Good news for South African investors

While significant risks are attached to South Africa, several local assets still present attractive opportunities for investors.

Momentum Investments’ head of asset allocation, Herman van Papendorp, assured local investors that South Africa’s country risk premium fell markedly from its pre-election high in April 2024.

This was primarily due to market optimism about the potential for enhanced policy reform implementation under the Government of National Unity (GNU), which many believe could lead to stronger economic growth for South Africa. 

“Although some of the risk premium decline has reversed in recent months due to slow reform momentum and a rise in global geopolitical risk, the current risk premium is still well below pre-election levels and roughly in line with the 10-year average,” Van Papendorp said.

Despite this, the valuations of South Africa’s equity and nominal bond markets do not reflect this significant positive sentiment about better growth potential for the country going forward.

He pointed out that South African equities continue to trade around one standard deviation historical lows against emerging market equities on a relative forward P/E basis.

They also trade more than one-half of a standard deviation below their long-term historical average.

Local bonds also offer significant opportunities, as South African vanilla government bonds still provide some of the highest backwards-looking real yields in the world.

Van Papendorp said that, relative to South Africa’s history since inflation targeting, the current more than 6% real forward-looking bond yield is comfortably more than one standard deviation above the historical average.

In addition, he said local inflation-linked bonds should receive fundamental support from the anticipated rising inflation trend from the likely low of 2.8% in October 2024 until late 2025, with some high accrual months expected in 2025. 

He said this should lead to a general widening of breakeven yields during this time that should underpin returns.

“Although we are likely close to the end of the current local falling interest rate cycle, both South African bond and equity returns have historically reacted positively to local interest rate cuts,” he said.

Despite these positive signs, Van Papendorp found that the local equity market remains under-owned within global emerging market funds, with South Africa currently the sixth-largest underweight in these funds.

“Furthermore, the exposure of local multi-asset funds to the SA equity asset class remains close to the historical lows that were reached after the February 2022 increase in the Regulation 28 foreign asset exposure limit to 45%,” he said. 

“Thus, there is at least no large overhang of overexposure to South African equities by global or local investors that could induce aggressive forced selling by these investors should they ever want to reduce risk exposure in portfolios.”

“Based on our expectation that inflation will likely average just above 4% in the coming year, SA cash still offers an attractive prospective real yield to investors, particularly on a risk-adjusted basis.”

Gold standard

Van Papendorp also highlighted gold as an asset class with significant potential upside in the coming months.

He explained that global central bank gold buying has been the overwhelming driver of a higher gold price ever since the Russia/Ukraine war in February 2022 initiated a period of elevated global geopolitical risk.

However, it did not stop there as central bank gold buying continued unabated in 2023/24, remaining close to the all-time high reached in 2022.

“As gold does not rely on any issuer or government, it enables central banks to diversify their reserves away from assets like US Treasuries and the dollar,” he explained. 

Many developed market central banks have apportioned a meaningful share of their reserves to gold over time. However, he said emerging market central banks hold only a small portion of their reserves in gold.

“This implies a meaningful potential upside for the gold price should the major gold holders in emerging markets like Russia, China, India and Türkiye decide to increase the gold exposure within their reserves towards the ratios prevalent in developed markets.”

From a portfolio construction perspective, Van Papendorp said the inclusion of a gold exchange-traded fund as an asset class adds to portfolio diversification due to its limited correlation with other asset classes. 

“Its safe-haven characteristics during turbulent geopolitical periods also mitigate portfolio risk,” he added.

“Furthermore, research from SBG Securities shows that the rand gold price has been a consistent top asset class performer among SA asset classes over most periods in the past 50 years, albeit partly due to perennial rand weakness.”

Listed property lagging

While equities, bonds, cash and gold present significant opportunities for investors, Van Papendorp warned that the risk-reward available to investors in the local listed property sector remains unattractive. 

He cited declining interest cover ratios approaching covenants, rising interest rates, and balance sheet restructurings that have increased pressure on finance expenses as risks for this asset class. 

He highlighted the local Office sector, saying vacancies have improved sequentially on a quarterly basis.

However, vacancies remain higher than in the Retail and Industrial sectors, while Office rental reversions are still significantly negative despite some improvement. 

“In contrast, Retail sector vacancies have started to decline, and rental reversions have turned positive,” he said. 

“Although the listed property earnings yield has historically traded at a premium to SA 10-year bond yields, it currently appears expensive versus history.”