Rand is undervalued

Arthur Kamp, Investment Economist at Sanlam Investments.

Anticipation of the hike in the US’s federal funds target rate and the steady decline in prices of SA commodity exports, as well as weak SA productivity performance, have gradually weakened our currency over the past few years.

Plotted against the Indian rupee, the Turkish lira, the Australian dollar and the New Zealand dollar, the rand has been the worst performer over the past 10 years.

Undervalued by how much?

We use a purchasing power parity estimate to calculate the fair value of the rand. In other words, we work on the assumption the currency will depreciate in line with inflation differentials in the long run. Viewed in this way we believe the currency is undervalued.

As illustrated in the graphs below, the rand is almost two standard deviations cheap against the dollar and almost one standard deviation cheap against the euro.

What would fair value be?

According to our calculations, the fair value for the rand would currently be R10.05/$ and R10.20/$ by the end of 2015. Despite the fact that the rand is fundamentally undervalued, this does not mean that it will strengthen anytime soon. All we can say at this stage is that we believe the rand is undervalued against the dollar. A currency can, however, trade away from its fair value level for years on end.

What does this mean for the SIM portfolios?

Seeing that the rand is currently undervalued, the Sanlam Investment Management (SIM) portfolios retain their underweight position with respect to their total offshore exposure.

In addition to this, instead of converting further US dollar cash outright into rand cash, we implemented a currency hedging structure in applicable portfolios during the past quarter, so that the SIM portfolios benefit if the rand appreciates.