Three catalysts should see equities beat cash in 2009

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By Chris Freund

Government and central bank intervention is battling to hold the tide against worsening financial market sentiment. The US bail-out package is likely to be passed in a moderated form now that the markets have demonstrated the potentially catastrophic consequences of inaction. In addition, we could well see coordinated government resolve in the form of an interest rate reduction programme from all the major central banks in an effort to restore confidence in the financial system.

The recent events will contribute to a material slowdown in global economic growth as credit conditions are tightened and consumer confidence plummets. The developed-world economic slowdown is exacerbated by an emerging “growth recession” or soft spot in Chinese economic growth. Commodity prices could well continue to weaken for the next six to nine months in the face of a rapidly slowing European economy and a slowdown in the commodity-intensive areas of the Chinese economy. In addition, risk sentiment indicators have spiked, indicating high levels of anxiety, with the oft-quoted VIX (Volatility Index) reaching levels seen in previous financial crises.

But, we don’t believe the world is coming to an end. Of more importance are longer-term expectations. Secular global economic growth factors of the past five years still remain firmly in place, namely Asia and the urbanisation and modernisation of China. Although Western economies are unlikely to grow for some time, they will eventually stabilise. Furthermore, the impact is likely to be worse in the financial sector than the real economy. Now is the time to remember that we are long-term investors, and although the next quarter or so may continue to bumpy, it is likely that when markets respond positively it will happen extraordinarily quickly, and we believe there are buying opportunities offering excellent value.

The horse has bolted already, and in our view it is too late to be cutting equity allocations aggressively in the expectation of re-entering at a more appropriate time in the future. We need to avoid making the standard behavioural mistake of emotionally reacting to fear.

During the course of 2009 we expect there to be three major positive catalysts that are likely to result in equity returns beating cash.

Firstly, US house prices are likely to stop falling or at least give a clear indication of doing so as the excess supply of homes begins to diminish. This is important as US property is the ultimate collateral for the banks and the stabilisation of this market will in turn allow banks to stabilise their balance sheets. Credit markets are likely to ease on this development.

Secondly, inflation rates around the entire world are expected to decline in response to the high base effect as well as lower oil and food prices in a reversal of what was witnessed in 2007 and 2008. There has been little wage pressure in developed economies, with the moderate increase in core inflation indicating relatively benign underlying inflation conditions. In the face of falling inflation and slower growth, central banks around the world will be able to cut interest rates and maintain credibility. Equity markets almost always respond positively to lower rates.

Thirdly, partly as a result of the first two catalysts and partly just due to the passage of time, we are likely to see a bottoming out of the global leading economic indicators such as the German IFO Index or the US ISM Index. This should be the first tentative signs of economic dawn in Western economies and are likely to be aided by continued economic stimulation in China in an effort to revitalise that economy. Equity markets are likely to discount the prospects of this higher growth in the future.

As we stand today, the market is drawing very little solace from the compelling valuation on offer in credit and equity markets, choosing to focus on the earnings risks. Faith in valuation has currently been broken. However, in the short term equity markets are likely to bounce in a relief rally from a very oversold position of high risk aversion.

Within SA the rand has held up remarkably well in the face of a massive increase in global risk, political upheavals specific to SA and lower commodity prices. Consequently the rand does remain vulnerable to further depreciation, but alternatively could also benefit from the expected reduction in risk as financial markets ease.

In terms of sectoral considerations, we expect resource shares to continue to come under pressure from falling commodity prices, notwithstanding the fact that they are currently good value. The domestic interest-rate-sensitive shares look encouraging as we do expect interest rates to fall materially in SA in 2009. We have chosen largely to take this interest-rate-sensitive exposure by way of retail shares as opposed to banks as we fear any continued fallout from global financials. Finally, we remain optimistic about the prospects for infrastructure or construction shares as their earnings certainty is superior to that of many other companies.

Source: Chris Freund, Investec Asset Management, October 3, 2008.


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