South African equities have been trading at developed market levels for the last few years, even though they have historically been traded at a discount to emerging markets (SA now commands a 35 percent premium over other EM). The situation isn’t likely to last, and according to Citi equities analyst Richard Schellbach there are five catalysts that could cause it slip back to EM levels.
South African inflation rate down to single digits
The first danger is that South Africa could enter a period of stagflation. After pulling inflation down into single digits, the Rand has started to slide and economic growth is being downgraded. With high unemployment typical of the region, this could rapidly drag South African equities down to EM valuation levels.
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Second is the possibility of industrial downgrades. “Lead indicators point towards increased headwinds against the South African consumer,” says Schellbach. “This, combined with elevated (and sticky) earnings expectations, prompt us to warn that earnings downgrades look set to accelerate through the non-resource sectors of the South African equity market.”
Third, investors have mostly changed their tune on credit account balances, and a large deficit will now drive them away instead of assuring them of strong demand. Coupled with the falling rand and a bullish stance on the U.S. and Europe could knock South African equities down a peg.
South African credit to be downgraded
South African credit could be downgraded again this year, though nothing is certain until the country’s annual budget is released next month. A downgrade could increase the perceived risk of doing business in South Africa and cause investors to look for lower prices or look elsewhere.
Finally, foreign investors have been strong buyers in South Africa so far this year, but they have been strong sellers in the past when the rand weakens (notably 2002 and 2008). If the rand continues to fall, at some point global equity flows may suddenly change direction as people head for the door.
Of course, none of these five catalysts address what many people have been seeing in the news: labor unrest with a tendency to turn violent. With mining operations being the country’s strongest industry and the source of most of the labor unrest, some stability is needed for South African equities to continue performing at DM levels.