Little margin of safety in South African equities

Unlike India and Indonesia, which implemented aggressive reforms to address economic imbalances after the “Fragile Five” suffered foreign portfolio outflows two years ago, South Africa remains exposed ahead of the next round of capital flow volatility associated with shifts in US Federal Reserve policy.

Commenting in Novare Investments’ economic report for the second quarter of 2015, Francois van der Merwe, Head of Macro Research, said: “The local economy has lost momentum through lower government spending and weakness on both the demand and supply side. It faces mounting risks of further weakness.

“The precipitous drop in commodity prices and its impact on South Africa’s trade through lower export prices is just one of them. Insufficient demand is a limitation on companies’ expansion plans, and consumer and business confidence levels are at historical lows. Overarching all of this is the shortage of electricity.”

Van der Merwe said that, while the valuation of the local stock market has eased from its recent peak, the FTSE/JSE All Share Index still trades at a historic price-to-earnings multiple of 17.5.

“This is uncomfortably high compared to its long-term average, and given company earnings expectations that are overly optimistic. Companies whose earnings are not dependent on the local economy are trading at even loftier valuations. There is little margin of safety in the local equity market,” he said.

The local bond market has a high dependency on short-term capital flows, and is characterised by high levels of foreign ownership, weak growth prospects and deteriorating credit quality. Local bond yields are somewhat more attractive than they were a few months ago, but there’s a probability of them underperforming cash over the next 12 months.

According to van der Merwe: “In an environment of increasing global volatility, an overweight position in offshore assets where investors can take advantage of potential rand depreciation and diversification benefits could be prove to be beneficial.

“Six years into the global economic recovery and the US is finally close to ending its big monetary policy experiment. This should create a global theme of diverging policies, as Europe, Japan and China look committed to supporting their economies, whatever it takes.

“In response to accommodative policies, global growth is gaining traction – a process that should be supported by the reflationary impact of weak oil prices and the recovery in credit growth.”

The US Fed looks set to raise interest rates for the first time as soon as September as it moves past the headwinds of a strong dollar and the energy sector slowdown. Sustained job growth will ensure that the demand side of the economy remains healthy. The drop in unemployment and rising inflation will force the Fed’s hand in hiking rates gradually.

Economic activity in Europe has picked up and the big risk of deflation has diminished. The low oil price will boost demand within the region as real disposable incomes rise.

“Stock market turmoil aside, China’s economy continues a slow transition to being demand-led. A hard landing should be avoided as the People’s Bank of China has adopted an accommodative policy stance with scope for further easing to support growth, should this be warranted.

“Overall, a slowdown in emerging markets will be a drag on global growth, with the International Monetary Fund (IMF) forecasting 3.3% this year and 3.8% in 2016. Given positive economic and policy fundamentals, there’s a case to be made for global equities. Although valuations are slightly rich, earnings expectations are low and have the potential to surprise on the upside,” van der Merwe said.