Why invest in South Africa and why invest now?
By Jacobus Lacock, portfolio manager, and
Chantelle Baptiste, senior equity analyst at Fairtree Asset Management
We have held a balanced view on South Africa for some time, but have become more positive over the last few months. Cyclically, South Africa is well-positioned to benefit from significant global tailwinds and increased local economic activity as the lockdown eases. Structurally, South Africa’s growth outlook remains weak and burdened with high levels of government debt. However, we are encouraged by the government’s Economic Restructuring and Recovery Plan and progress on the anti-corruption front. Should reform and anti-corruption momentum continue, South Africa may achieve a new growth trajectory, one that could open up opportunity and surprise investors, given the current low level of confidence.
South Africa has been stuck in a confidence crisis largely due to policy uncertainty, fiscal concerns and corruption being deeply rooted within the ruling party. Growth has remained below par and below many of our emerging market peers, and any prospects of future growth rebound appears to be constrained due to:
- an unstable energy supply;
- damage done by the national lockdown; and
- lack of structural reforms.
Despite these structural headwinds, high frequency data points suggest activity has normalised rapidly and industrial activity is in a strong up-cycle. At the same time, we are experiencing prominent external tailwinds offering support to emerging market commodity exporting countries such as South Africa.
Global view: cyclical tailwinds offer much-needed support
In light of the unprecedented speed, size and coordination of stimulus released into the global economy this year, both from a monetary and fiscal perspective, we have seen sharp economic and market recoveries across most of the developed world and China.
Unlike the US and Europe, China has managed to curb the spread of the virus and side-stepped a second wave and further lockdown measures. Activity in China has now almost fully recovered. A China restart has been supportive for emerging market commodity exporters, including South Africa, and has underpinned strong commodity prices, specifically iron ore and copper.
In light of a global rebound and the fact that the US dollar is a countercyclical currency, we may experience more US dollar weakness. Furthermore, the US twin deficit has exploded and interest rate differentials are moving against the US dollar. US profit repatriations that surged in the wake of the 2018 tax cuts and the foreign direct investment (FDI) that the US has attracted under the Trump administration are ebbing. If we were to see a confirmed Biden win in the 2020 US presidential election (at time of writing Trump has not yet accepted his opponent’s victory), FDI could flow out of the US rapidly, weakening the US dollar and benefiting emerging markets and commodity prices.
Figure1: High correlation between dollar weakness and emerging market outperformance
Source: Bloomberg; Fairtree
Precious metal prices across gold and the PGM basket remain high and have resulted in these companies generating a significant amount of free cash. Company valuations are still not reflecting spot metal prices. For example, Impala is currently generating approximately 40% of its market capitalisation in free cash, which is extremely attractive from a bottom-up perspective. The strong cash generation these companies are enjoying has resulted in much higher levels of tax and royalties being contributed, which will in turn support the fiscus. We believe the market is not yet pricing this tax windfall into its macro outlook.
Within South Africa, the mining sector is a meaningful employer and job security and growth within this sector have a significant multiplier effect across the local economy.
Local view: reform must address structural weakness
From a bottom-up equity perspective, SA Inc. counters have been decimated this year, due to concerns over the economic impact of lockdown. However, recent earnings results across the domestic sectors were far more resilient than the market had anticipated, and we saw a brief recovery, but valuations remain at depressed levels. Most economic indicators show a rebound in activity, almost back to pre-pandemic levels, but the market is not pricing in a recovery and we find the SA inc. equity counters to be at very attractive levels.
The aforementioned strength in precious metal prices and a prolonged period of low oil demand have bolstered our terms of trade and resulted in a first quarter current account surplus surprise. If metal prices continue to hold, we will maintain favourable terms of trade.
Figure2: Terms of trade drivers remain favourable
Source: Bloomberg; Fairtree
Unfortunately, these factors alone are not enough to offset the structural weakness we see through elevated debt levels, a bloated public sector wage bill, growing unemployment and little FDI inflows. To address structural flaws we need institutional reform, political reform and economic reform and we believe we are starting to see evidence of this.
But before we unpack why we are of the view that reform measures are in place, we need to look back and appreciate that President Cyril Ramaphosa’s (CR) administration is still in its infancy.
Figure3: It is important to understand what the previous administration implemented
Source: Standard Bank, Bloomberg, National Treasury, Fairtree. * S&P rating used
The current CR administration has inherited a ‘lost decade’ from the Zuma administration, which saw five finance ministers and 13 Eskom CEOs over 10 years. Consumer and private sector confidence remain low and, in fact, has not been this low since the 1985 Rubicon speech. Underpinning this low confidence is an energy crisis and a global pandemic which forced the hand of lockdown measures and lurched South Africa into deep negative growth and severe job losses. So, why are we positive?
Firstly, as mentioned, the local economy has rebounded, most pronounced in mining and manufacturing and we could see a third quarter GDP print north of 50%, up from a negative 51% in the second quarter this year.
Figure4: SA’s Primary & secondary sectors have recovered sharply
Secondly, we are of the view that we are on a path of reform and one which is gaining momentum and is steadily becoming the path of least resistance. COVID-19 exposed many of South Africa’s fault lines, one being deeply rooted corruption. This realisation, although painful, was necessary for the current administration to take a firm stance of zero tolerance against corruption, this was publicised by the President on 31 August this year after a special NEC meeting. But the foundation for this anti-corruption drive has been at play for some time and key institutions such as the Hawks and the NPA had to be rebuilt, delinquent leaders removed and new leaders appointed. Much work has been done and the fruits of this reform has only recently been seen with the VBS arrests in July 2020 and Ace Magashule (ANC secretary general) most recently.
Thirdly, keeping with the vein of reform, institutional reform is evident with much work being done to solve the capacity constraints of Eskom. André de Ruyter has only been at the helm for less than nine months, but has already started to clean up corruption by introducing a lifestyle audit to Eskom senior executives (resulting in many Eskom managers taking voluntary retrenchment), launching legal proceedings to recover R3.8bn in damages from former executives and the Gupta family, and a further R14bn of oil contracts have been cancelled, in attempts to contain costs.
To solve the supply constraint will take time but work has already begun, and three key ways to solve the problem are:
- Improve efficiency – the energy availability factor (EAF) is at 65%, down from above 90% in the early 2000s. De Ruyter plans to improve this to 75% over the next 18 months.
- Increase capacity – 8.8GW proposed in the 2019 IRP capacity plans but most of the renewables will only be delivered at the end of 2022.
- Relax self-generation restrictions – De Ruyter has communicated these measures will take time and we expect intermittent disruption for the next two years, which will create a headwind for the small- and medium-sized enterprises (SME) sector but will result in permanent and stable energy supply.
Lastly, we have not witnessed this form of social compact in our history with private sector, public sector and labour supporting economic policy and anti-corruption. The recently announced Economic Restructuring and Recovery Plan is evidence of this social compact and recognises four key areas of economic growth, namely, infrastructure investment; energy security; job creation; and industrialisation. The plan contains several measures that can be achieved within the next 12 months. Should government deliver on it, it will not only strengthen its support in the next election but also build much-needed credibility amongst investors.
South Africa screens attractively
We are of the view that South Africa is cyclically well-positioned for global recovery with a cheap currency, attractively priced bonds, an undervalued equity market and the possibility for continued US dollar weakness. Structurally we have problems, but we have begun a path of reform which is being championed at the highest level. With continued momentum and evidence of political, institutional and economic reform, we have started a new path. We will watch for key economic reform which would be demonstrated by public sector wage discipline and allowing for more private sector intervention in the failed state-owned enterprises.
Fairtree Asset Management (Pty) Ltd is registered as a financial services provider with the Financial Services Board of South Africa, with registration number 2004/033269/07 and FSP number 25917.