Market Summary from K2 Capital
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What is the currency exposure of your portfolio? Should this even concern you?
As with all investment firms, we consider a wide range of financial inputs when building portfolios for our clients. The ultimate objective is to construct an investment solution that, armed with what are hopefully fairly reasonable assumptions, will provide the best risk adjusted returns for each individual investor. There are times when this is easier. And then there are times, such as now, where this process is as taxing as it has ever been. The current difficulties have lots to do with the relentless march of globalisation and the resultant interdependency of global financial markets. It is further influenced by never before seen levels of central bank intervention and the lowest developed market interest rates on record. This combination of high correlations and artificially depressed interest rates will influence the expected returns of all asset classes. For portfolio diversification to be successful, it requires the component asset classes to behave in a manner that reduces the reliance on any single risk factor. Portfolio construction is an iterative process, continually stress testing the question: ‘if X happens, how does Y react’. The result is a portfolio that is traditionally neatly defined in terms of its asset allocation characteristics. And for much of my career this has worked very nicely and returns have been good and clients have been happy. Cue theme music from The Sound of Music.
So what has changed? Well, in my opinion, the influence of currency exposure in portfolios is becoming increasingly complex and the impact this decision will have on future returns is material. And do not be fooled into thinking the currency decision is merely a function of how much rand exposure you have in your portfolio. It isn’t. You will see in my comments below that we are entering a whole new era of manipulated and politically influenced currencies that are set to dominate return profiles of all portfolios. We have reached the final chapter of the Mills and Boons - Asset Allocation romance novel. The Stephen King - Currency Wars economic thriller is lying on the bedside table. But before we get there here are the summarized numbers for the usual key indicators in September 2016:

Index Description Month Year
ALSI Local equity -0.9% 6.6%
SAPY Local listed property 1.1% 3.8%
ALBI Local bonds 3.0% 7.6%
STEFI Local cash 0.6% 7.2%
Index Description Currency Month Year
MSCI Global equity USD 0.5% 11.4%
S&P 500 US equity USD 0.0% 15.4%
FTSE 100 UK equity GBP 1.8% 18.4%
JP Morgan Offshore bonds USD 0.5% 9.5%
Exchange rates
Exchange rate Rate Month Year
Rand / Dollar 13.8 7.0% 0.6%
Rand / Euro 15.5 6.0% -0.1%
Rand / Sterling 17.9 7.9% 17.3%

What’s the best performing stock market in 2016? It depends. What currency are you measuring it in? Let’s take a simple example and look at 4 of the stock markets that feature prominently in most portfolios. I will measure each of them in their base currency and then convert this to a different reference currency to make my point. The results are tabled below and cover the period 1 January 2016 to 30 September 2016.
Name Currency Code Base ZAR USD GBP EUR
FTSE/JSE Africa All Share ZAR 4.8% 4.8% 18.1% 34.0% 14.2%
S&P 500 USD 7.8% (4.3%) 7.8% 22.4% 4.2%
FTSE 100 GBP 14.1% (10.7%) 0.6% 14.1% (2.8%)
DJ EURO STOXX 50 EUR (8.1%) (15.6%) (4.9%) 7.9% (8.1%)

The table is largely self-explanatory. 4 stock market indices. 4 economic regions. 4 different performance numbers. Measured in base currency, the UK delivered the best return with the local JSE only delivering the 3rd best return. But reflecting these returns in different currencies provides a very different outcome. Let’s take the US dollar as our reference currency. This mirrors the reality of most offshore portfolios. In USD, the UK goes from the best to 3rd best performer and the JSE goes from 3rd to best. In fact, when you finish reviewing the table, you will notice that our local JSE is the best performing stock market for the year to date in rand, dollar, pound and euro terms. How significant is this? Well consider the circumstances we faced on 1 January 2016. We had just come off Nenegate and the Barmy Army were singing songs at the cricket reminding us what the exchange rate was. With perfect foresight I would have painted a picture of deep declines in global stock markets in January, increased harassment of Pravin Gordhan, an unexpected Brexit vote, a Donald Trump Republican presidential nomination and a European banking confidence crisis. If I had offered you a 9 month return of 18% in US Dollars would you have taken it? If I had told you it would require investing all your money in the South African stock market would you have believed me?
The rand decision in portfolios
The influence of currencies in portfolio returns is clearly significant. Our client base is almost exclusively South African. With most of them, there is only one currency decision that is important – how much exposure is there to the rand in their portfolio. This is understandable. Our neighbour is Zimbabwe. We have, shall we say, questionable politics. Our neighbour is Zimbabwe. Afro-pessimism is our national sport. Oh……and our neighbour is Zimbabwe. Discuss the currency issue with clients and the overwhelming consensus is that the rand will decline in value forever. Portfolios need to be heavily overweight non-rand exposure. But I had two very interesting reads present themselves this past week. The first was a report compiled by John Cairns, Currency Strategist at RMB Global Markets titled The Anatomy of Rand Crises. John has kindly allowed me to quote parts of the report but I would encourage readers to have a look at the original document which has been posted to our website and can be found here. The report looks at the current and the 3 previous ZAR ‘blowouts’ and analyses the subsequent currency performance after these events. The report draws the following conclusions:
  1. The rand always comes back in real terms.
  2. Rand recoveries happen very quickly.
  3. The rand strengthens a lot.
  4. Rand crises always start slowly and end quickly.
  5. Rand cycles are very long.
  6. Volatility is extreme at rand turning points and often elevated thereafter.
  7. The most important issue in determining rand turning points appears to be the dollar.
As I said, do yourself a favour and go look at the report to get a much better appreciation of how they arrived at their statements. The simple point I am trying to make is that history shows us that the rand is not a one way bet. Yet we need to be acutely aware that in the short term it is heavily influenced by political noise. Economics always trumps politics when analysing long term trends. There is also another, often neglected rand consideration in portfolios these days. It relates to the globalisation theme I alluded to earlier and I was reminded of its significance by Andrew Vintcent, long-time colleague and portfolio manager at Clucas Gray Asset Management. Andrew shared his investment views with the K2 team recently and highlighted this chart which shows the percentage of JSE top 40 company’s earnings that are exposed to offshore currencies. (Editors note: the original source of information is from Thomson Reuters, company data and RMB Morgan Stanley)

In the year 2000, the total exposure to foreign currency earnings for JSE top 40 companies stood at 37%. This has exploded to 73% in 2016. In plain English, for every R100 in earnings delivered by JSE top 40 companies, 73c is derived from a source outside South Africa. Not only is that remarkable, it’s hugely significant. It means a portfolio that only invests in a local South African stock market index has effectively implemented a 73% hedge against the rand. Yet, when looking at any portfolio analysis, this exposure will almost certainly be reflected as 100% domestic. Which it isn’t.
So there are two prevailing beliefs we need to prevent falling victim to. The first is that the rand is an inherently weak currency and will always weaken. And the second is that you shouldn’t have too much of your portfolio exposed to South African equities because you don’t get any currency diversification. Both beliefs are inherently false (over the long term). The rand strengthened against the USD by 7% in September 2016. That’s a significant single month movement, despite the domestic political noise intensifying. And before the rand bears haul out the chart of the last 10 years and scoff that in January 2006 the rand:dollar exchange rate was 6.32 and today it is 13.88, let me point out the often ignored fact that over the same period interest rates in South Africa have averaged about 6% and have been close to zero in the US. Any currency analysis that ignores the interest differentials between countries is not giving you the full story. If you want to get a better understanding of long term exchange rate comparatives then you need to be considering the Real Effective Exchange Rate (REER) which the South African Reserve Bank publishes in its quarterly bulletin. It is the existence of high interest rates that attracts foreign capital to our market. The REER is a credible way of judging currency movements.
What about the other currency decision in portfolios?
Having taken an active decision to externalise parts of your portfolio by either taking money offshore using your Foreign Investment Allowance (FIA) or utilising some form of asset swap facility, you are now hedging your currency exposure, right? Well, unfortunately it’s not that straightforward. Since the onset of the 2008 Global Financial Crisis (GFC) we have witnessed unprecedented levels of central bank intervention by authorities in America, the UK, the EU, Switzerland, Japan and China. This has driven interest rates to levels where there is simply no ammunition left in the monetary policy armoury. Low interest rates coupled with ridiculous levels of debt means there is only one other weapon that remains to be unleashed – currency manipulation. There used to be a time when the currency exposure in your portfolio was really a function of a single variable – how much rand exposure you had. You could have exposure to any basket of currencies as long as it wasn't rand. But in the age of currency wars, this is no longer the case. We’ve seen active intervention in the currency markets by central banks in Switzerland, Japan and China. We’ve seen the British Pound continue to weaken materially post-Brexit. And we’ve seen emerging market currencies rally materially at any hint of risk appetite returning to markets. The results of all of this have been remarkable. In the table below we have reflected the relative movements of a basket of currencies against the US Dollar since 1 January 2008 which crudely dates the early days of the GFC.
Name Currency Code
GBP -34.7%
EUR -23.1%
CHF +16.8%
YEN +10.3%
ZAR -50.3%

The relative movement of the dollar, both positive and negative is quite apparent. The Brexit referendum has seen the pound trading at its weakest levels in more than 30 years. Although the UK stock market wobbled immediately after the vote, this weakness was short-lived. The FTSE 100 is trading higher than it was before the vote, yet the pound remains materially weaker. This has turned out to have a number of benefits for the UK. A weaker currency has attracted foreign capital looking to purchase now relatively cheaper property, tourist activity has exploded and manufacturing and exports have become more competitive. All this will result in much needed inflation being injected into the UK economy. If you were measuring the returns of your portfolio in GBP, the performance numbers would be looking very strong. The exact opposite would be true if you were holding a USD or ZAR referenced portfolio that was holding assets in the UK. The relative movement of various currencies has significantly influenced the performance of the same basket of underlying assets.

The pound has weakened 21.8% in 2016 against the SA rand. That’s a significant number that has placed immense pressure on shares listed on the JSE that are either dual listed in the UK or have significant exposure to the UK economy.
Name of share Currency Code month of september 2016
Old Mutual -14.4% -3.1%
Investec -19.0% -3.1%
SA Breweries -13.9% -6.5%
Capital and Counties -33.4% -10.1%
Intu Properties -22.8% -13.5%
British American Tobacco -4.7% -3.7%
Billiton +11.8% +10.1%

At the end of the day, I honestly believe that it is the direction of the US Dollar that will be the single biggest contributing factor to portfolio returns in the next 5 years. Asset class returns will remain weak but at some point the strong USD will start negatively impacting both US corporate earnings and economic competitiveness. With the US Federal Reserve continuing to dither on interest rates, I see the only release valve in the debt balloon being the currency market. And a weakening USD will have a material impact on not only the non-rand component of your portfolio, but almost certainly in the basket of other currencies we tend to overlook. I see the significance of this factor even outweighing the impact of a potential credit downgrade in South Africa later in the year. It’s almost certainly more significant than the Zuma – Gordhan battle. It just won’t sell as many newspapers.
Ok let’s wrap this up. Why is this all relevant? Well, it’s relevant because the decision on currency exposure could overwhelm returns from the underlying asset classes in the next few years. No, let me rephrase that. It will overwhelm asset class returns in the next few years. We have long advised clients to manage expectations lower when thinking about expected portfolio returns. In global developed markets where cash is yielding zero, long term sovereign bonds are trading at negative yields and equities are trading at historically high PE multiples, the probability of anaemic returns from multi-asset class portfolios is higher than it has been in a long time. Applying blunt currency diversification overlays while ignoring the unintended tilts will lead to inevitable disappointment. Ignoring, in the words of Donald Rumsfeld, the ‘unknown unknowns’ will come at a price. At K2 we are continually refining our understanding of effective currency exposures in client portfolios while remaining acutely aware of the need to juggle both the political as well as the economic risks to the rand. Currently, we are still titling most portfolios to higher than average foreign currency exposures because we believe the political risks to be both real and probable. Faced with a fight or flight instinct, a caged president usually chooses to fight with disastrous short term implications. In the same breath, however, we need to appreciate the very negative impact this decision will have on portfolio performance in an environment of a rapidly appreciating rand. Both in the active offshore exposures and more importantly in the hidden ‘domestic’ allocations.
Getting the currency allocation correct in your portfolio has never been as important and it occupies our mind on a daily basis. This discussion will form a significant part of client review sessions when we meet.

For a full breakdown of fund and individual share movements, kindly click on the links above to access the September 2016 Local and Offshore Watchlists.
Copyright © 2016 K2 Capital. All rights reserved.

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