DAVID MCNAY and PETER VAN DER ROSS: The case for a healthy weighting to offshore assets

After some relative stability at end-September, the rand is under renewed pressure. That, combined with local economic instability fuelled by SA’s energy constraints and many other factors, is prompting investors to reconsider their investments’ local versus offshore exposure. Where to for SA investors as 2023 draws to a close?

The Stanlib multi-asset team has done significant analysis using historical data and forward-looking models to determine optimal portfolios in the context of an offshore-onshore split. They concluded that strategically the split should be a function of required real return, ability or willingness to hedge offshore currency risk, and implicitly the available asset class universe. 

When deciding whether to allocate assets onshore or offshore we cannot and should not separate offshore decisions from asset allocation and hedging. However, assuming a more balanced objective and the ability to hedge some offshore currency risk, we would recommend starting with an allocation of 38%-42% offshore for a portfolio. 

It is possible to source a one-month non-convertible debenture (NCD) yielding more than 8%, versus the most recent CPI print of 4.8%. That implies a 3.2% excess return on cash. Real cash rates have been the norm in SA over a long period, and we expect that to persist. Therefore, if you require modest real returns in rand you don’t necessarily need to take on the risk of investing your wealth offshore. 

However, if you are willing and able to hedge some of your currency risk, the situation changes. It would indicate a far more significant weight offshore at about 40% (assuming a Regulation 28-constrained portfolio). While hedging offshore currency back to rand may not be as profitable as before due to compressed rate differentials, it still expands the range of investment options, in effect making offshore assets behave like domestic ones. 

Eliminate volatility

Assume you hold a $1 note offshore, in dollar terms that has a volatility of zero — a dollar is a dollar. But translate that dollar-note into rand at the spot rate, and the volatility is enormous, typically about 15%.

While it may be acceptable to take this risk for volatile assets such as equities, it may not make sense for lower-risk investments such as corporate bonds. By hedging the currency you eliminate the exchange rate volatility, increase the yield and in effect transform the offshore asset into a pseudo-domestic asset, expanding your investment options. 

We see several headwinds over the tactical horizon, for periods up to 12 months. Over such a relatively short horizon our view on currency positioning is driven less by valuation and portfolio optimisation considerations and more by the unfolding of local and global cyclical dynamics. 

Focusing on the rand’s prospects in the next year or less, the major headwinds we are anticipating include: 

• A still-hawkish US Fed, reducing relative rand carry attractiveness. The easy wins on global inflation are behind us, and for now at least the Fed is resolute that it will keep interest rates high until they have done their inflation-fighting job. The positive real yield available on dollar cash and fixed income assets is a strong disincentive for global investors to allocate towards traditionally high-yielding currencies such as the rand. 
• Weak terms of trade, that is the prices of exported vs imported commodities. Cross-border trade directly affects the demand and supply of rand in international markets. When we pay more for our imports than we receive for exports, the net supply of rand must typically be matched by foreign portfolio inflows to keep the currency stable. Those flows remain scarce due to the combination of high yields available in the developed world and a stagnant local economy. On the imports side, strong oil prices (oil remains a major import for SA) are likely to persist due to tight supply. If global energy prices remain elevated SA’s terms of trade will remain under pressure. 
• Ongoing effect of load-shedding and declining tax revenue. These are self-explanatory and many readers will have their own view about when load-shedding will ease. Though many renewable energy projects are in the pipeline, load-shedding will not disappear soon.

Given the limited size of SA capital markets, constituting only about 0.5% of global markets, we believe a strategic allocation of about 60% of assets to local markets represents only a tiny portion of the global investable opportunities. Therefore, we recommend a healthy weighting to offshore assets to capture the broader global opportunity set. 

Despite significant rand weakness over the past two years we do not anticipate near-term conditions being supportive of the rand. We are thus overweight offshore assets, net of our currency hedges. 

By hedging a portion of our global allocation back into rand we can dampen portfolio volatility (from the perspective of a rand-based investor). This is particularly valuable for local investors who are closely matching their local liabilities or who are drawing down on their savings. 

• McNay is a senior portfolio manager, and Van der Ross a portfolio manager, at Stanlib Asset Management.