RANDS AND SENSE
By Bryn Hatty
Given how tough global markets have been it is quite remarkable that for 2022 both the FTSE/JSE All Share Index (Alsi) and the All Bond Index (Albi) produced positive returns.
We think that both local equities and bonds are still attractively priced, and that investors should get a decent return from them almost regardless of how the South African economy performs. It won’t require a big bounce-back from the economy to achieve, as markets are still pricing in a lot of bad news.
Though negative for the economy in many ways, the ongoing electricity crisis has spurred action – government reforms have been approved allowing the private sector to produce significant amounts of alternative power. In addition to reducing the pressure on Eskom, these reforms will drive significant capital expenditure in the medium to longer term, which will have a positive impact on the economy. This shows the big impact even a small amount of structural reform can have on the economic potential of the country.
This is just one example of low-hanging fruit waiting to be picked – a little bit more structural reform is needed from government to unlock the growth potential, job creation and greater prosperity.
Equities are cheap and could see a re-rating
With company earnings relatively strong, and current valuations still very depressed, most investors are expecting a low-road scenario for the local equity market. This means, however, that even a little bit of positive sentiment could result in a re-rating of equities. Forward price earnings are showing how cheap South Africa is relative to its emerging market peers and to its recent history. Emerging market equities are also cheap relative to developed markets, which tells you how cheap South Africa really is.
Forward dividend yields for the year are also looking attractive, particularly compared with other emerging markets. In addition, the balance sheets of South African corporates are generally very strong, and this tends to indicate that their ability to pay these forecast dividends is high regardless of the economic environment we’re going into. Companies in the commodities sector are cash flush because of the recent mini commodities boom, but for the broader equity market, political uncertainty is making companies reluctant to borrow to invest in additional capacity. Apart from the investments in alternative energy sources, additional structural reforms and sound policy decisions are needed to encourage corporate South Africa to use some of this latent firepower.
We’re comfortable holding government bonds
The yield on South African government debt is attractive in both nominal and real terms – with inflation rolling over, the real yield of these bonds looks even more attractive. We expect a gradual move to lower inflation over 2023 – services inflation is quite benign with limited pressure from a weak economy, while core inflation is also in check.
The average yield of the 10-year SA government bond over 2022 was 10.5%, while headline inflation averaged 6.7%, with the latter expected to reduce further in 2023. This translates into an average real yield of roughly 3.5% through 2022.
SA government bonds relative to a broad range of global government bonds, apart from a couple of exceptions, offer the most attractive real yields globally. They also continue to be attractive relative to local cash yields, though the gap between cash and bond yields has narrowed somewhat over the past year as the SA Reserve Bank’s Monetary Policy Committee has hiked short-term rates to fight inflation.
Why are we comfortable holding South African government bonds from a return-on-capital perspective?
First, most government debt is denominated in rands rather than foreign currency, which means it’s highly unlikely to default, as the SA Reserve Bank has the option to “print’ sufficient rands to repay the debt in a crisis. The impact of this would, however, be extremely negative for the economy and one only needs to look north of our border to Zimbabwe to see the longer-term impact of such a policy.
Second, we have a relatively long-dated maturity profile on our debt, so there is not a wall of debt coming up for repayment in the next few years. Treasury did a good job of extending maturities during the 2008 to 2019 period, when they took advantage of low yields and issued more longer-dated bonds. Overall, the maturity profile has been very well managed by the National Treasury. The credibility and independence of our central bank as well as a soundly managed Treasury function increases our comfort in buying government bonds.
Hatty is chief investment officer at Stonehage Fleming South Africa.