South African Investment Overview 2005
Good growth prospects and low inflation owing to a relatively strong rand in 2005 are expected to herald another good year for the South African equity, bond and property markets. But, as always, there are still risks. Particularly, developments in the international environment entail risks that could cause a much bleaker end to 2005 than to 2004. Large deficits in the USA, asset bubbles in many countries – particularly in housing markets – and rising household and government debt levels – especially in the USA and Japan – pose a threat not only to global economic growth prospects, but also to the performance of financial investments in the developed countries and in emerging markets.
The JSE (Johannesburg Stock Exchange) all-share index continued to reach new highs during the final quarter of 2004 amidst growing foreign buyer interest, and rising confidence levels. The generally favourable domestic economic conditions with regard to economic growth, inflation and interest rates lent support to the market, as did the view that global growth is set to remain strong, albeit slower, for another year.
Positive sentiment started to emerge in the third quarter of 2004 regarding the expectation that South Africa could at long last become an attractive destination for international capital. This continued to support South African financial markets in the fourth quarter. Factors that contributed to this positive perception included the interest shown by foreign banks in acquiring stakes in South African banks, the deregulation announced for the telecommunications sector and growing expectations of a possible upgrade of the country’s credit risk rating. This expectation materialised early in 2005, when Moody’s raised South Africa’s sovereign rating to Baa1.
Net foreign purchases of South African shares amounted to R32.9bn in 2004, with R21bn in net purchases taking place in the fourth quarter alone.
Although the prospect for most resources shares (which include big counters such as BHP Billiton and Anglo American) are adversely affected by a stronger rand, foreign inflows occurred despite renewed rand strength during much of November and December. Consequently the resources index fell by 15 per cent from its high in early October to end-December. However, the gold price showed further strength during the fourth quarter although its price by year-end 2004 was some $20/oz lower than the high of $456/oz attained in early December.
The weakness in the resources sector was more than compensated for by a nearly uninterrupted rally in both industrial and financial shares since mid-August. The prices of top shares in the financial (FINI15) and industrial indices (INDI25) increased during the fourth quarter – by respectively 29.5 per cent and 25.9 per cent in rand terms.
Valuations for most major indices, except insurance companies, have risen during the course of 2004 and PE ratios are also above their three-year average levels. However, it is only mining, real estate and resources shares that appear rather expensive compared with historical levels.
In terms of an international comparison, the South African equity market put up a remarkable performance in the fourth quarter of 2004 and, aided by some significant strengthening in the USD/ZAR exchange rate, registered a total return (quarter-on-quarter annualised) of no less than 193.5 per cent in dollar terms. This compared very favourably with the annualised dollar return of 89.1 per cent for emerging markets equities and the 57.6 per cent for world equities during the fourth quarter of 2004. Over a three-year period (up to the end of 2004), South African shares’ dollar-returns, at 48.8 per cent, were only slightly lower than the performance of South African bonds, but well ahead of either world equity returns (7.4 per cent) or emerging markets equity returns (22.8 per cent).
Despite the continued rand strength anticipated in 2005, the year also promises to be one of the best in recent times where economic growth is concerned. Domestic interest rates should remain low and commodity prices are expected to remain strong on the back of solid global growth – especially in Asia. South Africa’s gross domestic expenditure could rise by more than 5 per cent in real terms, which should ensure another year of good company earnings growth, especially for consumer and banking shares. After a slump of more than 30 per cent in the earnings of resources shares in 2004, some recovery is also expected in this sector and a rise of some 25 per cent in the ALSI earnings growth figure might be possible. This could facilitate a total return of 27.8 per cent for equity in rand terms.
Globally, equities are once again expected to perform better than bonds. Corporate profit growth is nevertheless bound to slow fairly sharply in both the United States and Europe. High valuations and a strong possibility of higher interest rates are additional negatives for the US equity market. Japan and emerging Asia appear to have relatively more attractive valuations. The profits outlook in this region is also more appealing.
Bond yields declined further during the fourth quarter of 2004, with the benchmark R153 bond yield ending the quarter at 7.8 per cent, 110 basis points lower than at the end of the third quarter. Lower-than-expected inflation and hopes of more interest rate cuts in 2005 buoyed the market, as did some renewed buying interest from foreigners. Net foreign purchases totalled R3.7bn in the fourth quarter, compared with R1.3bn in the third quarter and net foreign sales of R4.7bn in the second quarter of 2004.
The significant capital gain owing to falling bond yields in the fourth quarter of 2004 translated into an annualised dollar return of 134,5 per cent. This healthy return was very different from the experience in most other emerging markets, with bonds in these markets managing ‘only’ a 22 per cent return over the same period. World bond returns registered 38.6 per cent in dollar terms. Over a three-year period, South African bonds remained one of the best performing asset classes, showing a total return of 50.1 per cent in dollar terms for the period from 2002 to 2004, far outpacing world bonds (14.9 per cent return) and emerging market bonds (18.1 per cent return).
The longer-term outlook for South African bonds remains positive, given the government’s track record and continued commitment to fiscal discipline and low inflation. Although some risk of higher food and international oil prices remains during 2005, the outlook for bond yields is generally positive, with not too much upward risk, given the expectation of stable to slightly lower short-term rates and a relatively strong rand. But the convergence of headline inflation with the higher CPIX inflation figure will cause real yields to diminish. This, together with a much higher public sector borrowing requirement in 2005/06, implies limited scope for drastically lower bond yields. Total real returns on bonds should nevertheless remain substantially positive – at around 15.4 per cent – during the course of 2005.
Government deficits have edged higher in many of the world’s biggest economies and some inflation may start to emerge during the course of 2005, as economic growth rates are expected to moderate only slightly. Bond yields in 2005 should therefore rise by up to 100 basis points in the USA and by some 50 basis points in the UK, Euroland and Japan.
International oil prices remain a very important factor for domestic (and global) inflation. The benchmark Brent crude oil price reached a high of more than $51/barrel in October, but prices eased significantly to less than $38/barrel by mid-December. However, oil prices continued to be quite volatile. By mid-January prices were back at around the $45/barrel mark, mostly on the back of increased demand because of the northern hemisphere winter. South African petrol prices are expected to rise once again in February 2005 and could, together with a possibility of higher food prices owing to persistent drought conditions in some parts of the country, contribute to a slight uptick in inflation expectations.
The other issues which should remain of some concern to the Monetary Policy Committee (MPC) as it starts its 2005 meetings in February include the high levels of household consumption expenditure and credit growth; high asset price inflation; a widening current account deficit; and steep increases in unit labour costs.
It would therefore appear that the current domestic interest rate cycle is at or close to its lower turning point. Technical factors will work in favour of lower CPIX numbers during the early months of 2005 and could, together with a weak dollar/strong rand outlook, still force the MPCs hand, causing it to lower the repo rate by 50 or 100 basis points. But for most of 2005, short-term rates are predicted to be fairly stable. Our forecast for total cash returns over the next twelve months is 7.9 per cent.
Despite the weaker dollar and strongly growing economy, the USA has not really been subjected to inflationary worries. The reason for this is to be found in some deflationary forces still at work in many sectors and regions, rising levels of productivity, and low capacity utilisation. The expectation is nevertheless that the Fed will continue to tighten in 2005, with short-term rates reaching around 3.5 per cent in early 2006. Elsewhere, interest rates could remain on hold as the European economies continue to grapple with a strong euro and Japan moves only gradually out of deflation.
The annualised return on the JSE Listed Property Index measured 295.5 per cent per annum in dollar terms in the final quarter of 2004, although in rand terms the return was a more moderate 126.7 per cent. Over the past three years, total listed property returns averaged 75.5 per cent per annum in dollar terms and 38,3% in rand terms, making this the best performing asset class over this period.
According to the Alexander Forbes Direct Property Index, the direct property returns index has increased by a constant 1.18 per cent per month over the past two years, implying that the annualised return over the past three years amounted to 13.2 per cent per annum in rand terms.
Residential property market values have increased very strongly over the past three years and are set for another year of positive – albeit lower – real growth in prices. However industrial rentals are picking up strongly and non-residential property will possibly attract more investor interest in 2005. Capitalisation rates (the non-listed property sector’s equivalent of the earnings yield of shares) for all property types are generally expected to continue to fall during 2005. With hurdle rates remaining fairly high, investors would probably expect capital return rates on property of between 5.5 per cent and 7.5 per cent.
Given the positive outlook for inflation, relatively low interest rates and falling bond yields, both the listed property sector and directly held property should continue to perform well. Other factors such as declining vacancy rates and growing real rentals should also underpin the market. Direct property returns are expected to average some 15 per cent in rand terms in 2005.