By: Jan-Daan Van Wyk, Stonehage Fleming Investment Management Associate Director
The South African euphoria trade is not over yet, and the figures show that foreigners are nibbling in South Africa’s financial market. While the equity market is still experiencing net negative flows this year, the dial shows signs of a shift in the bond market.
South Africa’s foreign investment in the stock market has steadily declined since 2005, when active Global Emerging Market (‘GEM’) investors held 9.3% of their emerging market portfolio in South African assets, according to SBG Securities research and EPFR data. Since then, exposure has declined to less than 2.7% – more than two-thirds lower than the peak almost two decades ago.
When considering this positioning within active strategies, one has to account for the decline in SA equity representation within the MSCI Emerging Markets (‘EM’) index. Changes in active investors’ appetite for South Africa’s assets would signal a fundamental shift in sentiment. Passive investors invest based on the country’s weighting in the underlying index as their performance is intended to mimic that of the index.
Many factors are driving the size of SA within the EM index, but if stronger share price performance begets inclusions into the index and SA grows in significance, this would prompt passive flows into SA equities. This year’s upcoming MSCI index reviews in mid- August and mid-November should provide early indications.
According to Prescient Securities research based on JSE settlements data, the government bond market experienced the strongest net inflows in recent years in July, after treading water in May and June and net selling by foreigners earlier this year.
However, National Treasury data reflect that the holdings of outstanding domestic government bonds are still significantly lower (25.0%) than when these holdings averaged around 40.2% in 2018.
So, what will it take to really shift the dial on South Africa?
Over the past decade, the national government has been long on promises and short on delivery. This has given rise to anemic growth weighed down by loadshedding and logistical constraints, which the errant implementation of structural reforms has been slow to ameliorate. We believe that a sustained shift in the vector of big-ticket economic data, such as at least two to three quarters of strong economic growth numbers, may start to dent this skepticism.
Ongoing fiscal prudence will also be crucial, and there has been good progress in this regard. For the fiscal year ending March 2024, National Treasury recorded the country’s first primary surplus since 2009. Additionally, national revenue and expenditure continues to meet expectations set by National Treasury during the budget in the first three months of the fiscal year to end June.
An improved growth trajectory combined with continued fiscal prudence should improve national credit metrics, which opens the possibility of a rating upgrade. S&P still has South Africa’s local currency debt rated at two notches below investment- grade status at BB. Credit rating upgrades would significantly enhance the country’s status as an emerging market destination and unlock billions of rand potentially available for investment in South Africa.
Political risk will remain a factor to contend with, but initial developments post the national elections leave us optimistic. The cabinet may be more bloated than ever, but it is better than it was. There’s a diverse group of decision-makers hungry to prove themselves, with the broad representation enhancing input, oversight and accountability.
Operation Vulindlela (‘OV’) is the glue for the GNU: should all parties agree with the path ahead and allow it to continue unfettered, investor sentiment would be substantially bolstered. The achievements during the first phase of OV make us optimistic that there will be continued progress towards achieving its policy objectives over the next five years, during the second phase.
SA investment base case improves, but challenges remain
We consider the prospects for SA equities attractive, particularly those counters in the ‘lost and found’ bucket. Our analysis shows that, from a valuation perspective, the aggregate SA market remains about one standard deviation cheaper than its long-term average. This backdrop is similar for SA industrials, but within the sector, there is material dispersion – with, for example, Retailers, Construction, and Industrial Transport all trading at a more than 20% discount.
We believe this is the first phase in a multi-phase recovery. Should a capex and credit cycle commence in earnest, the knock-on effects will be significant, leading to a major reversal in trend growth after the lost decade.
This outlook led us to tilt around 2-3% of the equity exposure in our multi-asset growth fund to lean into the SA mid-cap space, specifically the currently unloved sectors of the market where we think there are great opportunities. With our primary focus being on risk diversification, we feel that this positioning reflects our optimism in a prudent manner.
It goes without saying that South Africa remains an emerging market economy, historically subject to volatility and significantly impacted by global events. While there seems to be consensus on the direction of travel for global interest rates (lower), views on the potential paths followed remain fluid and continue to drive much volatility. Uncertainty around global growth remains, and geopolitical risks continue to hold investors’ attention, especially in the Middle East. However, investing is never smooth sailing.
