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Here's How South Africa Lost its Rep as a Stock-Market Darling

It's a cardinal rule of investing in less-developed countries that what can go wrong, often does go wrong.

And that's what worries an increasing number of investors about South Africa. Some analysts and economists fear President Jacob Zuma is pushing to deepen the government's interference in the affairs of companies while undermining mostly-independent institutions like the judiciary, the central bank and the National Treasury. The latest jolt came when Zuma on March 30 dismissed Finance Minister Pravin Gordhan, who was seen as a prudent steward of fiscal affairs.

At stake is the hope -- expressed from earlier this decade through big foreign-capital inflows and a surging stock market -- that South Africa was en route to becoming a powerful economy along the lines of then-emerging-market standouts like Brazil and Mexico. Ever since the Apartheid era of state-mandated segregation ended in 1994, the government had maintained a healthy respect for shareholder rights and the lines between government and business.

"The concern is it's turning into something which is much less fiscally responsible and much less balanced, in terms of the relationship between the state and the private sector, than has been the case in the post-Apartheid era," said John-Paul Smith, a former Deutsche Bank analyst who now heads emerging-markets research firm Ecstrat in London.

Both Standard & Poor's and Fitch underscored the anxiety last week when they slashed South Africa's international credit rating to junk status, citing Zuma's dismissal of Gordhan as a sign that budgetary discipline could slip, in turn pushing up the country's borrowing costs.

"Policy shifts are likely, which could undermine fiscal and growth outcomes," S&P wrote in an April 3 note.

Capital outflows by bondholders -- triggered in part by the rating downgrades -- could put downward pressure on the country's currency, the rand, sapping returns for international investors once translated into dollar terms, according to Stuart Quint, an emerging-market specialist who serves as chief investment officer of Ambassador Wealth Management in Vancouver, Wash.

Geoff Dennis, head of emerging-market equities research for UBS , forecasts the rand could weaken to 15.25 per U.S. dollar by the end of this year, representing a roughly 10% depreciation from current levels. This week, Dennis reiterated his underweight rating on South African stocks, saying prices are high relative to the profit potential -- leaving little upside for value-seeking investors.

Indeed, South African stocks are trading at roughly 20 times estimated profit over the next 12 months, a price-to-earnings ratio that compares to 15 for emerging-market stocks broadly.

"If Zuma is there, then the P/E has to go quite a bit lower," says Jorge Mariscal, chief investment officer of emerging markets at UBS Global Wealth Management, which oversees $1 billion.

Gordhan was replaced as finance minister by Home Affairs Minister Malusi Gigaba, who's "seen as a Zuma loyalist with no financial or market experience," according to Win Thin, head of emerging-markets strategy at brokerage firm Brown Brothers Harriman in New York.

And Gigaba, in his first press conference following the announcement, said that the National Treasury he now heads has been seen for too long as belonging to "big business, powerful interests and international investors," according to the BBC.

In an April 3 note to clients, Thin wrote that he's "very underweight" South African stocks, given the likelihood that Zuma will pursue populist policies in advance of the 2019 elections, creating "upside risk" to budget deficits estimated at 3.2% for 2017 and 2.9% for 2018. While the president is already in his second five-year term and isn't supposed to stand for reelection, it now looks like he'll have the upper hand in influencing the choice of his successor, possibly his ex-wife, according to Thin.

Gordhan's dismissal could represent a "watershed moment for the country," Thin wrote. "Zuma probably wouldn't have made such controversial moves if he hadn't shored up support first."

South African stocks were a bright star among emerging markets early this decade, as investors bet the country's stocks would benefit from an upswing in economic-growth rates north of 3% in 2010 and 2011. The country is the world's largest producer of gold and platinum.

Yet unemployment has remained stubbornly high at around 27%; South Africa ranks second in the world after Lesotho on the Central Intelligence Agency's list of countries with the highest wealth inequality. External debt, as a percentage of the economy, has climbed to about 45% from 25% at the start of the decade.

Inflation, currently running at 6.3%, is above the official target of 3% to 6%, and some traders are now starting to wager that the central bank may have to undertake more growth-sapping interest-rate hikes. Growth slipped to 0.3% in 2016, and little improvement is expected this year. Lower gold and commodity prices have hurt exports.

BlackRock's iShares MSCI South Africa Exchange-Traded Fund , which tracks the country's stock market, has gained just 3.8% this year, mostly missing out on a 12% rally for emerging-market stocks overall.

"This underperformance should continue," Thin wrote. "The only positive scenario we can draw from recent developments is if popular and parliamentary opposition leads to Zuma's early exit."

For S&P, a major concern is that capped electricity rates at the giant utility Eskom will force the company to borrow as much as 70 billion rand ($5.1 billion) to cover its revenue gap, much of which could come with government guarantees.

"Contingent liabilities to the state are rising," the ratings firm said.

At the heart of Zuma's shakeup is a struggle for control of the African National Congress party, which has ruled the country since the election of Nelson Mandela in 1994.

Ecstrat's Smith says that while Zuma is unpopular in urban areas, partly due to anger over perceived corruption, he has appealed to ANC voters and affiliates in rural areas.

One concern is that Zuma moves toward more "racially-based, redistributional politics," and that the government might interfere in domestic companies for the purpose of black economic empowerment, Smith says.

"It's the same old story in emerging markets, where the lines are blurred between the government and private sector," Smith said. "Nobody's talking about Zimbabwe -- yet."

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