New Year New Opportunity
As set out in our Offshore Outlook – Mirror Image, the major news outlets continue to beat the drum on the impending doom of global recession, yet the expectations are for a recession that is mild; inflicting a de minimis amount of pain across main street. Inflation rates have peaked and interest rates look to turn in the coming months. The Chinese economy has reopened, much to the pleasure of world equity markets, and suddenly we are starting to see a change in the global outlook for offshore equities.
The South African market continues to be primarily guided by the global outlook. However, underlying fundamentals remain strong across most fronts. Consensus earnings expectations for the coming 12 months remain attractive, yet the market is pricing a far more dire outcome with very little optimism priced in. In our opinion, this disconnect presents an opportunity as the local equity market remains undervalued at current levels.
South Africa’s economic environment – not too shabby
As South Africans, our view on the actual economic environment is easily clouded when faced with a fresh spate of loadshedding or the ever-increasing cost of a basket of groceries. However, emothions aside and despite the dark clouds of a global recession looming, the SA economic context remains intact. SA’s GDP is forecast to grow at 1.2% for 2023, which ranks attractively relative to many developed markets.
Local inflation expectations are anticipating a gradual pull back from 2022 to within our target range of 3-6% as early as this year. Comparing the latest forecasts to those set in the prior year, it is evident that although inflation expectations have increased, they have not moved significantly from previous forecasts. Furthermore, similar to offshore markets, peak inflation seems to have occurred and the market is anticipating for it to move down from here.
SA government debt falling back in line
The trajectory of SA government debt, which saw a sharp increase following the pressure of the pandemic, has seen a number of positive lower revisions over the past year. Expectations for a primary surplus are projected for as early as 2024/25. As a commodity driven country, the reopening of the Chinese economy presents a further tailwind to these expectations.
Further supporting this, tax collections continue to show growth across all spheres. When looking over the tax year to date, VAT and property tax receipts have so far experienced a mid-teen increase, with employee and corporate income tax close behind in the upper single digits.
Strength of the SA consumer remains
The SA consumer continues to defy the odds showing no significant cracks despite a consistent increase in the cost of living. Debt remains at manageable levels and even with a sharp uptick in interest rates, debt service costs as a percentage of disposable income remains relatively low versus historic levels.
Savings rates in South Africa remain above typical levels for both corporates and households. In time, the deployment of these savings will have a significant impact on various areas within our economy.
Households in particular are holding a higher percentage of short-term deposits relative to their disposable income compared to what had been noted prior to the pandemic.
Turning our focus to retail sales, these remain resilient despite the challenging economic environment. However, while it is prudent to be cautious when predicting the resiliency of retail sales into 2023, the significance of the additional savings must not be forgotten as it represents a potential driver for retail sales under the right conditions. Based on our calculations, the excess short-term deposits held by households represent 20.5% of 2022 year-to-date retail sales. This is significant when considering the eventual deployment of these funds by consumers.
Private Sector Credit extension continues to grow steadily off its 2021 lows, with household credit continuing to rise at a healthy level but with the primary driver being the strong demand in commercial loan growth. However, despite the uptick in commercial credit demand, business confidence in SA remains negative with manufacturing production lacklustre. Unlocking this potential remains a key driver for economic growth in SA. What is holding corporates back?
SA’s economic handbrake
Focusing purely on the South African context, it does not take any stretch of the imagination to understand why corporates think twice when it comes to committing to large capex projects. Crumbling infrastructure, water and sanitation concerns, labour struggles and the mammoth in the room, the Eskom Electricity crisis, have many reconsidering potential projects.
The last few months have seen Eskom’s generation capability (Energy Availability Factor) at less than 60% on average – with lows close to 40% experienced at the start of this year. Planned maintenance makes up a small portion of the loss factor experienced, with unplanned outages being the largest limiting factor. Failure of aged machinery, the inability to bring offline units back online, and even the mention of sabotage, continue to stall our economy. There is no simple solution but the ability to increase our renewable energy via independent power producers does offer some relief.
More than three years ago, Eskom declared a power generation gap of between 4,000-6,000MW. REIPPP Bid Window 6 offers a potential lifeline of 5,200MW, which depending on the EAF at the time, will go a long way in supporting energy demand.
Light (and wind) at the end of the tunnel
SA’s current weakness also offers upside potential in the form of earnings accretion from REIPP projects. The primary beneficiaries being South African banks in the form of incremental loans in the ballpark of R1trillion over the next 5-10 years. This is not a trivial amount and putting this into perspective highlights this. Taking the average forecast for SA loan growth into account, the contribution of REIPPP loans could see potential annual growth in the SA loan book of 9% per annum.
It’s a no brainer – what is holding us back?
In two words: grid constraints. An upgrade in the ballpark of R210bn is required for the transmission and distribution grid to enable new REIPPP projects (primarily in the Western and Eastern Capes) to transmit power to the rest of the country.
Upgrades are planned but funding needs to be approved, and with the generation division remaining on the shared balance sheet, the process is stalled. Expediting the division of Eskom into generation, transmission and distribution remains a priority.
Equity valuation remains attractive
Despite SA’s idiosyncratic issues, overly negative sentiment continues to weigh heavily on valuations. With the risk of sounding like a broken record – the SA Equity Market remains undervalued. Looking at forward PE’s discounted to 5 year averages, it is clear that almost the entire market remains in discount territory.
Despite global economic growth concerns for 2023 and our own economic climate, earnings growth forecasts remain mid-double digit on average for 2023 with almost all sectors anticipating a year-on-year increase.
How do we compare?
Comparing SA to both developed markets and emerging markets it is very clear that we are being overly discounted when looking at forward P/E ratios.
We have touched on South Africa’s economic drawbacks and as such it is fair to assume a discount versus our emerging market peers. However, when comparing sectoral EPS growth estimates of a basket of emerging markets versus our own, South Africa clearly outpaces across most sectors. It is clear that very little optimism is being priced in by the market.
The increased discount is inordinately large in our opinion, as on a sector level the fundamentals remain strong.
- Discounted by the market on the back of peak earnings expectations, fed by concerns of the health of the consumer over the coming months.
- However, earnings updates continue to show resilience from most retailers.
- This sector is trading in undervalued territory weighed down by pessimism and it is one to watch over the coming months for potential entry points.
- Banks continue to show strong earnings growth, supported by loan growth and increased transactional activity.
- The opportunity for incremental loan growth through REIPPP remains large.
- Bank valuations remain very attractive.
- Concerns over global growth, Chinese lockdowns, and inflationary pressures have held back prices despite improving earnings as well as increasing earnings expectations.
- This has resulted in a mixed performance in the sector.
- Valuations remain undemanding.
- Held back in 2022 amidst global recessionary concerns.
- Long term underinvestment in new capacity continues to be a theme constraining supply and supporting commodity prices.
- Reopening of the Chinese economy will be supportive of earnings, in addition to long awaited expansionary fiscal and monetary initiatives.
SA Listed Property
- Discounts remain large despite growing dividend yields, declining loan-to-values and vacancies, and transactions that are at or near NAV’s.
- Overall, the improvement in the sector over the past 3 years remains undervalued by the market.
- Watch our video, produced late last year, providing commentary and insights on this sector for more information.
The pace and direction of inflation, interest rates, and resultant economic growth in developed markets, remain the primary driver for risk assets in general and, in particular, our local equity market. Focusing closer to home, we are faced with significant economic drawbacks; yet, earnings expectations remain strong for the local bourse. Despite the earnings outlook, the market is overly discounting the SA market, which in our opinion remains undervalued. Given these factors we are positively predisposed to local equities and believe they hold the potential for solid returns.
If you missed our 2023 Global market outlook, you can read our insights here.