Are SA equities just cheap or is there more to it?


Over the past decade, SA equities have significantly underperformed its global peers, as macro factors have significantly deteriorated in South Africa. The investment case for SA equities, as a result, has centred around a valuation argument rather than that of an improving structural story. In the article, we unpack such dynamics but propose four drivers of return, which we think are likely fuel a strong cyclical rebound for this asset class.

South African equities have fared particularly poorly over the past decade having underperformed the MSCI World Index, in US dollars, by 7% per annum over this period.

While this performance is broadly explained by deteriorating SA macro-economic factors, particularly in the post-Covid era, many South African investors appear to be turning positive despite no obvious improvement in medium-term expectations. At face value, the most common reasons for this center around technical factors (such as de-listings and corporate actions), cheap valuations and the concept of “how low can the market really go?”

On a three-year time horizon, empirical data shows that attractive valuations are generally a good entry point for JSE investors. At present, although there are significant opportunities because of this, we believe that the SA equity investment case has more to it than just valuation support.

The elephant in the room: SA’s growth and fiscal position
South Africa’s weak growth track record over the past decade highlights its deep structural constraints and the urgent need for significant reform. A good way of assessing the impact of this, and the deteriorating South African fiscal position on asset prices is to regress monetary and fiscal variables. These include the likes of debt-to-GDP and budget balances, thus evaluating their impact on the cost of capital, or as a proxy the South African 10-year bond.

Chart 12: South Africa 10 Year Bond – Regression Model

Sources: S&P CapitalIQ, Bloomberg and Northstar Asset Management (May 2024)

As expected, it is evident from Chart 12 that both monetary and fiscal factors have pushed yields higher since the “GFC”, and more recently following the Covid pandemic. But while the impact caused by monetary effects tends to be more cyclical in nature, and has arguably peaked in this cycle, the impact caused by weak growth and higher sovereign debt levels is more structural and persistent. Based on national treasury’s latest debt and budget balance forecasts, however, with debt-to-GDP now expected to peak in 2026 at 75.3%, and with debt service costs forecast to decline thereafter, we think the pressure on yields caused by fiscal dynamics could subside somewhat from current levels, and support asset prices.

The State, SA Consumers and Corporates
In a relatively stable fiscal environment, as modelled by national treasury, various cyclical tailwinds should provide significant impetus for SA sensitive assets.

Arguably the fiscal and monetary support provided during the Covid pandemic was not enough to help local consumers recover to the extent seen in other economies. The subsequent tighter monetary conditions (475bp of interest hikes), high inflation and load-shedding have further impinged upon consumer health, and expenditure.

The lethargic post-Covid rebound in corporate earnings has reflected this slow recovery in consumption, and unsurprisingly sectors that benefit from global drivers have fared much better. In particular, precious and industrial metal miners have experienced a powerful profit rebound, whilst SA sensitive sectors such as retail, healthcare, property and general industrials have been weak as evidenced in Chart 13 below.

Chart 13: Average Profit Before Tax (indexed to 100 – Dec 2019 to Dec 2023)

Sources: S&P CapitalIQ and Northstar Asset Management (May 2024)

Four drivers of a potential cyclical rebound
There are four main bull case drivers for local equities, which are likely to have a strong positive effect on consumer health, corporate earnings and ultimately stock price returns.

Firstly, it is estimated that loadshedding alone shaved 1.5% from 2023 GDP growth numbers, and the SARB forecasts a 0.6% impact this year. Improvements over the past six months, with the return online of Kusile units, together with better-than-expected private sector investment in solar generation has seen various economist revise growth estimates higher.

Secondly, expected interest rate cuts later this year will significantly buoy both consumption and corporate health, and as previously noted the cost of capital. Whilst this cycle is expected to be rather “shallow”, with only a 1.0% to 1.5% cumulative cut forecast, we believe its effect, as inflation further moderates, to be meaningful.

Thirdly, the outcome of the SA national elections has had a far-reaching impact on local assets. There is no doubt that in the last year leading up to the elections, local asset prices suffered from abnormally high-risk premia. While we noted that there were binary risks to the election outcome, particularly in the event of an ANC/EFF/MK tie-up, the recent formation of a coalition government has added a new dimension of political stability and policy direction.

And finally, while not necessarily an economic driver, it is hard to disregard extremely depressed equity valuations, against, in our opinion, improving corporate fundamental prospects. In particular, this asymmetric return profile for “SA Inc.” equities presents an excellent medium term entry point for investors.