How do you know if a country’s currency is going to continue to weaken or whether it is about to get stronger? Not easy, but there are some clues. The Economist came up with the Big Mac Index, which compares prices of identical burgers sold by a global fast-food outlet to show you what your money will get in each country. Burgernomics  gives a very rough idea of purchasing power parity.
In this blog, investment analyst Mike Brown of Seed Investments takes a more technical look at the concept, focusing specifically on the rand’s value in relation to foreign currencies. His message: don’t expect the rand to improve or weaken in any significant way because it looks like it is where it should be. He has put together a graph to illustrate his point. – JC
By Mike Browne
Investing offshore is often an emotive subject, particularly in South Africa where many investors got burnt at the turn of the century. In the early 2000s the rand weakened considerably against most global currencies and investors sent large portions of their hard earned savings into developed market equities at exactly the wrong time.
From the end of 2001 until now we have seen both the rand strengthening AND the local market outperforming in local currency terms, i.e. investors who sent money offshore lost out both from a currency AND a stock market perspective. These investors are therefore very sceptical about sending any more money out of the country as they don’t want to get burnt again. On the other side of the coin you have those investors that are worried that South Africa is ‘going down the tubes’ and will take ANY opportunity to get money out of the country.
The reality is, as always, somewhere in between. In our view, investors taking money offshore need to answer two explicit questions:
- Is the rand over- or under-valued?
Mike Browne of Seed Investments explains PPP. - Are the offshore assets (equities, property, bonds, etc) over- or under-valued?
This article looks solely at the first question.
Purchasing Power Parity, more commonly known as PPP, is a common method of valuing currencies that is popular among academics and investment practitioners alike. Essentially PPP estimates the fair value of a country’s currency based on inflation differentials and the law of arbitrage. While this relationship often doesn’t hold over the short term, it has a good predictive power over the longer term.
All models have potential pitfalls where human intervention and logic are important to ensure that sound theoretical reasoning doesn’t result in illogical results. One potential pitfall of PPP is that the output is highly dependent on the starting date. One can get wildly different estimations of fair value by using the same model, but different starting dates. When looking at the fair value of the rand vs the US dollar one can calculate PPP anywhere between R6.90 (1995 start) and R17.72 (2002 start). Blindly inputting a starting date can therefore produce an output that is far removed from (what we perceive to be) reality.
The model’s output is extremely useful, and a powerful predictor of future movements, for investors who apply an element of logic when making their initial assumptions. At Seed we look at PPP from two viewpoints. The first looks at the average PPP for periods between 5 and 20 years (i.e. 180 observations). This method gives a current fair value of R9.44 /USD. The second method uses the end of 1984 as a starting date, and the result is below. This model’s fair value is R9.47/USD compared to the current rate (as at 30 September) of 10.03.
When the rand is above or below the dotted line (1 standard deviation) we are fairly confident that it’s trading significantly away from fair value and make investment decisions accordingly (send ZAR offshore when it’s too strong and bring USD back to South Africa when it’s oversold).
We used this model to reduce our foreign currency exposure at the end of 2008, and then again to take it to its maximum at the end of 2010. The rand is currently fairly close to fair value and we therefore aren’t making investment decisions solely based on an expectation of currency movements.
Mike Browne started his investment career with Exsequor Investments (Seed’s forerunner) in 2005 after graduating from the University of Cape Town with a BBusSc (Finance) degree. While working at Seed, Mike successfully passed all three CFA exams, and was awarded his CFA Charter in 2009. Mike currently manages Seed’s unit trusts and spends a large portion of his time conducting investment research and meeting fund managers. Mike is on the Investment Committee and is a Portfolio Manager at Seed Investments.
