Assessing SA’s risk landscape

More than 20 years ago, as a young associate, a partner and I analysed what markets were telling us about risk. While much has changed, the key insight then was the divergence between theoretical risk models and reality – different role players in the economy will price the same risk differently, and that risk is dynamic.

“Implied risk premia” is the current market price of risk, which may differ from the historical or future risk profile. Assets that look cheap may be “cheap” for sound objective reasons, and being “logical” about risks doesn’t mean you will be correct. The best investors (of the ‘ice in the veins’ variety) tend to take informed ‘bets’ that many of these implied premia are wrong. Identifying a market mispricing of risk gives rise to great investing opportunities.

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Within South Africa, the current risk is high, and the value of the rand, often seen as a critical barometer of investor sentiment, paints a gloomy picture. However, the currency’s fluctuations are just one facet of the overall risk of investing in South Africa.

The Country Risk Premium (CRP) is a composite measure that captures the additional compensation investors demand to offset the broad risks associated with a specific country. The broader CRP impacts the equity risk premium, increasing the returns investors seek from equities and adding to the yield required on government and corporate debt. Calculating the country risk premium lacks a universally accepted methodology. Some experts employ quantitative techniques, while others adopt a qualitative approach. Nonetheless, a range of factors contributes to the CRP. By adopting a qualitative approach, we can offer a practical framework for objectively assessing shifts in investment, economic, and social conditions.

The country risk premium framework encompasses six overarching categories: political risk, economic risk, financial risk, legal and regulatory risk, social and environmental risk, and geopolitical risk.

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Political risk encompasses stability, government policies, corruption, unrest, and the rule of law. Economic risk considers growth prospects, inflation rates, fiscal and monetary policies, exchange rate stability, and income inequality. Financial risk revolves around the strength and stability of the financial system, credit availability, and regulatory effectiveness. Legal and regulatory risk evaluates legal system efficiency, property rights protection, contract enforceability, and regulatory frameworks. Social and environmental risk factors include social unrest, inequality, labour market conditions, and environmental sustainability practices. Finally, geopolitical risk entails regional conflicts, security threats, trade disputes, and diplomatic tensions.

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While economic indicators like GDP growth, interest rates, and inflation figures tend to grab headlines, alternative measures proposed in the framework offer a more profound, perhaps more nuanced view of the risk landscape. Some high-level factors have easily accessible data, while others require subjective judgement. The combination enables investors to construct a composite picture of the country’s risk premium and anticipate potential shifts in South Africa’s risk profile.

An equity risk premium is traditionally computed as the difference between equity market returns and the risk-free rate. The long-term estimated equity risk premium for South Africa is typically around 7% (depending on the methodology). This value represents the return required over cash as compensation for the additional equity risk if a company has a risk similar to the average company in the market.

Quantitatively, by reviewing the South African credit default spread, which incorporates the sovereign credit rating as assessed by Moody’s, S&P and Fitch, we could estimate a country risk premium of about 5%.

We may choose to adjust our estimation of the CRP by subjectively using the blend of factors highlighted in the framework above. For example, we may assess that the risk environment may de-escalate as the South African government takes positive steps, reducing the CRP estimation.

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By adding the country risk premium to the equity risk premium, we can estimate more realistic return levels currently required by equity investors. Using the figures presented, South African equity investors may need returns closer to 12%/13% over the medium term rather than 7% over the risk-free rate to compensate them for the equity-specific and country-specific risk landscape adequately.

Some companies have sound business models but, for well-known reasons, are currently trading at share prices below their fair value. Their future normalised earnings and dividend growth implies returns greater than those reflected by this share price. Therefore, these companies should be considered good value in a portfolio context. It isn’t easy to do, but that’s how the returns mentioned above are made.

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With your financial advisor, it is sensible to make an informed assessment of the likely risk profile of South Africa and use that to determine a prudent allocation to financial assets. Throughout history, the market has swung between exuberance and panic; exuberance when risks are underestimated and panic when risks are overestimated. By systematically approaching the concept of risk, it is possible to navigate the current landscape and come to a less emotive, more rational investment decision.

Armien Tyer is managing executive of Private Wealth Banking at Absa Relationship Banking.