Upbeat sentiments: Market reaches record highs in 2012 despite macroeconomic challenges

Home to the globe’s 19th-largest exchange, South Africa has mature capital markets able to serve not only the domestic economy but also the wider continent. While its sophisticated nature allows the country to tap financial resources at a lower cost than any of its African peers, its openness has also exposed the economy to the volatilities of emerging market portfolio investment. Significant regulatory reform is on the horizon, but authorities have adopted a gradual and consistent approach to implementing new rules, including the current iteration of the King Code of Governance Principles as well as the “twin peaks” model of oversight. The past year saw mixed signals on the macroeconomic level for foreign direct investors – with strikes, a broadening current account deficit and slow implementation of a national development strategy – but equity, bond and derivatives markets have been upbeat.

Trading Infrastructure

Offering five key financial markets for investors – equities, interest rate products, equity derivatives, commodity derivatives and currency derivatives – the Johannesburg Stock Exchange (JSE) was formed in 1887 to facilitate the first South African gold rush. Following the first legislation covering financial markets in 1947, the JSE joined the World Federation of Exchanges in 1963 and upgraded to an electronic trading system in the early 1990s. In 2003 the bourse launched an alternative exchange, AltX, for small and mid-sized listings, followed by the Yield-X for interest rate and currency instruments. The JSE also acquired the South African Futures Exchange (SAFEX) in 2001 and the Bond Exchange of South Africa (BESA) in 2009. The bourse demutualised and floated shares in 2005, while integrating Yield-X, BESA and AltX under one roof. SAFEX, meanwhile, remained a separate entity hosting equity, commodity and currency derivatives.

Traditionally a T+5 settlement system for equities, T+3 for the spot bond market and T+1 for physical commodities, the processing time for equities will shorten to three days (T+3) following reforms by the exchange to attract more liquidity, including from high-frequency traders. The central securities depository Strate (44% owned by the JSE, with the balance held by the big four domestic universal banks plus US-based Citibank) is responsible for electronic settlement of transactions, handling some 30m transactions annually.

Sizeable Equities

With a market capitalisation of $929bn as of the end of 2012, Johannesburg is by far the biggest exchange on the continent, significantly larger than both Cairo ($60bn) and Lagos ($55bn). It is also highly liquid, with the value of trades hitting R3.4trn ($418.2bn) in 2012, up from R3.3trn ($400.1bn) in 2011 and R3trn ($364.5bn) in 2010. To put these figures in perspective, the value of an average day’s trading on the JSE dwarfs the combined annual trades of Mauritius or Kenya, according to the JSE’s CEO, Nicky Newton-King. While a number of heavyweights like AngloGold Ashanti, British American Tobacco (BAT), SABM iller and telecommunications firm MTN account for a large share of the market, the exchange has cultivated a diverse variety of offerings.

As of December 2012, the JSE listed 400 companies (including 59 smaller listings on AltX), of which 112 were engaged in industry, 78 in financial services, 69 in basic resources, 52 in services and three in venture capital, according to local financial institution NedBank. The number of listed companies has remained relatively constant in recent years, with 12 initial public offerings (IPOs) in 2012, representing a combined capitalisation of R35bn ($4.3bn), and 17 de-listings, although some of these relisted under different names.

The JSE is indexed by the FTSE/JSE Africa Index Series, a partnership between JSE and the FTSE Group. The main two measurements of performance are the All Share Index (ASI), covering 99% of market capitalisation, and the All Share Top 40 Top Companies Index, which tracks the top listings in a representative spread of sectors.

Uneven Performance

Despite South Africa’s labour unrest and lower commodity prices, the JSE recorded healthy growth in 2012, with market cap increasing by 22.22%, outpacing Tel Aviv (7.57%) and Casablanca (15.18%), but lagging markets like Nairobi (28.62%) and Cairo (50.8%), according to the WFE. The ASI rose nearly 27% year-on-year (y-o-y) in 2012, with share prices exhibiting particularly strong growth from September onwards on the back of action by the central banks of the US, UK, EU and China, while the price-to-earnings ratios for these listings rose from 12.7 to 14.3 over the same period, according to investment firm Absa Capital. Dividend yields have also been up, increasing from around 2% in 2010 to nearly 3% in 2012. In all, equity returns in 2012 were driven mainly by an increase in earnings (50%), a rise in dividends (15%) and a re-rating of shares (35%), according to a January 2013 report from local financial services provider Old Mutual.

This impressive growth came despite global financial challenges, Michael Prinsloo, the head of best practice at Alexander Forbes Financial Services, pointed out to OBG. “There has been a disconnect between global politics and the macroeconomic picture on the one hand and returns on the equity market on the other in 2012,” he said. “Local equity markets have hit all-time highs, yet global growth forecasts are weak.”

Wide Impact

A slowing global economy and labour strikes hurt investment and investor perception in the short and medium term. Sectors across the board are likely to be affected negatively, in particular mining stocks, where the greatest labour market uncertainty exists. According to Elias Masilela, CEO of the Public Investment Corporation, “Property is a good asset to hold, as it tends to preserve value better than most investments and is a good hedge against inflation. As the slowdown in developed markets continues, the market can absorb more property funds listing as globally people are hungry for yields.”

Indeed, despite a decline in exports and commodity prices, as well as lower mining output, property and domestic consumption provided a convincing investment portfolio proposition. “Foreign interest in the local consumer goods, consumer services and health care sectors remained strong for most of 2012, helping drive the markets to new highs,” Prinsloo told OBG.

Financial stocks that did well included Sanlam (up 40%), FirstRand (42%) and Old Mutual (47%), while big industrial listings like Richemont (52%), SABM iller (30%), Aspen (63%) and Bidvest (35%) also turned in good performances, according to financial services firm Absa Capital. The year’s top performers were retailers like Woolworths and Mr Price, rising 77% and 74%, respectively, while Clicks and Truworths recorded above-average growth at 35% and 27%, respectively. This growth has had its detractors, however. “Retailers are posting positive growth,” Adam Craker, the CEO of IQ Business, a management consultancy, told OBG. “The concern is that this has been driven by credit from unsecured lending, which cannot be sustained”

Meanwhile, some of the worst performers were mining securities, with Lonmin dropping 69% in 2012, followed by a 27% drop for Harmony, 28% for AngloPlats, 21% for AngloGold and 19% for AngloAmerican. Construction stocks were also lacklustre, with shares at Murray & Roberts and Aveng falling 15% and 17%, respectively. The sector did have a few exceptions, with BHP Billiton rising 16% and Kumba by 6%, for instance.

Derivatives

The JSE offers trading of a variety of derivatives, including futures and options on equities, bonds, indices, interest rates, currencies and commodities. Currency and interest rate derivatives were areas of growth in 2012, with the former increasing 12% in volume and 20% in value, according to JSE data. The most important product was dollar/rand contracts, which accounted for nearly 80% of trades, followed by pound/rand and euro/rand contracts. Total interest rate derivatives trading grew from 70,000 contracts worth over R10.5trn ($1.3trn) in April 2008 to over 500,000 contracts worth R71trn ($8.7trn) in October 2012. The commodities derivatives market also expanded, averaging some 15,000 contracts traded daily.

Over-the-counter (OTC) derivatives trading is also available, primarily from banks, but this market is undergoing changes as South Africa looks to implement reforms introduced by the G20 Financial Stability Board. “We have seen a pick-up in exchange-traded derivatives in 2012 as banks and traders ready themselves Composition of public debt by instrument, 2011 for the implementation of G20 rules on derivatives,” Warren Geers, the general manager of the derivative trading division at the JSE, told OBG. “We are likely to see even more in 2013.” The exchange also plans to establish a code of conduct for market participants and a clearing and trade repository for OTC derivatives, which would be an entirely new body, to facilitate the registering of derivatives trades in 2013.

While these regulatory changes will likely hasten the move of trading from OTC to the JSE, authorities have also taken steps to make the exchange a more attractive platform for this activity. “We have consistently lowered fees on non-equity derivatives in every one of the last seven years and will continue to do so,” Geers told OBG. “We are also improving the transparency in our fee structure to clearly delineate our fees from those charged by brokers and other financial intermediaries.” Product innovation by the JSE plays a key role. The introduction of an “any-day” delivery contract, where issuers can structure the maturity of contracts to fit their needs and list on the JSE platform, along with the “can-do” and “forward-forward” contracts have offered more flexibility for listed derivative structures.

Investor Base

With foreign portfolio investors accounting for about two-thirds of the value of listed bonds and one-third of equities at the close of 2012, the South African markets remain highly correlated to swings in global investment appetite for emerging markets. On the domestic side, institutions owned about 40% of equities as of the end of 2012, compared to JSE All Share Index projections, 2009-17 24% for local direct investors. Although the JSE and brokers have launched outreach and education drives to expand the value and numbers of retail investment, progress has been slow. The biggest domestic institutional players are the banks, as well as the state pension fund GEPF, which holds about R1.2trn ($146bn) in assets, and domestic life insurers, which own more than R1.6trn ($195bn) in investable assets, according to local investment bank NedBank Capital. “Value-based strategies have come to dominate the active institutional investor space in South Africa,” Prinsloo told OBG. Thus, the domestic equity investor base was generally overweight commodities and underweight industrial shares in 2012, missing many of the gains recorded by top-performers like retail stocks.

Brokers

More than 110 equities and 50 bond brokers, a mixture of local and foreign outfits, are licensed in South Africa. Broker pricing has remained fairly constant in recent years, despite the fact that the JSE has reduced its fees, and even online brokers have adopted similar fee structures to more established firms.

Remote membership in the exchange is not presently allowed, but this may soon be an option for bond trading. “Although we do not expect that remote membership of the exchange will be allowed for equity trading in the foreseeable future, we are lobbying for this in the fixed-income market to attract more members, and likely liquidity, to the exchange,” Geers told OBG. Retail investors also have the option to invest via unit trusts, which have become more popular as people have shifted away from bank accounts towards alternative forms of saving. More than 900 such funds are available, including those that invest in domestic equities.

Etfs & Etns

While direct investment by retail clients has remained relatively flat in recent years, the value and number of passive investment instruments such as exchange-traded notes (ETNs) and funds (ETFs) has grown significantly. As of the end of 2012, there were 38 ETFs and 24 ETNs listed, compared to just 10 ETFs and zero ETNs in 2007. These products are mainly purchased by institutional investors, although brokers are increasingly marketing ETFs to individuals. “More and more brokers are using ETFs as entry-level products for retail clients, although investor appetite for such instruments continues to be dominated by institutional investors,” Nicola Comninos, the senior manager for business development at the JSE, told OBG.

The big players in the ETF market are Absa Capital and Satrix (owned by insurer Sanlam’s investment management division), together accounting for 82% of assets under management as of the end of 2012, according to etfSA, a local company that provides information on domestic ETFs. Absa is also the largest outfit when looking at the combined exchange-traded product (ETP) market, managing 20 ETPs worth R21.31bn ($2.6bn), followed by Satrix (R12.78bn, [$1.56bn]), Deutsche Bank (R5.36bn, [$653m]) and Standard Bank (R1.25bn, [$152m]). Deutsche Bank was one of the best performers in 2012, with the market capitalisation of its ETPs growing 36.3%, followed by 13.8% for Absa Capital and 12.4% for Satrix. With a strong record and institutional investor support, the exchange expects the pace of issues to sustain in 2013.

Upgrades

The JSE has undertaken technological upgrades over the past two years to improve the latency of trading times and embarked on reform of the clearing and settlement timeframe. In February 2011 the JSE announced that it would licence a new trading platform – the Millennium Exchange – from the London Stock Exchange Group, while at the same time moving the trading system from London to Johannesburg.

Following a successful transition in July 2012, trading times experienced are 2.7 milliseconds for Johannesburg, 20 milliseconds for Cape Town and 167 milliseconds for international destinations. The aim of adopting the new system is to boost liquidity and open up to more high-frequency traders. According to Siobhan Cleary, the director of strategy and public policy at the JSE, market participants have welcomed the change. “The shift of the trading platform back to Johannesburg in 2012 significantly reduced trading latency and was very well received by the market,” she said. The new set-up could allow the JSE to lease server space to high-frequency traders and data vendors, creating new revenue streams for the exchange. Although the JSE has worked on migrating from a T+5 to T+3 settlement cycle for its equities platform since 2007, the move will only be finalised in 2015 following delays in automating and improving the clearing system. The exchange has long enforced a system of guaranteed irrevocable settlement, with no failed trades, and with work by brokers and institutional investors now near completion, the scope for counterparty risk under the new three-day system is minimal. Meanwhile, since January 2012 the central depository Strate has worked with Clearstream, a supplier of post-trading services and a wholly owned subsidiary of Deutsche Börse, to introduce a tri-party collateral management system.

Regulatory Reform

The JSE currently acts as the frontline regulator, setting listing requirements and enforcing trading rules. The Financial Services Board (FSB) supervises the JSE in the commission of its regulatory duties and, as the JSE has no criminal or civil jurisdiction, processes any cases where statutory legislation has been contravened. The regulatory landscape is set to change significantly in the near future, as South Africa looks to implement a twin peaks model of oversight (see analysis). Under the new system, prudential supervision will be transferred to the South African Reserve Bank (SARB) and market conduct regulation will be led by a bolstered FSB. As part of the changes, some 60-100 FSB staff members are set to transfer to the SARB. The JSE will continue to act as front-line regulator while it will report to the FSB as the lead regulator, a concept endorsed in 2012 to avoid overlaps in jurisdiction between the FSB and the SARB.

The JSE has also implemented the King Code of Governance Principles, the current iteration of which is commonly referred to as King III. The code is a response to changes in international governance trends and, although it is implemented on a voluntary “comply or explain” basis, aspects of it have been made mandatory by the JSE as part of their listing requirements.

Foreign Listings

Another regulatory change that could have widespread implications is the 2011 decision to alter South Africa’s inward listing rules, allowing foreign domiciled companies to be treated as domestic listings. While foreign firms had been allowed to list on the JSE since 2004, they were previously subject to foreign exchange rules, which limited the amount of these equities that local investors could hold. The lifting of these restrictions has been an important shift, according to Cleary. “The treatment of JSE-listed foreign companies with trade settlement in Rand in the same way as domestic firms, exempt from capital controls, since 2011 was a major step for us and we hope to replicate this in other asset classes,” she told OBG. Presently, there are 38 securities listed on the JSE with primary listings in offshore exchanges such as London and Toronto, and two more firms have signalled their interest as well. In February 2013 Swiss-based Glencore, soon to become the world’s fourth-largest mining firm following its $36bn acquisition of Xstrata, announced it was considering listing part of its business on the JSE given the significant South African assets operated by the merged entity. Glencore’s shares are presently traded on exchanges in London and Hong Kong. Another mining outfit, Ivanplats, which had an IPO in Toronto in 2012, followed suit with plans to dual-list on the JSE shortly thereafter.

In trying to attract foreign listings, the JSE faces stiff competition from other exchanges, including those in the UK (London’s Alternative Investment Market in particular), US, the EU, Australia and Mauritius. Closer to home, the Quote Africa Group, which is active in bidding for licences in the Seychelles and Namibia and holds a 30% stake in London-based Aquis Exchange, has announced plans to launch a competing bourse in Johannesburg, pending approval by the FSB. The planned South African Financial Exchange (SAFE) could start by launching fixed income, equity and currency derivatives, as well as contract-for-difference instruments. The upstart could also dual-list bonds currently traded on the JSE, without the need for approval and just as the JSE had done prior to acquiring BESA. SAFE claims backing by investors (banks and brokers) representing some R3.5trn ($427bn) in assets, although progress in FSB licensing was uncertain in 2013.

Gateway For Private Equity

South Africa has also developed a sizeable private equity (PE) industry (by African standards), expanding from being entirely donor-funded at the start of 2000 to attracting some of the world’s leading PE funds. According to international consultancy KPMG, funds under management by PE firms have grown by about 11% per year over the last decade, reaching R115.8bn ($14.1bn) as of the end of 2011. However, domestic investors are still fairly underweight when it comes to this type of investment, with just 1% of South African pension assets allocated to PE funds. Donors like the UK’s Commonwealth Development Corporation, the International Finance Corporation (IFC), the African Development Bank and the US’s Overseas Private Investment Corporation were key early investors in African PE, with the IFC backing South Africa’s Ethos, which closed its sixth fund worth $750m in late 2012. In recent years, however, global players like the Carlyle Group and Dubai’s Abraaj Capital have established offices in South Africa, targeting opportunities locally as well as across the continent. Indeed, slightly more than half of all Africa-based fund managers operate out of South Africa. While the country faces competition from other possible PE fund headquarter locales, including nearby Mauritius, the government has taken steps to make South Africa an attractive financial gateway to the continent, such as relaxing exchange controls and eliminating corporate taxes on certain offshore operations.

Outlook

As global risk appetite for emerging market equities returned from mid-September 2012 following concerted interventions by the world’s central banks, South African equities rallied sharply. Bonds also did well in 2012, despite sovereign rating downgrades from two major ratings agencies and macroeconomic imbalances (see analysis). The medium-term prospects are dim, as Prinsloo of Alexander Forbes Financial Services told OBG. “Given the market’s recent performance, future asset class returns, including equities and bonds, are expected to be significantly lower and for longer,” he said. However, while downside risks remain, the domestic capital markets provide a clear conduit for portfolio investment to Africa and emerging markets. Wide-ranging reform of the regulatory framework will strengthen prudential rules and market conduct. With interest rates low in developed economies, South African securities’ yields will continue to attract foreign investors.

Annual performance of MSCI, 2001-12