Upside for equity investors if SA can materialise reforms

This article first appeared in the Financial Mail Ranking the Analysts 2021 Special Report on 27 May 2021.

Considerable upside for equity investors if SA can materialise reforms

By Matthew Rattray and Mary Curtis

South African (SA) equity returns have started the year on a very strong footing. YTD, the JSE Capped SWIX is up 16% in ZAR terms and 21% in USD terms, outstripping emerging market (EM) equities by some 15%. The records show that this is the best start to the year for SA equities in 15 years.

However, the records also show that the foreign participation in the SA equity recovery remains relatively lacklustre. According to RMB Morgan Stanley, EM active investors have only 2.7% allocated to SA vs an MSCI EM weight for SA of 3.8% and an MSCI ESG EM weight for SA of 6%.

There are several reasons supporting the SA equity rally. First up are super strong commodity prices, driving the basket of SA export prices up 21% YTD (in real terms) and the SA trade accounts to a record surplus in March at US$3.55bn. Naturally, this has also driven a big rise in forecast earnings for the JSE Resources, which account for 30% of the Capped SWIX index.

Secondly, sentiment has improved with a spate of upward revisions in SA GDP growth – as the SA economy has proved more resilient to the hit from Covid-19 than most expected. Thirdly, the fiscal picture is already looking better than it did - even since the finance minister’s February budget update, and significantly better than it did in the depths of last year’s Covid-19 crisis.

With the tax take set to be boosted by the surge in mining profits and a stronger than expected economic recovery, expectations around the 2021/22 fiscal deficit have continued to improve, leading the government to slash the amount of weekly borrowing in the bond market.  All of this has also contributed to a more constructive view on the rand exchange rate, which is now up 4% YTD against the USD.  

The question is ‘What next’? Cyclical factors continue to look supportive: global GDP growth is forecast to be the best in 60 years underpinning high average commodity prices; although unusual, the SA earnings trajectory is firing on all cylinders in 2021 - with strong earnings for the Resource sector coupled with a significant rebound in domestic sector earnings off the low base established last year; and there is still a cheap equity market multiple on offer against history and relative to the EM peer group. Specifically, we calculate that the All Share is trading at a 26% discount on 12 month forward PEs compared to its own 5 year average, and a 29% discount relative to EM.

Although these cyclical factors are more than welcome, foreign (and long-term) investors are keen to see more progress on structural reforms in SA that can help put the economy on a sustainably higher rate of real GDP growth.

There are arguably three key initiatives that foreign investors are keen to see progress on in the near-term, before changing their allocation to SA

• A more concerted clampdown on corruption across government. Data from the Auditor General of SA shows that some R75bn in expenditure (worth 22% of the fiscal deficit) was lost to irregular spending, wasteful expenditure or unauthorised expenditure over FY 2020, much the same as the amount lost (R71bn) in FY 2019. Recent moves to suspend party members accused of corruption may be good news for the market but clearly this is only the first step in a clean-up process;
• Easing the power generation bottle-neck. Power shortages are an ongoing impediment to direct investment. It’s good news then that Nersa has approved Gold Fields 40MW solar installation and a 10MW solar field for Amazon Web Services. With well over 1GW of private sector generation plans on the cards (mostly from the mining sector), there is plenty of potential to ease the power constraint in SA;
• Fiscal reform to cut the burden of current expenditure (government wages) in favour of public sector investment expenditure. Finance Minister Mboweni has certainly made bold strides in this direction since he took over in October 2018, but the next 3 months of negotiation with the public sector unions will be a key test of the resolve of the reformers.

The upside for equity investors is considerable if reforms can materialise. By the end of March 2018, in the wake of President Cyril Ramaphosa’s victory at the ANC conference in late 2017, SA Inc traded on 13.6x 12-month forward earnings. Re-rating to the same multiple now would mean price appreciation of 26%.

Matthew Rattray is the CEO of RMB Morgan Stanley, Mary Curtis works in research as the SA market strategist.

 Contact:

Joandra Griesel l Rand Merchant Bank l joandra.griesel@rmb.co.za l 082 462 6741