EZA - EZA: A Much Improved Outlook (Rating Upgrade)

2023-07-26 15:07:47 ET

Summary

• Although economic trend growth remains of concern, key indicators suggest that South Africa's cyclical outlook has improved, providing the iShares MSCI South Africa ETF with latitude to perform.
• A current account deficit and a weak South African Rand contribute to promising expected returns as it suggests a cyclical bottom has been reached.
• Furthermore, a potential global interest rate pivot and reduced load-shedding might assist South Africa's means of production.
• The iShares MSCI South Africa ETF has exposure to stocks that are globally integrated, which phases out much of the nation's regional issues. Moreover, the ETF's high-quality stock concentration is appealing.
• History suggests the EZA ETF's dividend is lucrative and sustainable.

iShares MSCI South Africa ETF's ( EZA ) month-over-month surge is not a surprise, given a shift in South Africa's interest rate outlook and the exchange-traded fund's ("ETF's") updated portfolio composition. Despite the negativity surrounding South Africa, a few structural changes have occurred in recent months that we believe deserve deeper analysis.

Results show that our past analyses of the ETF were fairly accurate. However, we missed a trick by failing to predict its recent uptick. Although the golden rule of the market is to buy low and sell high, we think the ETF's recent surge might sustain itself; here is why.

Why EZA's Expected Returns Are Looking Up

As South Africa is an emerging market with a large reliance on the primary sector, we believe its stock market is primarily linked to its current account. The nation's current account is often driven by the South African Rand and commodity prices, which have both faltered in the last twelve months amid a slowdown in the global economy.

South Africa's current account remains in a deficit, and the nation's currency is down against the U.S. Dollar in the past year. However, our argument is that a bottom has been reached, allowing for higher expected returns with a "buy the dip" type of scenario presenting itself. The word on the street is that global interest rates are set to taper in early-to-mid 2024 (keep in mind commodities are priced in advance), which could lend significant support to industrial metals, precious metals, and related commodities.

Furthermore, South Africa's energy crisis is finding relief. The nation's energy mix has improved considerably in recent months amid lower fuel costs, abating wage disputes, and an urgency to avoid further political conflict ahead of the 2024 national election. In our view, potential outsourcing to the private sector and an approaching spring season could phase out much of the nation's grid issues.

Lastly, rumors exist that the country's Reserve Bank has completed its most recent monetary policy contraction. South Africa's Reserve Bank started its interest rate hikes early (versus other nations), which kept the nation's yield curve intact. Moreover, the Reserve Bank did not raise rates last week as anticipated by the market, providing an argument that rate hikes are in arrears.

In our view, the Reserve Bank is done hiking short-term interest rates. Consequently, we expect repricing in the bond market (short-term bonds especially), a reduction in equity risk premiums, and higher real returns for real estate. As such, we think EZA ETF's financial sector holdings will experience increases in their asset bases, concurrently adding to the ETF's fair value.

Portfolio Analysis

As mentioned before, many of EZA's holdings are basic material stocks, which are volatile by nature. In addition, the ETF is overweight on the financial sector, with a blend of banks and insurance companies in its portfolio.

As mentioned in the previous section, we are bullish on the financial and basic material sectors as we believe higher commodity prices and repricing in the banking space is en route; moreover, the ETF's exposure to the likes of Standard Bank and ABSA means it is invested in banks with strongholds over the South African high-yield debt space, which is highly lucrative. Another draw towards EZA is the ETF's 6.02% exposure to Gold Fields ( GFI ), which is a stock we recently assigned a strong buy rating to in a Seeking Alpha analysis .

Despite our bullish outlook on basic materials and financials, we remain concerned about the ETF's exposure to communication stocks. South Africa's communication stocks have performed poorly in recent years amid various restructurings and decaying infrastructure. Based on our regional portfolio management experience, we consider communication stocks low-reward assets.

Solid Dividends

As displayed below, a large proportion of EZA's returns is attributable to carry returns, otherwise known as dividends. As such, an analysis of the vehicle's dividend profile is essential.

Past data suggests the ETF is generous to its shareholders with a trailing twelve-month dividend yield of 3.04%, accompanied by 13 consecutive years of dividend payments. As such, we have no reason to believe a change is pending.

Risks

As an emerging market economy, South Africa's primary risks include a volatile economic environment and biased political policies. EZA is exposed to large regional companies that rely on the nation's infrastructure, which is deteriorating under the incumbent South African government. Thus, creating a less conducive environment for means of production.

Furthermore, an overlooked risk factor is the nation's recently passed expropriation without compensation bill . The bill allows the government to expropriate 'unproductive' property without compensation. If this agenda sustains its momentum, South Africa's private sector could be at risk of diminishing foreign direct investment and an unfavorable national balance sheet.

Lastly, South Africa's stock market liquidity is very concentrated. Thus, EZA's portfolio managers have limited investment options; as such, portfolio rotation is bound to be inefficient at times.

Concluding Thoughts

The iShares MSCI South Africa ETF's outlooked has improved in recent months as economic and market-based variables have aligned toward a more positive outlook. Weak commodity prices and a current account deficit might reverse as we exit peak interest rates, allowing regional stocks to reprice. Moreover, we believe the ETF's portfolio's sector composition is favorable, with exposure to high-quality stocks with substantial global integration.

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