South African shares offer value despite economic challenges

South African equities are trading at historically low valuations, offering opportunities for investors to generate outsized returns along with local bonds. 

Portfolio manager at PPS Investments Reza Hendrickse recommended investors remain neutral towards South African equities and underweight foreign equities.

His view on South African equity is premised on local shares being cheap relative to where they have traded in the past. 

Though the domestic growth outlook is weak and confidence is low, elevated pessimism paves the way for reasonable equity returns. 

However, Hendrickse does not think investors should put their money in local equities now but rather have cash on hand to invest in South African equities once the market has fully turned. 

Regarding foreign equity, the strength of the rally in US stocks this year has come as a surprise but is a testament to what can occur when pessimism reaches an extreme level.

The rally has been driven by a narrow segment of the market, the so-called “Magnificent Seven”, to the extent that it is reasonable to expect a degree of consolidation now.

Market sentiment is also approaching levels of extreme optimism. Recent US Federal Reserve signalling suggests further rate hikes, which may create a recession. 

Staying underweight foreign equity is the appropriate call at this juncture, Hendrickse said. 

Local cash and fixed-income investments are the one area where PPS is overweight elsewhere. Interest rates have risen dramatically in recent months to the point where holding cash is a viable investment providing real returns. 

This is unlikely to persist over the long term, but while it does, it provides a significant opportunity to generate risk-free returns. 

Therefore, investors can generate returns while keeping cash on hand, waiting for a more suitable time to invest in riskier assets when the time is right. 

Hendrickse warned that the market remains volatile, and investors would be best positioned to maintain diverse portfolios to reduce risk while generating reasonable returns. 

Market performance in 2023 so far

The JSE was up a modest 1.2% in the second quarter thanks to the rally in June, which drove the index back into positive territory year-to-date with a return of 3.6% in 2023 so far.

Financial stocks rallied by 6%, driven by banking stocks, which continue to trade on attractive valuations while proving resilient in the challenging macroeconomic environment. 

Industrials were up by 3.7%, extending their phenomenal year-to-date advance to 18.7%, led by shares such as Aspen, Bidcorp, Life Health, and Naspers/Prosus.

On the other hand, resources shares were down 6.4% in the second quarter, and platinum stocks performed exceptionally poorly.

Foreign equity was up significantly in rand terms, with the MSCI All Country Index up 13.1% in the last three months. Half the annual return came from rand depreciation. 

Year-to-date, foreign equity remains substantially ahead of local equity, returning 26.5% versus 3.6%. 

The recent rally in foreign equity has been narrowly driven by US tech shares, which stand to benefit from AI developments.