Global Markets - 4th quarter 2002

Never underestimate the importance of real returns

Many South Africans have become accustomed to periods of high returns, particularly in the domestic market. This has often created an expectation amongst investors that these periods of high returns will continue in the future. However, investors have tended to focus exclusively on these nominal returns (disregarding the prevailing inflation rate) rather than on real returns. Simply put, real returns are those returns, after having allowed for the deduction of inflation. The importance of real returns cannot be stressed enough, especially in light of the fact that South Africa has tended to be a high inflationary environment, particularly since the mid seventies when we experienced continuous double digit inflation right through to the early nineties and now again in 2002. The under mentioned graph reflects South African inflation from 1965 to 2002 ? with domestic inflation reaching highs of 18.6% in 1986. It is interesting to note that the cumulative price increase between 1974 and 1992 was 933.90% - the cost of a R100 basket of goods in 1974 cost R1 033.94 in 1992.


Single digit equity returns of between 6% and 7% in the United States of America are viewed as reasonable going forward. In real terms, however, using the prevailing inflation rate of approximately 1.5% in the United States, these figures are adjusted down to potential real returns of between 4.5% and 5.5%. In a South African context, taking the current inflation rate of approximately 12% into account, to achieve a real return of 5% (before tax and fees) an investment would need to generate a nominal return currently exceeding 17%.

Investec Analytics recently conducted a study based on the returns of a portfolio comprising 60% domestic equities, 30% domestic bonds and 10% domestic cash over a 15-year period (January 1986 to December 2001). Based on historical rolling 3 year annualised returns over this 15 year period, the result was that the simulated real returns generated by this portfolio ranged between 2 ½% and 7% (ignoring tax and fees) 55% of the time.


Accordingly, it is important to constantly manage investment return expectations. It follows that in a low inflationary environment, lower nominal returns need to be achieved in order to produce the desired real return, whereas in a high inflationary environment (which has been the case in South Africa), the opposite holds true. Furthermore, it must be remembered that high returns are often associated with higher levels of risk, so it is essential that investment return expectations are commensurate with the asset class (or combination of asset classes) appropriate to the risk profile.

We now take a look at some of the major economic regions around the world.

UNITED STATES OF AMERICA

At their meeting on the 6th November the Federal Reserve (in a unanimous decision) cut interest rates by 50 basis points for the first time this year (following 11 interest rate cuts in 2001), bringing the Federal funds rate to 1.25% - the lowest level in 41 years (since July 1961). Overall markets reacted well to the announcement, as a cut of 25 and not 50 basis points had been expected. Following the aggressive 50 basis point cut, the Federal Reserve changed their policy stance from ??easing? to ??neutral? stating that monetary policy is currently ?accommodative? and is ?providing ongoing support to economic activity?. While the markets are not expecting interest rates in the United States to move much lower (and there is a view that interest rates will move back to around the 2.25% level in 2003), geopolitical factors like a war on Iraq would impact negatively on American markets, if a protracted war led to a sharp rise in the oil price ? this could put pressure on the Federal Reserve to once again consider reducing interest rates or to motivate fiscal measures like further tax cuts. Because interest rate changes have a lag effect of between six to eighteen months, the immediate significance of the latest interest rate cut was psychological rather than economic, as lower interest rates will reduce household and corporate debt service costs even further. In addition, lower interest rates should encourage consumers to continue spending. It must be remembered, however, that rate cuts have a converse effect on retirees and those who rely on interest income.

Third quarter GDP, boosted mainly by consumer spending, grew by 4% quarter on quarter, annualised (beating economists forecasts of 3.8%) - up from second quarter growth of 1.3% (quarter on quarter, annualised). The stimulatory fiscal and monetary measures (tax and interest rate cuts) that were implemented throughout last year have kept consumers feeling wealthy, encouraging them to continue spending. Despite encouraging growth in quarter three, however, it is expected that growth in the fourth quarter will be weaker unless final demand levels are maintained. According to the Blue Chip Economic Survey, personal consumption is expected to grow at an annualised 1.1% during the fourth quarter of 2002.

While in the minority, some analysts have expressed their concerns about deflation (continual decline in the overall level of prices) in the United States of America. A deflationary environment can often prove to be far worse than an inflationary environment. In a deflationary environment, because prices are falling continuously, companies find it difficult to survive as they are often forced to sell goods at prices lower than their input costs. Accordingly employees are retrenched or salaries are reduced resulting in falling incomes, with consumers becoming reluctant to continue spending. This ultimately impacts significantly on production and on economic growth. Borrowers are often the hardest hit, as deflation tends to increase the real value of debt.

However, the consensus view is that the Federal Reserve has been aggressive enough in their stance and expect inflation to remain benign for some time. The general view is that inflation should average 1.6% for 2002 and 2.1% in 2003.

EUROPE

The European Central Bank (ECB) once again left interest rates on hold this quarter (3.25%), despite a 50 basis point cut by the Federal Reserve in the United States of America in early November. This was the twelfth consecutive month that rates were left unchanged in the Euro zone. Commenting after the recent meeting, ECB chairman, Wim Duisberg said: ?The governing council has discussed extensively the arguments for and against a cut. The view in the end has prevailed to keep interest rates unchanged. However, the governing council will monitor closely the downside risks to economic growth in the euro area.? The fact that rates were left unchanged, combined with a stronger Euro and a subdued economy should serve to restrain price pressures ? once again reaffirming the ECB?s absolute commitment to price stability (and ultimately benign inflation). The ECB may have no alternative but to consider a rate cut at their next meeting scheduled for 5th December, if domestic demand and employment levels do not improve. Inflation in the Euro zone is currently at 2.3% - slightly higher than the 2% target.

During the quarter, the Euro supported mainly by interest rate differentials (now 2% between the Euro zone and the USA), reached parity to the US Dollar ? putting exports under pressure yet again.

JAPAN

Third quarter GDP grew by 0.70% quarter on quarter, beating expectations of 0.50% quarter on quarter growth (down from 1% from the previous quarter). In addition, consumer demand increased at its fastest pace in more than 18 months during the third quarter, with consumer spending (which accounts for 55% of the economy) rising by 0.80%. However, the stronger Yen against the US Dollar impacted negatively on business spending mainly by reducing exporters? earnings, resulting in a 0.90% drop in business spending during the third quarter. The impact of a strong Yen continues to be a cause for concern as it is the view of many that an upturn in Japan is largely reliant on exports and foreign demand. A stronger Yen combined with weaker exports will serve to fuel deflationary pressures.

In the first reshuffle of the cabinet since taking office, Prime Minister Koizumi replaced the Financial Services Minster, Hakuo Yanagisawa, with Heizo Takenaka. Mr Yanagisawa was most noted for opposing the use of public funds for salvaging Japan?s battered banking sector. This move made it possible for the Bank of Japan to commence buying Japanese bank shareholdings in an attempt to deflect a potential financial crisis. Statistics released recently showed that, in October, bank lending fell to its lowest level in more than 10 years. In addition, Japanese bank?s bad loans are now estimated at being Yen 13,000 billion higher than expected.

In an announcement in early November, the government indicated that it would work closely with the Bank of Japan in an attempt to reduce the bad loan ratio of major banks by 50% by fiscal 2004. Corporate restructuring, structural reforms and resolution of the financial sector bad debt crisis remain key issues that require attention.

UNITED KINGDOM

Despite mounting pressure for an interest rate cut at their last meeting, the Bank of England left interest rates on hold at 4% for the twelfth consecutive month. Factors currently endorsing a rate cut include a tenuous UK manufacturing sector as well as slow economic growth abroad. However, there is concern that a rate cut in the prevailing environment of consumer borrowing and strong growth in housing prices could fuel inflationary pressures. Domestic demand has continued to be supported largely by the strength of the housing market (house prices increased by 4.7% in October), government spending and consumer resilience. Inflation is currently at 2.1% - well below the target level of 2.5%.

SOUTH AFRICA

The markets were taken by surprise when the Monetary Policy Committee increased domestic interest rates by a full 1% yet again at their meeting in September 2002, bringing the total rate increase this year to 4%. Defending the rate increase, Mboweni said "So you are better off with this tough stance that is gradual than to sit and do nothing and come later with a sledgehammer, causing market dislocation ? we don't want to do that.?

Despite the four interest rate increases this year, real interest rates have remained fairly constant as a result of the proportionate increase in CPIX over the same period. CPIX is expected to have peaked in October / November, with the Government?s medium term forecast for this number to average 9.6% for 2002, 7.2% for 2003 and 5.5% for 2004. CPIX increased to an annual 12.5% in October (12.1% expected), up from 11.8% in September. This is the twelfth consecutive month that CPIX has fallen outside the 3% to 6% target range.


During the Medium Term Budget Policy Statement, Finance Minister Trevor Manuel announced changes to the 2004 and 2005 inflation targets. The 3% to 6% inflation target range for 2002 and 2003 was left unchanged (as it is has now been accepted by most that the target range for 2003 will in fact be missed), while the target range for 2004 and 2005 was increased from the 3% to 5% range to a range of between 3% and 6%. Commenting on the decision by government to ease the 2004 inflation target, Mr Manuel said ?If we had left the target in place?my fear is that increasing interest rates might have had a profound impact on economic growth outlook going forward?. It is likely that this adjustment to the inflation target range will give the Reserve Bank more scope with regard to monetary policy, and accordingly with adjustments to interest rates. Despite this broader scope, the consensus view amongst analysts is that rate cuts are only likely to take place during the second half of 2003.

Interest rates remained unchanged at the Monetary Policy Committee meeting held on 27th and 28th November 2002 ? reasons for this include the strengthening of the Rand against the US Dollar this year, together with the increase in the upper limit of the 2004 inflation target and the better than anticipated PPI numbers.

GDP figures for the third quarter of 2002 were released on 21st November 2002. These figures came in at an annualised 3%, in line forecasts, from a revised 3.8% in the second quarter (original estimate was 3.1%).

The Rand appreciated by 12.58%, 11.67% and 12.34% against the US Dollar, Euro and Sterling, respectively during the last quarter (1 September 2002 to 30 November 2002). The strength of the Rand this year has been fuelled, to a degree, by the closing out on short positions taken on the currency at the end of last year, together with general US Dollar weakness (research has found that the demand for US Dollars by importers often tends to be lower from November through to January) and high interest rate differentials. In addition, the recent strength of the Rand combined with high domestic interest rates has encouraged exporters to repatriate their funds from abroad, thereby adding to Rand demand and causing the local currency to strengthen further.


CONCLUSION

Global markets breathed a sigh of relief in mid November when Iraq confirmed that it would accept United Nations arms inspections. This relayed mounting fears of an impending attack by the USA on Iraq. The United Nations resolution agreed to by Iraq threatened ?serious consequences? if Iraq did not allow free weapons inspections to take place. Iraq has been given until the 8th December 2002 to disclose what they have by way of weapons of mass destruction. The crude oil price fell to five month lows (at $25.19 a barrel) on the back of this news. The oil price ended the quarter at $26.89 per barrel, declining by 2.11% from the previous quarter.

The gold price ended the quarter at $317.80 an ounce, 1.24% higher than the closing level for the previous quarter ($313.90).

Global markets ended the quarter on a good note after staging a comeback during October and November, delivering the following performances from the levels of early October 2002. (The Nasdaq reported its third best November ever, in terms of percentage increases).

This report is based on information sourced from various institutions, both local and international. The report reflects a variety of views and is not intended to convey investment advice. Please consult us to obtain specific advice relevant to your investment portfolio.