We started off the year looking forward to the initiation of the decreasing interest rate cycle. South African equity was priced at a significant discount given the economic climate and expectations of a potential ANC/EFF coalition following the national elections.
Fast forward six months and while interest rates remain unchanged, SA Equity has rallied on the back of an election outcome that is far more positive than those envisioned by the market. Loadshedding has been absent for 100 days with a positive outlook, while Transnet inefficiencies continue to drag however, the right people appear to be in place to make a difference. The sudden shift in SA’s outlook had those who were underweight SA Inc hastily adjusting to the new landscape. The sharp upward push in the local market was testament to our view that the market has been severely undervalued, as the absolute worst expectations were being priced in.
Looking ahead, the focus now turns to the implementation of the two-pot retirement system in September and the first cut in the rate cutting cycle – both positive catalysts for the local equity market.
Year-to-date, the JSE’s All-Share Index has rallied over 6% with most of the gain taking place over a very short period. It begs the question, is it too late to enter the SA Equity market?
Valuation and Earnings Growth – The Opportunity Remains
Comparing company forward PE’s to their 5yr historical averages, it is clear that discounts remain across the board despite the recent push in the market.
The market as a whole is priced around 13.4x on a forward PE basis. However, the past five years have arguably been challenging for both earnings and valuation, resulting in soft comparative numbers. COVID, the subsequent recovery, electricity constraints and the increasing interest rate cycle added a few speedbumps to earnings along the way. If valuation is compared to a more normalised period of growth (2016-2019) valuations appear even more attractive. Stretching this out over 10 years, the most recent movement in the market has yet to push it into premium territory. A multiple around 17-18x may be more appropriate in time.
On a sector level, what is deemed a “fair multiple” also comes into question. For example, valuing SA banks using a Price-to-Book Value multiple, the most recent price movement is evident in a jump on the chart. However, the current level remains far below long-term averages suggesting further upside from here.
Valuation is important but ultimately companies need to show earnings growth supportive of a higher multiple for markets to rerate to more appropriate levels. FY2024 average earnings growth expectations have slowed from those seen at the start of the year. Unsurprising given the extended pressure the higher interest rate environment has had on the local economy. Interestingly, the growth lost in FY2024 has shifted into growth expectations for FY2025. The market has reassessed when the decreasing interest rate environment is likely to have the biggest impact on earnings moving the subsequent growth from FY2024 to FY2025.
Importantly, high-single-digit earnings growth for FY2024 and mid-teen earnings growth for FY2025 remains decent given the country’s high interest rate environment and lacklustre GDP growth of 1.1% forecast for SA FY2024. If economic conditions improve, the growth in earnings will surprise on the upside.
What is the Next Step
Valuations remain attractive and earnings growth is decent, so what would be the next catalyst to drive the SA equity market higher? Ultimately, economic growth is the most important factor for share price performance over time as it is the driver of sustainable earnings growth. Business needs confidence to increase gross fixed capital formation, and the consumer needs to be strong enough to drive earnings growth in the future. A supportive environment for investing is imperative to achieve this.
In this context, there are a number of factors to consider:
1. Leadership Change – Did you, or should I say GNU, see it coming?
The result of the 2024 South African National Elections surprised the market for the better. If populist agendas are left on the sidelines and differing opinions can come together to create a stable operating environment, it will go a long way in supporting sustainable growth. A political landscape supportive of business and investing attracts both local and foreign fund flows.
2. Loadshedding – Anything but 2023!
Eskom has managed to achieve over 100 days with no loadshedding. It was not a long time ago when retailers were printing annual diesel spend in the R500m range. These cost savings are immediate in the short-term but over the long-term having a reliable energy source is necessary to support economic growth.
3. Transnet – We may have seen the worst
Transnet’s inefficiencies continue to drag on economic growth. However, we have potentially seen the worst. Operation Vulindlela, one of the most effective programs under President Ramaphosa’s first term, has moved onto Stage 2 of its turnaround strategy. Stage 1 focused on stabilizing the likes of Eskom and Transnet whereas Stage 2 moves onto growing GDP through these entities.
4. Consumer Strength – Hanging in there
High interest rates continue to put pressure on the SA consumer, yet consumers are proving resilient. Private Sector Credit Extension has increased but remains at lower levels as consumers demand credit to get by, as opposed to lending for big ticket items. Household debt levels have picked up on the back of this but remain at low levels. However, the service cost attached to this debt continues to climb.
Retail sales have continued to slow (+4.1%) but remain at normal levels. Perhaps supported by gross average earnings (wages) growth which on average remains above our current inflation print of 5.3%. In addition, the number of persons employed in SA are back at pre-COVID levels and have stabilised at this level.
Importantly, consumer confidence has followed the market and moved higher under the new political landscape. Interestingly the gap between confidence in one’s own financial outlook and that of the economy has started to close. This gap continues to highlight perceptions of the economy to be far worse than that of the individual and the opportunity remains in this gap closing as condition improve.
Potential for GDP to Surprise
If Eskom continues on its current track, Transnet is able to increase efficiencies at the ports and along the rail corridors, and the new GNU can surprise the market by working together; creating a stable investing environment in the process – there is potential for GDP to surprise.
South Africa’s GDP forecast for FY2024 remains at 1.1%, increasing to 1.4% in 2025 and 1.6% in 2026. However, market commentary is beginning to acknowledge that if one or two things continue in the right direction, South Africa could hit 2% growth far faster than currently being priced in by the market.
Addressing the Elephant in the Room
The election result and subsequent rally in South African markets has seen our risk profile move back within its normal range with the spread between the US 10yr and SA 10yr government bonds back to 2018 levels. The significance of this is the compensation that foreign investors receive for buying our bonds has decreased back to more normal levels. It is important to maintain this spread to compensate foreign investors for the risk taken when investing in SA. Therefore, it gets tricky (but not impossible) for the SARB to decrease rates before the Fed. Decreasing rates in South Africa is clearly needed sooner rather than later to support our economic growth, but we are unlikely to do so until the Fed does. Therefore, the start of the Fed’s cutting cycle remains significant to SA economic outlook.
In line with our outlook at the start of 2024, the timing of that first cut remains the most important catalyst on our horizon.
Additional Catalysts on the Horizon
The two-pot retirement system comes into play September this year. While figures are still being thrown around, some calculate the potential for greater than R50bn in pension withdrawals, which would have the potential to uplift real GDP by >0.5% in 2025, in addition to R10bn in extra tax revenue. Ultimately the market is unsure of how big of an impact these withdrawals will have and as such may surprise on the upside. The main beneficiaries here being food and apparel retailers and banks.
Foreign funds have consistently left South African shores for a number of years. Sentiment change in June following the election outcome saw a slight change in this trajectory. Foreigners remain cautious of the SA investment story and while some may have nibbled after the positive political change, the vast majority will continue to wait until a better track record is achieved before diving in. The significance of this is simple, the amount of foreign outflows over the years is sizeable. If this tide begins to change in our favour, the impact on SA equity and bonds will be considerable.
The Opportunity Remains
SA equity remains attractively valued despite the recent push in the market. Earnings growth remains decent with the potential to grow further if conditions continue to improve.
Our timeline from here focuses on two catalysts in the form of the implementation of the two-pot retirement system and the start of the rate cutting cycle. The size and resultant impact from the implementation of two-pot remains to be seen with some forecasting a potential >0.5bp addition to our GDP expectations for 2025. Secondly and most importantly, the initiation of the rate cutting cycle remains the biggest driver for equity price performance in the short term.
Looking further out, GDP growth will be the largest determinant of sustainable earnings growth and ultimately market performance over time. If Eskom can keep a handle on loadshedding, Transnet can begin to turn a corner and the new GNU can create a stable operating environment supportive of capital formation there is potential for SA’s GDP to surprise on the upside.
Finally, as a potential sweetener in time, foreigners have yet to return to our shores. The quantum of foreign outflows has been significant and if we are able to redirect flows back into our markets, we will see a sustainable change in our market environment over time.
The opportunity remains and the markets’ most recent performance should be testament to the potential that can be unlocked over time.