By Justin Floor
It’s a challenging time to be an investor in domestic South African securities.
Some of the well-telegraphed issues and challenges that exist and that have dominated headlines include infrastructure collapse across the country, the highest interest rates since the Global Financial Crisis, load shedding and corruption.
In response to these challenges, many local assets have derated materially over the last few years.
The equity market is being priced at historically low valuation multiples, and in some cases, companies are acutely undervalued relative to their prospects for growth and shareholder return.
Additionally, South African Government bond yields are hovering around at 12%, one of the highest real rates globally. The rand has also been weak and has underperformed the currencies of many other emerging market countries.
In an environment like this it's worth recalling John F. Kennedy's observation that in Chinese, the word 'crisis' comprises two characters - one symbolizing danger and the other opportunity.
Take note of the long-term US dollar cycle
Since the late 1960s, the trade-weighted US dollar has been through multiple cycles in which it was either dominant, or weak. These cycles have typically lasted between five and fifteen years, or around ten years on average. They generally have coincided with large inflation and interest rate cycles.
Emerging markets and commodity markets seem to be particularly sensitive to the strength or weakness of the greenback. The world has just concluded a notably long and pronounced cycle of dollar strength, which commenced during the Global Financial Crisis in 2008 and ended in 2020. The evidence of the last few years suggests that we may be in the early stages of a dollar down-cycle. History suggests this cycle could gather momentum and last for many years. This has important implications for investors.
In the past emerging market and SA equities have not fared well during strong US dollar periods. However, periods of dollar weakness can be a significant tailwind for investment returns in emerging markets, including South Africa.
Some domestic headwinds are starting to abate (and may turn into tailwinds)
Our analysis indicates that certain domestic challenges mentioned earlier are poised to improve, potentially shifting from headwinds to tailwinds. While each improvement in these factors holds promise, their collective enhancement could wield significant influence.
Firstly, while our interest rates are influenced by US Federal Reserve policies, our own inflation dynamics are reasonably well behaved. We therefore think there is a good chance of interest rates starting to fall later this year and into 2025. With inflation expected to average around 5%, we anticipate the South African Reserve Bank (SARB) maintaining the real rate at approximately 1% to 2.25%, allowing for a reduction in interest rates by 1% to 2%.
This would result in a substantial decrease (15% to 30%) in the base cost of capital in the economy, potentially benefiting consumers' disposable income and reducing company interest rate expenses. Moreover, it could have a positive impact on security valuations such as PEs and bond yields.
Secondly, SA’s infrastructural challenges may be set to improve. Loadshedding is likely to be less frequent in the next few years as we note progress on some of the much-needed energy reforms. The private sector is forging ahead and there is considerable new capacity in the pipeline.
In addition, private sector resources have been deployed to Eskom’s generation fleet and the large Medupi and Kusile units are coming online. More reforms are needed, but the current direction of travel will be evident in economic growth, as well as the earnings and cash flows of affected companies.
Furthermore, while progress has been sluggish, there are signs of improvement emerging at Transnet and the ports, alongside increasing private sector involvement. Anticipated further enhancements in the near future, albeit from a low starting point, are expected to benefit select sectors of the local economy.
A confluence of technical factors is greatly increasing the likelihood of better outcomes ahead
The last five years have seen a vicious cycle of foreign equity and bond outflows, relaxation of prudential offshore limits (Regulation 28), and local and foreign institutional investors reducing allocations to SA assets. The average global emerging market portfolio is now underweight to South Africa.
The reality is that many large SA balanced funds are close to maximum offshore capacity and may need to start directing funds back to rand assets. A further sign of a bottom in the market, is the fact that private capital is buying and delisting South African companies.
Be selective about SA assets – but don’t ignore the opportunities
When looking at the SA market, we seek out companies with the potential to grow, especially where that growth is less dependent on the broader SA economy. Good examples are infrastructure stocks and the tourism and leisure industry.
In addition, we aim to identify companies with agile and entrepreneurial management who consider how to protect and grow the value per share of the companies they manage. We are also closely watching the increasing trend among companies to repurchase their undervalued shares on the market, as this can be a sign of strength and may benefit shareholders.
PSG Asset Management follows an integrated global investment process, and we find that examining the SA opportunity set through the eyes of a global investor provides a valuable perspective. It is helpful in contrasting the potential opportunities and risks in local assets relative to competing offshore opportunities.
While acknowledging the risks inherent in the domestic environment, we believe there's a compelling opportunity for healthy returns ahead if one is selective. Therefore, we have been adding exposure to South African securities in our multi-asset portfolios over the last few months.
Justin Floor, Head of Equities and Dirk Jooste, Fund Manager at PSG Asset Management
BUSINESS REPORT