widespread riots. In fact, according to the latest Global Peace Index, the number of riots, strikes and anti-government protests worldwide jumped 244% percent in the last decade. The frustrations and depravations of Covid-19 lockdowns have been fuel to the fire in many cases.  

Even the US was engulfed by protests against police brutality and discrimination last year. And of course it doesn’t take much for football supporters in Europe (the UK especially) to become unruly.  

The JSE as a whole was largely unchanged, but that is because it is mostly a global index and rand hedges rose. Retail and bank shares were quite a bit weaker, as could be expected. 

Bonds were weaker, but South Africa’s dollar credit default spread (its market-based credit rating) has moved in line with its emerging market peer group. The rising bond yields therefore do not reflect a fundamental change in the assessment of the government’s creditworthiness, but rather the weaker rand.  

Chart 3: South African dollar credit default swaps vs peers 

Source: Refinitiv Datastream 

It is ultimately global financial developments that matter most to our markets. And as things stand, the global environment remains very supportive. Commodity prices are still elevated, and capital still abundant.  

How should investors respond? 

If you have a diversified portfolio, there is no reason to take any immediate action. As citizens we are saddened and angered by the events of the past few days, but as investors we can spread our eggs over many baskets. Global markets are unaffected by what happens in South Africa. 

A knee-jerk reaction would be to sell out of South African investments completely and take all the money offshore. However, remember that the local assets are already pricing in a lot of bad news hence the surprisingly small market reaction to these events. It is sensible for local investors to have substantial global exposure to manage risks and to access different return opportunities, but be careful of throwing out the baby with the bathwater. It is generally better to be a buyer when others are selling in a panic. If you are aiming to increase offshore exposure, do not attempt to be too clever in timing the rand. Focus on what you want to buy on the other side.  

We can’t ignore what is happening around us. We are all shaken. Ultimately, however, what happens in Beijing and Washington and the trading floors in New York and London matters more for your portfolio than chaos on the streets of Durban or Soweto. 

 

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Running with the rand

By Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr

10 May 2021: The rand turned 60 this year. It was introduced in February 1961 as a decimal replacement for the South African pound, which operated on the pounds, shillings and pence system. Named after the gold-rich Witwatersrand, the rand had a pretty sheltered childhood, until the early 1980s, mostly pegged against the US dollar and the UK pound. It was cut loose around the time of adulthood, and as a free-floating currency it’s had a pretty wild existence ever since.

In fact, it is widely considered one of the most volatile currencies. South Africa’s large and deep capital and derivative markets give it liquidity compared to other emerging countries with very little control over foreign participation. However, it lacks a massive and diversified economy behind it to give it stability. South Africa’s level of foreign exchange reserves is also quite low relative to the size of the economy and imports, which probably makes it a more attractive target for speculators.

Chart 1: Long-term rand-dollar exchange rate

Source: Refinitiv Datastream

The Bank for International Settlements (the central banks’ central bank) has a triennial survey of daily foreign exchange turnover. At $72 billion per day on average, the most recent survey (2019) puts the rand ahead of the currencies of Poland, Brazil and Turkey and only slightly behind Russia, even though they are all much larger economies.

Nonetheless, the rand is highly correlated with other commodity-linked emerging market currencies, which tend to rise and fall together with the commodity cycle, global investor risk appetite and major US dollar trends. 

Classic cycle

The past 18 months have of course seen a classic rand cycle. It blew out completely when global markets panicked about the Covid-19 pandemic in March and April of 2020, falling to record lows against the stronger dollar.

The recovery was almost as swift as the sell-off was brutal. Eventually it becomes too cheap to ignore, and investors start piling in as soon as the worst of the market anxiety passes. And once it gains momentum, traders smell a trend and it just snowballs.

This particular cycle has seen a massive boost in the form of commodity prices, particularly platinum group metals and iron ore. This impacts the currency directly through flows of higher export earnings, but also indirectly because the currency is so closely associated with commodities. 

Rand return boost

Local investors can benefit from the rand’s volatility. Given South Africa’s higher inflation and lower competitiveness compared to other major economies, one would expect the rand to weaken over time, boosting offshore returns. In fact, over the long term, it has weakened by about 1% per year more than inflation differentials imply, boosting the real rand returns on global assets.

Chart 2: Exchange rate volatility and its declining inflation impact

Source: Refinitiv Datastream

Meanwhile, the impact on local inflation of rand weakness has declined over time and is currently estimated by the SA Reserve Bank to be around 10%. In other words, a 1% depreciation adds 10 basis points to inflation but 1% to offshore returns, all else being equal. Therefore, rand depreciation tends to boost real returns of local investors from offshore assets in the short to medium term as well. And since local investors, pension funds and corporates have more foreign assets than total foreign debt, national net wealth is also boosted.

But all else isn’t always equal. One of the biggest headaches for local investors is that the same conditions that cause the rand to rally also cause global investments to rally: risk appetite, global economic and profit growth, and rising commodity prices. The converse is also true. The rand often falls with global markets, as we saw in March last year, cushioning the blow for local holders of offshore equities.

One exception was 2002, when the rand recovered sharply from an earlier blow-out just as the dotcom bubble was deflating and corporate scandals rocked markets. Rand returns from global assets were decimated, soon after many South Africans invested abroad for the first time following the easing of exchange controls.

Is this a good time?

Many investors are wondering whether it is a good time to increase offshore exposure. Firstly, trying to time investments, whether equities, bonds or currencies, can do as much harm as good. If an individual’s long-term financial plan or pension fund’s strategic asset allocation requires offshore exposure, then don’t worry about the currency too much. 

Secondly, getting a handle on whether the rand is cheap or not usually involves a lot of guess work. Rather than looking for specific levels, investors should think about broad ranges. Based on inflation differentials (purchasing power parity theory), the rand looks fairly valued around R14 to R15 per dollar.

Thirdly, as mentioned above, waiting for a strong rand to take money offshore often also means buying into more expensive investments on the other side. That might very well be the case now. The rand has gained 27% against the dollar over the past year, but global equities have gained 48% in dollars. Global equity valuations have increased from an attractive to reasonable over this period, with the US now expensive.

At the end of April, MSCI put the forward price: earnings ratio for the world market at 18 times, the highest since 2002, while SA equities traded at 10 times forward earnings. Similarly, the South African 10-year government bond yield is double the Reserve Bank’s 4.5% inflation target, while the US equivalent is still below the Federal Reserve’s 2% target. This implies positive expected real returns from SA bonds and negative real returns from US bonds. While local cash returns are not as juicy as they once were, they might keep up with inflation while developed market central banks have all but promised negative real rates for the foreseeable future.

Chart 3: Global forward price: earnings multiples

Source: Refinitiv Datastream

Diversification and sources of return

So why invest offshore at all? The answer remains diversifying to reduce exposure to SA-specific risks, and adding valuable and extensive sources of investment returns that are not available locally.

Yes, global equities are more expensive in aggregate, but among the thousands of listed companies there are those that are cheap relative to their fundamental value or growth prospects. In contrast, a big part of why South African equities trade on low valuations is because of high commodity prices boosting prospective earnings.

These prices might stay high, but they might not. If they decline, it is a risk to local investments. Apart from mining, the JSE is simply very concentrated, with a single underlying exposure (Tencent) accounting for 15% to 25% of the overall market, depending on the benchmark. If we look at the FTSE/JSE All Share Index, 60% of its market cap is contributed by the top 10 shares. For the MSCI All Country World Index, the largest 10 of the 2 974 constituents only make up 15% of the total market cap.

Emerging market equities in general trade at cheaper levels than developed markets. Local investors might shun emerging markets because South Africa is one, but we have a very different profile to the more dynamic East Asian countries with scores of innovative world-leading companies.

In terms of local fixed income, the bond market is dominated by the government and its state- owned enterprises (virtually all junk status) and the money market by the big four banks. By contrast, the global fixed income universe is massive, spilt roughly half-half between sovereign and corporate (and other private) borrowers, and across all imaginable regions, maturities, credit ratings and currencies.

Local property is heavily exposed to offices (at risk from the shift to working-from-home) and shopping malls (ecommerce), as well as Eastern Europe. Global property is an extremely diversified asset class, including sectors that barely feature on our market, such as data centres, various residential options, hospitals, laboratories and communications facilities. Global property is not overvalued by any standard metric.

Home bias

Home bias is common, even in countries where there are few or no restrictions like Regulation 28. People tend to invest in what they know, whether it’s the savings account of a local bank or the shares of the brand names they consume every day. But it’s a big world, and home bias can mean missing out on opportunities not available locally.

For many South Africans, their biggest assets are probably their company pension fund and their home. Some own businesses. The more affluent might have a holiday property. That means they are overexposed to the domestic economy and its cycles.

Therefore, there is a strong case to be made for investing a significant portion of discretionary money offshore. The size of the allocation of course depends on individual circumstances.

This is not about “fleeing” South Africa at all, or implying the country is falling apart. It isn’t. Local politics may be as noisy as always, but there are signs of improved governance and key institutions acting against abuse and overreach. Local growth prospects are also improving on the back of a strong global economic recovery. It is rather about prudently spreading risk and widening opportunities to gain a better overall chance of generating inflation-beating returns, particularly through offshore growth assets.

Increased offshore allocation will also not starve the country of funds for development. Given our sophisticated financial markets and banking system, the biggest problem is not a shortage of funds, but difficulty in spending it properly. The answer to our developmental challenges is therefore not to force capital in a certain direction, but to build state capacity to spend it constructively and get the most out of every rand. Improvement in this direction will in fact attract foreign money. Capital will always find its way to where the returns are. And as mentioned above, foreign assets build resilience for the local economy.

Keep emotions at bay

However, as always, beware of making decisions based on emotions. It makes sense to hedge against potential domestic political and economic instability, but the hedge also has to be proportional to the risk. The rand’s behaviour will probably continue to belie its age, and we can expect it to continue jumping around like a teenager at a party to the hectic rhythm of global capital flows. This volatility means investors can burn their fingers if they respond reactively to episodes of weakness, rather than proactively diversifying.

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