It Looks Like a Rather Blustery Year

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By Shaun le Roux

Hum for a Blustery Day – Winnie the Pooh

Hum dum dum ditty dum
Hum dum dum
Oh the wind is lashing lustily
And the trees are thrashing thrustily
And the leaves are rustling gustily
So it’s rather safe to say
That it seems that it may turn out to be
It feels that it will undoubtedly
It looks like a rather blustery day, today
It sounds that it may turn out to be
Feels that it will undoubtedly
Looks like a rather blustery day today

When things are going well, economists like to talk of “tailwinds”, whilst economic challenges are referred to as “headwinds”. Markets around the world have moved sharply from having a nice steady breeze at their backs, to facing into the teeth of a category five hurricane. Nowhere is this more the case than in South Africa.

Economic conditions prevalent in the five years preceding 2008 were remarkably benign and asset price friendly. The US Fed pumped massive amounts of liquidity into global markets after the Dotcom meltdown. Central banks around the world appeared to have mastered the art of keeping a lid on inflation, though increased globalization and disinflationary forces from China clearly helped. Economies grew on a synchronized basis in all corners of the globe.

In South Africa the tailwinds of 2003 to 2007 were especially favourable. Domestic shares, property and bonds thoroughly enjoyed lower than normal interest rates on the back of a very strong currency, which in turn was supported by healthy capital inflows from abroad. A roaring bull market in commodities drove the share prices of the mining and resource stocks on the JSE strongly upwards. The economy expanded on a sustained healthy basis.

Then things changed.

Globally, a normalization of interest rates in the US was enough to firstly reveal the excessive risk-taking and leveraging in the Financial Sector through the sub-prime crisis, and secondly, pop the massive real estate bubble that had been allowed to build over many years. The resulting blowing up of credit markets and collapse in housing markets has left the real economy in the US in a very precarious position and it is more than likely in a recession as we speak. In addition, inflation has moved from being remarkably benign to a serious problem for the global economy. The run up in commodity prices, which is largely a function of surging demand with limited supply response, has stoked consumer price inflation in emerging markets where things like food and fuel account for a significant proportion of the spending basket. China has a serious inflation problem, with consumer inflation running well above comfort levels, driven primarily by food prices. China and other producer emerging economies have become sources of inflation by virtue of the rising prices of their exports.

The US Fed has responded to the current financial crisis by pumping liquidity into the system and slashing their lending rates. One of the consequences has been a very weak dollar which will also be negative for imported inflation in the US.

The South African economy is relatively open and rather vulnerable to gyrations on financial markets. The building headwinds facing the global economy have knocked investor confidence and foreign selling has hit our capital markets and the rand hard. Unfortunately, confidence has been further eroded by the Eskom debacle and a distinct lack of clarity on the future leadership of this country and the policies they will be
implementing. This is not an environment that is friendly to foreign investors.

Up, Up, Up.

Domestic consumer inflation is worryingly high. Ordinarily one could take comfort from the fact that this is a global phenomenon, but we have mandated our Reserve Bank to target a range of 3% to 6%. Current inflationary forces are well beyond their control and the only policy tool they have at their disposal, interest rates, would only be effective if they were used to bludgeon domestic demand into the dust. The already stressed domestic consumer is likely to take serious pain in the event of further rate hikes.

Recent years saw the near perfect alignment of positive factors which drove financial asset prices substantially higher and real returns were fantastic. We have now moved into the almost completely opposite scenario, the perfect storm. With inflation becoming a problem, real returns are going to be much more difficult to come by over years ahead.

What to do, what to do?

In the context of the current environment we keep getting asked where investors should be putting their money.

At the outset, let us please remind everyone that we continue to bang the drum about the critical importance of having a long-term investment plan. We know that it may sound boring, but frankly it’s the only way to go.

It is worth pointing out that many local investors missed a good portion of this current bull market on the JSE by being in cash when the run started or by selling too early into it. This should illustrate how difficult it is to time the markets. If you are looking to sell equities now, you have probably missed the boat as there are many very good value opportunities on the JSE at present. After the rand’s recent battering (22% down on the euro year to date), the benefits of offshore diversification should be apparent and as one has just discovered it is impossible to time such adjustments in the currency with any accuracy.

If you insist on trying to time your asset allocation more aggressively it is worth remembering that the best time to invest is when things look at their worst and the best time to cash-in is when everything looks wonderful. Things could definitely get worse over the months ahead and whilst a better entry point may well await us, levels of extreme pessimism often provide excellent opportunities. Good quality SA companies that will not go bust are trading as cheaply as they ever do. Current inflationary pressures point towards holding off on buying your interest-rate sensitive stocks just yet, given the risk of further rate hikes. We would currently stick with the defensives and rand-hedges.

We would be avoiding residential property in the meantime as we would anticipate that there will be a lot of pain to come in the middle- to upper-end over the next couple of years. We would also be sitting on the sidelines as far as bonds and investment property are concerned, as yields are not yet attractive enough relative to cash rates. Offshore remains an essential component of a sensibly constructed investment portfolio and trying to time currency movements and entry points is hazardous.

The good news is that the best opportunities are found when things get blustery. These are opportunities to buy assets that provide superior levels of return at lower levels of risk. There are undoubtedly some of these arising on the JSE as there will be on other global markets. Investors should allocate some of their capital to money managers to exploit these opportunities in the months ahead.

Source: Shaun le Roux, Alphen Asset Management, March 31, 2008.

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