South African equities hit record highs, doomsayers left waiting

August 8, 2012

Earlier this year it seemed that an increase in global bullishness meant the end of the road for risk-off investment strategies and, by extension, the rise in South African equities. However, 6 months later, the band is still playing, and the ship is refusing to go down.

South African equities have flourished in the face of the doomsayers, with returns this year doubling the emerging market benchmark equity performance. Both the all-shares index and the top-40 share have hit fresh all time highs this week, and prophecies of gloom for South African stocks appear to have missed the mark somewhat.

Part of the reason for this is that, when it comes to risk attitudes, much of the song remains the same. South Africa has certainly benefitted from its continued attractiveness to risk-off investors, as global bullishness has receded from whence it came. For instance, as it is relatively well sheltered from euro zone turmoil, and as major gold exporter, firms based in the gold sector are ostensibly an attractive investment for the globally cautious.

However, while ongoing uncertainty in the euro zone has meant that global sentiment has not recovered to a consistently risk-on position, there is more to South Africa’s performance than just a reliance on safe-haven gold. This is demonstrated by the highly fluctuating performance of gold during 2012, adding 3 percent to its value in total in 2012 and dropping in value over the second quarter. By contrast, South African equities have grown in value consistently over the year, adding ten percent thus far.

Indeed, according to John Paul Smith of Deutsche Bank, it’s not because of the country’s natural resources but despite them that equities have hit fresh highs. Resources have notably underperformed in South Africa this year, and other sectors such as financials, consumer stocks and telecommunications have been supporting the rise.

“The banks have always been considered relatively dull, which I think is to their advantage,” he said.

The market also draws strength from its diversity of investors as well as companies. “It has a very broad local investor base, including local pension funds,” said Dominik Garcia, a strategist at Credit Suisse, who added that banks and consumer discretionaries had done well, benefiting from strong local demand.

Moreover, the success of South African equities has not come at the expense of the popularity of its bonds. Usually investors turn to government debt during a downturn at the expense of stocks, unless there’s a good reason to think that the government might be about to default. However, this surge in South African stocks is not a result of changing asset allocation strategies, for the bond market has received inflows of over $7.5 billion year-to-date.

However, there are threats to this strong performance. Garcia is neutral on the market, because valuations are quite high – trading at 10.9 times forward earnings compared to 9.3 percent for broader emerging markets, and sometimes much higher.

“When you’re buying expensively priced equities, on price-earnings of 20 or over on peak earnings, your risk of permanent capital destruction is very, very high,” said Nic Norman-Smith, a portfolio manager at Lentus Asset Management in Johannesburg. There are still growth concerns in the South African economy, and while investors were encourage by recent monetary easing and anticipate more, they may be disappointed if interest rate cuts don’t have the intended effect, or indeed don’t transpire.

Smith’s concerns are not so much with the corporate sector, but with the economy as a whole. He sees recent moves towards import-substitution industrialization and state sector involvement as threatening the vitality of the private sector, which could spill over into the performance of equities.

However, these concerns were aired 6 months ago, and are yet to have come to fruition. The bears are still sitting on their hands, waiting for their prophecy to be borne out. But the music hasn’t stopped just yet.

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