Why are local equities surging when the economy is spluttering?
The strong performance of the local equity market since the lows of March 2020, relative to the lacklustre performance of the local economy, has raised investor questions.
- South African equity market composition has shifted over time, becoming dominated by Multi-National and Resources company shares and therefore driven by global business cycles
- Global asset flows and SA’s open financial system mean equity market performance has high correlations to global asset allocation decisions, which are disconnected from local economic performance
- The local equity market is likely to continue to follow the global business cycle, implying a tight relationship with both Emerging Markets and Commodity indices
Typically, this type of disconnect is explained worldwide by the fact that equity markets are forward-looking, so they anticipate the recovery of an economy. However, structural impediments to SA’s future growth, including electricity supply constraints, inflexible labour markets and ineffective government growth initiatives, make it difficult to apply this theory domestically. Our local economy is forecast only to reach its pre-pandemic level by late 2023. China has already exceeded this level and the US is forecast to get there by mid-2021.
The reality is the Johannesburg Stock Exchange (“JSE”) does not represent the local economy. The largest companies listed on the exchange are multinationals, which earn very little revenue from selling goods and services into the South African economy. There are some companies (the so-called “SA Inc.” companies) where local economic factors do have a significant impact on financial performance, because they derive the majority of their revenue within the borders of the country. However, SA Inc. companies comprise just over a quarter of the JSE All Share Index’s market capitalisation. Global factors are the dominating driver of returns on the local stock market.
China is by far the world’s largest consumer of commodities and it also has the largest country weight within the MSCI Emerging Markets Index (“MSCI EM”), driven by its technology-related dominance. The JSE is predominantly exposed to China, because of its high combined weighting of Resources companies and Naspers/Prosus, whose value is mostly driven by its investment in the Chinese technology platform behemoth, Tencent. Consequently, it is unsurprising that the South African equity market has a strong correlation to both the MSCI EM and the commodity price cycle. This is common among many open emerging markets (“EM“), which are perceived to be intricately linked to the vagaries of the global business cycle.
The JSE is now mostly multinational
The JSE has evolved over many decades to represent progressively less of the local economy. There are a number of reasons.
- Initially, local companies expanded internationally as their local market share matured, especially as SA’s longer-term low-growth reality became more structural.
- Global merger and acquisition activity reinforced this trend, as local companies wanted to diversify their revenue sources.
- Lastly, SA’s large domestic savings pool, aided by exchange control limits on offshore investment, especially for the retirement savings industry, attracted a lot of foreign multi-national companies to list on the JSE (the so-called “inward listings”), partly to tap into this sizeable domestic savings pool.
Even the mining industry, which has a material impact on local labour and makes a sizeable contribution to our exports, constitutes only about 8% of SA’s GDP. The Basic Resources sector’s contribution to JSE market capitalisation has fluctuated between 9% and 54% over the past two decades, depending on the stage of the global commodity cycle. Although the locally-listed gold and platinum group metal miners are often headquartered in SA, most of their minerals are sold internationally and many of them also have mines in various parts of the world. This is similar for the smaller diversified mining houses. However, large diversified miners, such as BHP, Anglo American and Glencore, are headquartered offshore and South African-domiciled assets have become a very small contributor to their overall financial performance.
Figure 1 illustrates a split of the JSE All Share Index’s market capitalisation weights into buckets that we think better depict the source of underlying constituents’ revenue (designated SA Inc. or Multinational, based on where the majority of each company’s revenue is generated). Only marginally more than a quarter of our local equity market capitalisation (SA Inc) is directly linked to the South African economy.
We have also seen significant changes in sector and company weightings over the past two decades. These changes were mostly dominated by the Basic Resources sector and Naspers (recently split into Naspers and Prosus). As Figure 2 depicts, the weighting of Basic Resources reached over 50% at the peak of the China-driven commodity supercycle in 2008, but then fell to less than 10% by 2015. The weighting has strongly rebounded in the latest commodity bull market, as explained in the article, “Has the pandemic induced a commodity super cycle?” In recent years, Naspers’ weight has regularly exceeded 20% and, given its strong absolute and relative performance, it has often generated most of the All Share Index’s total return.
Local equity markets tend to be driven by global investment flows
Although some parts of the technology ecosystem, such as social media, have recently been heavily criticised, this has by no means weakened one of technology’s most important enablers in recent decades. Virtual connectivity across borders, aided by continued advancing technology, has played a significant role in improving access to global capital markets. This has increased correlations between markets, meaning they tend to be grouped together, whether fundamentally appropriate or not. The trends for global investment flows have also been driven by the increased investment into passive unit trusts and ETFs. Regional flows into EM passive funds are directed to countries based entirely on their index weights, regardless of any other fundamental company drivers. Figure 3 illustrates this point, showing the close correlation in movements between the JSE All Share Index and the MSCI EM (both indices are in US dollar terms – giving the perspective of a global, not a local, investor).
The strong relationship depicted above is interesting if we consider the composition of MSCI EM, both geographically and by industry. Figure 4 shows the current dominance of Asia in the index, and the sectors are dominated by technology-related companies (which could be as high as 43%). The Consumer Discretionary sector includes the likes of Alibaba and Naspers, which at their core are technology-driven companies.
Historically, the MSCI EM had a higher Basic Resources sector weighting, but the emergence of the Asian technology giants over the past decade has reduced this highly cyclical exposure. Despite this change in EM composition and the re-emergence of a materially higher Basic Resources weighting on the JSE, our local equity market has continued to remain closely correlated to the movements of the MSCI EM.
The key drivers of this ongoing tight relationship continue to revolve around the openness of global equity markets and the fundamental reasons for the majority of EM investments. In practical terms, EM, including the JSE, are seen as high beta plays on the global economic cycle. This is because EMs, unlike the service-orientated developed market economies of today, still tend to have large exposures to commodity extraction and manufacturing. These primary and secondary industries are strongly linked to the machinations of the global business cycle. We encapsulate this relationship in Figure 5 by illustrating the strong correlation between the MSCI EM and the commodity price cycle, which is a good representation of the global business cycle. Historically, when the global cycle is reflating, commodity prices increase and emerging markets attract capital, enabling strong performance. For the same reason, EM currencies, including the rand, also tend to do well in reflationary economic periods.
What does this mean for SA equity investors?
The composition of the JSE and its sector and large company weightings are highly likely to fluctuate materially in future, given their cyclical nature. The strong correlations between our domestic equity market to both EM and commodity indices will also remain, because of their significant multi-national composition, and the nature of EM investing. It is critical to recognise this when evaluating our local market’s impressive recent performance relative to our country’s structurally low growth economic reality and when considering what will drive future performance.
We cannot ignore the fact that our domestic equity market represents less than 1% of the global listed equity universe and clearly has high individual company risk, given the JSE’s concentrated nature. However, an open EM economy like SA, together with an open stock exchange dominated by globally-exposed companies, means we will dance to the tune of the global business cycle.
The greatest unknown from here, for both our local equity market and currency, is the longevity of the current reflation cycle as the world re-opens after the pandemic-induced lockdowns. Furthermore the timelines for central bankers and governments to rein in their extraordinary levels of monetary and fiscal stimulus remain uncertain.
South African equity investors should not to be disheartened by the weak growth in our local economy. It is preferable to focus outwards, not inwards, when considering the dominant future driver of our stock market.