The time for rand hedges has arrived

THE RAND’S explosive run against major currencies is likely to begin to lose momentum.

My analysis indicates that the rolling 12-month momentum of an equity market weighted currency index of emerging markets excluding Asia (based on the MSCI Emerging Markets ex Asia Index) against the US dollar is highly correlated to the momentum of the S&P Goldman Sachs Commodity Index (S&P GSCI). The S&P GSCI cover physical commodities spanning five sectors: energy, industrial metals, precious metals, agriculture, and livestock, weighted in relation to their global production levels.

South Africa’s weight in the MSCI Emerging Markets ex-Asia Index is currently 18.45 percent.

The S&P GSCI’s momentum in April hit an all-time high (since 2004) of nearly 97 percent. Although the S&P GSCI is still rising it is rapidly losing momentum and is currently at 64 percent. The historical relationship between the momentums of the S&P GSCI and my currency index of emerging markets excluding Asia indicates that, as things stand, the currency index should have been 14 percent higher than a year ago. That compares to just over 8 percent currently and therefore indicates that the currency index still has about 6 percent upside.

The correlation of the rolling 12-month momentum of the USDZAR (US dollar per rand) exchange rate and the momentum of the S&P GSCI since 2004 was much weaker than that of the currency index of emerging markets excluding Asia and the momentum of the S&P GSCI. Since 2016 the correlation between the momentums of the USDZAR and S&P GSCI increased significantly. The historical relationship between the momentums of the S&P GSCI and the USDZAR since 2016 indicates that, at Friday’s close, the USDZAR should have been 23 percent higher than a year ago. That compares to just over 29 percent currently and therefore indicates that the rand is overpriced by about 6 percent.

My analysis also points to a very high correlation between the rolling 12-month momentums of the USDZAR and the currency index of emerging markets excluding Asia since 2016. It is worth noting that the rand is highly geared relative to changes in the currency index of emerging markets excluding Asia. For example: a 10 percent change in the currency index of emerging markets excluding Asia over 12 months is likely to lead to a 15 percent change in the USDZAR in the same direction – yes, a beta of 1.5.

In general, it appears to me that the outlook for emerging market currencies outside Asia is highly dependent on the behaviour and outlook for commodity prices. Surely, the outlook for the various countries may differ vastly and currencies will diverge accordingly.

One thing is certain though. The momentum of commodity prices as measured by the S&P GSCI determines investor sentiment toward emerging market assets and therefore capital flows. Yes, also the environment where speculators roam.

As things stand, sentiment toward commodities is extremely bullish. No one sees an end to the shortages of raw materials and intermediate goods as the major economies open up as the coronavirus is conquered. Let us be honest. It was China who pulled the world out of the economic quagmire caused by the coronavirus.

But China is facing a conundrum as a result of the turbocharged stimulus financing to get the economy going. Consumer spending and confidence improved to pre-coronavirus levels and the shift in the economy is aimed at investment and exports. The massive inflows led to a the yuan surging by more than 12 percent against the US dollar over the past 12 months and together with the surge in commodity prices are likely to make China’s goods more expensive. Latest indicators already show moderating growth.

Furthermore, speculative flows are rife as demand for Chinese assets such as equities, properties and even company loans have reached bubble proportions. The Chinese stock market as measured by the Shanghai Index (in US dollar) surpassed the highs of early 2018 while house prices are surging at the fastest monthly pace since last September to the highest level in more than five years. According to the People’s Bank of China (PBoC), the combined domestic debt of corporations, households and the public sector last year amounted to 280 percent of GDP compared to 255 percent in 2019.

The current situation is very similar to what happened in the last quarter of 2017 and early 2018. The Chinese authorities have already started to intervene in the currency market to deter speculators and raised the level of foreign currency reserves that banks must keep on deposit with the PBoC from 5 percent to 7 percent. The government also instituted measures to cool the property bubble.

Further draconian measures to cool the property market and limit credit expansion to address the indebtedness of corporations and households will soon be on the cards. I will not bet against a significant intervention by the PBoC in the currency markets to devalue the yuan.

In my opinion, commodity prices are likely to continue to lose momentum due to the Chinese factor and so will emerging market currencies. The rand is therefore probably trading at or near its best levels for the foreseeable future. Yes, I think the time for rand hedges has arrived.