This question is regularly put to fund managers and advisers, and there are no simple answers. In this article, two of STANLIB’s most experienced portfolio managers, David McNay and Peter van der Ross, present their views.

David McNay:

Last year we published an article about “optimal offshore allocations”, in which we analysed optimal portfolios using historical data, as well as our forward-looking models. We concluded, strategically, the offshore-onshore split should be a function of:

1. Required real return
2. Ability or willingness to hedge offshore currency risk
3. [implicitly] the available asset class universe.

At this point, our money-market colleagues could source a one-month NCD yielding over 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, which means if you require modest real returns in rands, you don’t need to subject yourself to the risk involved in placing your wealth offshore.

But assuming you are willing and able to hedge some of your currency risk, then the arithmetic changes. It would indicate a much more material weight offshore, at about 40% (assuming a Regulation 28 constrained portfolio). Our article last year discussed how hedging offshore currency back to rands is a “positive carry” trade, where one is typically paid for hedging. Rate-differentials are currently compressed, reducing this opportunity. However, currency hedging still widens the opportunity set, making offshore assets pseudo-domestic.

Here’s the explanation.

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 rands at the spot rate, then the volatility is enormous, typically around 15%. You may take that risk for something volatile, like equities, but does it make sense for something lower risk, like a corporate bond? Hedging the currency removes that exchange rate volatility from an offshore asset and uplifts the yield, effectively creating a pseudo-domestic asset and increasing the investable universe.

To answer the original question, we must talk about asset allocation. We can’t, and shouldn’t, disentangle offshore decisions from asset allocation and hedging. But assuming a more balanced objective, and the ability to hedge some offshore currency risk, our starting point would be to allocate 38-42% offshore.

Peter van der Ross:

There are numerous headwinds over the tactical horizon, i.e. for periods up to twelve 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.

A year from now, the rand could be doing reasonably well, but only if we endure a deeper near-term recession that reduces corporate earnings, commodity prices, and inflation. That one sentence encapsulates too many moving parts on which to base a sensible discussion, so if we shift our outlook to less than a year, we think the major headwinds for the rand are:

1. 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 like the rand.
2. Weak terms of trade, i.e. the prices of exported versus imported commodities. Cross-border trade directly impacts the demand and supply of rands in international markets. When we pay more for our imports than we receive for exports, the net supply of rands 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. Over the next few quarters, we do not foresee a strong rebound in commodity exports to China as the Chinese Communist Party seems intent on not further exacerbating their structural infrastructure and property imbalances. On the imports side, strong oil prices (oil remains a major import for SA) are likely to persist due to tight supply. We need a US recession to really soften demand for oil, but even then the US needs to rebuild its strategic oil reserves and the rand would weaken further into a recession.  Note that our base case is not for a deep US recession. That probably means global energy prices will remain elevated, and SA’s terms of trade will remain under pressure.
3. Ongoing impact of loadshedding and declining tax revenue. These are self-explanatory and many readers will have their own view about when loadshedding will ease. Yes, there are lots of promising renewable energy projects in the pipeline, but these are not going to save us from at least one more tough winter of loadshedding.

Pulling that all together, we favour a healthy weighting to offshore assets to capture the broader global opportunity set. Bear in mind that South African capital markets constitute about 0.5% of global markets, so a strategic allocation of roughly 60% of assets to local markets represents only a tiny sliver of global investable opportunities.

Dave discussed how hedging a portion of our global allocation back into rands dampens portfolio volatility (from the perspective of a rand-based investor). This has real value, especially to local investors who are closely matching their local liabilities, or who are drawing down on their savings. Tactically, we vary the size and shape (payoff profile) of those hedges in accordance with our tactical views. The reality is that, despite the significant rand weakness over the past two years, we still do not foresee near-term conditions as being rand supportive. Net of our currency hedges, we are overweight offshore assets at this time.