Futuregrowth’s Zain Wilson: Worst could be over for the Rand

In this Special Podcast, Futuregrowth fund strategist Zain Wilson takes a counter-intuitive view of the Rand's prospects over the next few months. After getting smashed by the strengthening US Dollar, on a relative basis South Africa's is now more attractive than most other Emerging Market currencies. Zain takes all the important factors and rationally argues that although he doesn't expect any immediate fireworks, with the current account improving and stability provided by a credible new SA Reserve Bank Governor, the Rand's worst days are behind it. – AH 

ALEC HOGG: This Undictated Special Podcast is brought to you by Futuregrowth. Zain Wilson, Fund Strategist and Fixed Interest Analyst at Futuregrowth, joins us to talk about the mighty Greenback. Zain, the Dollar just seems to get stronger and stronger. What's behind it?

ZAIN WILSON: Year-to-date we've had probably a ten percent gain for the Dollar across all currencies and it really started to happen since the end of July. What we're seeing and what's driving it is that the US economy is getting better. Banks are healthier. The current account balance is getting better and the US is moving closer to a more normal world, whereas the rest of the world is not recovering as quickly. It just means there's a lot of support for normalisation in the US and that means the market's pricing-in the removal of some liquidity. Obviously, that's supporting the Dollar across multiple currencies.

ALEC HOGG: Why would that be the case – in other words, when Quantitative Easing ends – that the US Dollar should rise?

ZAIN WILSON: A very simple way of looking at it – and it's a bit of oversimplification – is that it's just a supply and demand story. When QE happened, it forced a lot of Dollars into the system, so there was an increase of supply of Dollars and that meant that the price of Dollars went down, the Dollar weakened. If the market's pricing-in QE ending, they're assuming that QE is going to pull out all that liquidity. Less Dollars in the system means the price of the Dollar will go up, which means a stronger Dollar.

ALEC HOGG: That makes a lot of sense. The implications though, for other currencies are stark. We'll get to that in a moment. But first, what are the implications for American corproate profitability? There are big exporters in the United States.

ZAIN WILSON: Yes. American corporates are a bit more complicated because they obviously have revenues which are generated offshore, but a lot of the time those revenues and profit are kept offshore in different tax havens. The simple version of it is that if the Dollar strengthens too much, export revenues will decline and if those revenues are pulled into the US then for the head office of each of those corporates, you'll see lower export revenues and a pull down in profitability. I think it is a lot more complicated because the US is quite a strong domestic economy as well, and there's been a lot of manufacturing pulled back into the US over the past five or so years, as a result of the crisis. There's a lot of profit being generated internally, so it's probably a case of certain exporters will be hurt, but not necessarily the whole US economy or profitability for US corporates.

ALEC HOGG: So you wouldn't necessarily expect the S&P 500 Index to start falling as a result of the stronger Dollar?

ZAIN WILSON: I think what you're seeing with the S&P 500 Index and equity markets in general is not necessarily a result of the stronger Dollar and earnings forecast being pulled in. It's more a result of what happens to global equity markets when the liquidity's been pulled out of the system. We've had a very strong run over probably four years now and there's a lot of concern that if there's no longer QE, not a lot of liquidity in the system, and rates start to rise, the alternative assets to equities (bonds and short-term cash deposits) start looking a lot more attractive. It's probably more a function of that, than it is of earnings being revised.

ALEC HOGG: But bonds are not giving you a great yield, particularly US bonds?

ZAIN WILSON: Yes. If you had to look at US bonds now, real rates are still negative, or slightly positive and moving further out on the curve, but they don't offer a great yield. What generally happens as short rates rise, if the market starts looking two years ahead the Fed Fund rates will be two percent higher than the relative value you'd see on a two-year view. And a two percent cash yield based on a zero percent cash yield now, set against equities, looks a lot more attractive. The alternative asset class for equities starts looking more attractive on a forward-looking basis and so I would say the market's probably getting ahead of itself now in assuming that you're going to have quite a sharp acceleration in the hiking cycle in the US.

ALEC HOGG: The other big issue here, and particularly as far as South Africans are concerned, is the carry trade where people have been borrowing very cheap in the United States and investing in a currency where the interest rates are higher (like the Rand). There's lots of talk about this unwinding. What are your thoughts?

ZAIN WILSON: I think the last time we chatted (in July) we spoke about that. It's a result of the current account deficit and the fiscal deficit, meaning that South Africa has a large funding requirement. As long as we continue to have those imbalances and a large capital requirement, we still need finance to fund our growth. What happens with yield and the Rand is that as US rates rise, and as liquidity is pulled out of the system, it increases the base for that carry trade. As the base increases for the carry trade, our yields have to rise in response in order to attract the same capital flows. If we don't, that means foreigners will penalise South Africa. You won't see as much money flowing in, and that obviously puts pressure on the Rand.

ALEC HOGG: Surely, if you're seeing the US Dollar rise, you don't really want to go and put your money into Rands if you're a foreign investor.

ZAIN WILSON: I would also look at it on a longer-term basis, look at what the Rand has done over the past three years and how much it's already depreciated against the Dollar. While you've had a lot of Dollar strength year-to-date the Rand has actually held up quite well against other currencies. So this hasn't been a 'weak Rand' story over the last couple of months, it's been very much, a 'strong Dollar' story. The Dollar has reacted quite quickly and it's moved by probably ten percent. But in the long run, the US Treasury is not going to remove all that liquidity from the system in a month or even a year. It's going to be done very gradually. I would actually venture to say that given how much the Rand has moved over three years, you haven't really seen many episodes in the past where the Rand depreciated by 30 percent and then depreciates by another 30 percent. I guess that in markets, it's times like these when you've seen a lot of value loss that you really want to look for opportunities to invest when everyone else is selling. It might be an appetising time to start buying the Rand.

ALEC HOGG: That's interesting. Very counterintuitive.

ZAIN WILSON: Yes. Well, I think that's where opportunities arise in the market – when you have a lot of momentum selling. The Rand has done a lot of work and if you look at it across multiple bases/fair value, be it PPP or account-to-account, if you assume that the fundamental drivers start to improve. We starting to see indicators that they're starting to turn. You're seeing manufacturing and exports pick up gradually, and you're seeing consumer imports pull back gradually, which will help the current account correct. If these things happen, which is obviously a big 'if', then the Rand starts offering a lot of value. The other side to that is if we still have credibility coming from the Central Bank that will give support for the currency as well.

ALEC HOGG: Well, that brings us to the appointment of Lesetja Kganyago as the new Governor of the Central Bank. If you just take a complete outsider's view, he's (in theory, anyway) better qualified to take that job than his two predecessors who were more politicians than Central Bankers, whereas he's more of an economist than a politician.

ZAIN WILSON: I think Lesetja has been groomed for the job. He's ticked all the boxes. He's an economist. He spent time at the Central Bank but he's been in Treasury before that. He has the ANC backing as well. I think the market is happy that this has happened. The point is that we've seen the Rand strengthen so yes, in many ways I agree that he fits very easily into the role. And it's a good support for the Rand, because it's a continuation of the credibility that the Central Bank has built up.

ALEC HOGG: So that would be a bull factor. What about some of the strange political stories that we hear coming out of South Africa, though? Are they not maybe taking the edge off the possible appreciation of the currency?

ZAIN WILSON: Yes. It's already going to be a function of balancing those different factors. We had labour union issues in the last couple of years. We've had strikes. We've had political issues starting to come up probably last year with the strikes and internal conflict, and what we're seeing in Parliament now with the EFF. However, if you look at the rest of the world, these are not uniquely South African problems. On a relative value play, comparing us to other Emerging Markets, which is what a global currency investor, global bond investor, or any investor who is looking at multiple EM's, would look at Turkey as well. There are plenty of political problems in Turkey and similarly, in Brazil. So it's very easy for us to get very negative on South Africa and the political outlook, but you have to see it… When you look at currency, you have to look at it from a global investor perspective.

ALEC HOGG: So Zain, the worst might be over for the Rand and, quite against the momentum theme, this could perhaps be the time to start thinking of adding Rand to your portfolio.

ZAIN WILSON: I would say if the Dollar continues to strengthen and you keep an eye on the drivers of the current account deficit (because I still think that's probably one of the most important things)… If we start seeing platinum exports coming back on line then I think there's an opportunity to add Rands and start buying the Rand into Dollar strength. It really does depend on that current account outlook and as long as the deficit stays wide, it's easy for foreigners to not be sold on the fundamental positive story in South Africa.

ALEC HOGG: Zain Wilson is Fund Strategist and Fixed Interest Analyst at Futuregrowth, and this undictated special podcast was brought to you by Futuregrowth.