1st Quarter 2005: Global Markets 1st quarter 2005 - Will the stampede of the South African equity bulls continue in 2005

Having recently visited several fund management houses in Cape Town it was interesting to note the views expressed regarding the outlook for domestic equities this year. We all know that most domestic equity unit trust funds delivered exceptional performances during the second half of last year, but of course, the important question now is whether or not these performances are likely to continue in 2005? Although the consensus view is that they should, there are varied opinions as to how much "steam" is left in the current equity bull run.

An interesting view was put forward by one of the larger investment houses. They highlighted three possible scenarios for 2005, but the one which they currently believe is the most likely, is that it appears as if the domestic economy may be back in a "60's" type environment. Typically inflation is benign, interest rates are low, GDP growth is respectable and domestic demand is resilient. Included in this set of variables is a stable Rand. In addition, commodity prices should remain fairly stable and global growth is likely to be sustainable. Of course, this type of environment would be favorable for domestic equities.

While the other houses visited didn't necessarily disagree with this scenario, the much talked about negative issues of three years ago - the impact of aids on the economy and more particularly on the labour market, the expensive domestic labour market and the likes of Zimbabwe, etc - were raised. In fact, some argued that instead of improving, these factors had become progressively worse and therefore could not be ignored. Other headwinds raised include the rising domestic current account deficit and the possibility that interest rates in the US could be raised much faster than expected.

When all was said and done they did agree that domestic equities, while no longer cheap in absolute terms, are expected to deliver good returns this year. But of course, this does not mean that they all agreed on which sector would win first prize this year. Will it be financials again or will the industrial sector exchange second place for first? Could the Rand surprise on the downside and bring resources back into the limelight?

Despite our view that domestic equities should once again deliver respectable returns, we believe that the "easy money" has been made. Accordingly, it is important to modify performance expectations from this asset class, especially in view of the fact that the market is now coming off a much higher base.

Because the same asset class cannot consistently outperform the others, we believe strongly in the merits of diversification across asset classes in accordance with one's personal risk profile. Finally, it is at times like these, when one asset class is clearly outperforming the rest, that it is never wise to "tilt" your portfolio in that direction at the expense of your personal risk profile.

In line with expectations, interest rates were increased by 25 basis points at the February meeting of the Federal Reserve.

The decision to raise rates by a quarter percent was unanimous and brings interest rates to 2,50%. This was the sixth consecutive increase since last June. Following on from the announcement, the Federal Reserve stated that "output appears to be growing at a moderate pace, despite the rise in energy prices and labour market conditions continue to improve gradually."

According to an economist from Dresdner Kleinwort Wasserstein "they are basically laying the groundwork for another rate hike in March and there was no surprise in today's hike or language."

Rates are expected to end the year at between 3,50% and 4%, provided the Federal Reserve observes their "measured" stance. This should serve to keep inflation benign, without limiting economic growth. The risks of an upturn in inflation have increased recently as a result of a combination of a weak US Dollar, low interest rates and higher commodity and oil prices. The environment of tax rebates and low interest rates supported growth in 2004, which is estimated at 4,40% for the calendar year.

Alan Greenspan's term as Governor of the Federal Reserve ends in January next year after a 14 year term and, with less than 12 months to go, there is much speculation about who will succeed him. Three candidates who are the most widely talked about currently are Ben Bernanke, Don Kohn and current Fed Vice Chairperson, Roger Ferguson.

Despite market pressure to cut interest rates, interest rates remained unchanged at 2% in the Eurozone. Inflation is still above the target level of 2% and there are growing concerns about the potential impact of a sustained high oil price on this number going forward. As stated in our last report, the European Central Bank still has concerns about liquidity and this would imply that the next move in interest rates is likely to by up. However these high levels of liquidity have been around for some time now, with no changes to interest rates.

The GDP number for 2004 is expected to be confirmed at 1,70%. This is fairly pedestrian when compared to the expected growth rates from the other economic regions.

Interest rates remained at 4,75% and have been kept on hold for the last six months (since August last year). Rates, which moved up by 1% during 2004, could still rise further during 2005.

The primary reason for this view is that inflation, although still under the targeted band of 2%, has risen steadily in recent months. In December CPI rose to 1.60% (remaining at this level in January), which is the highest rate recorded in six months. Factors contributing to this increase were housing, electricity, gas and water costs, which have risen by some 5,40%.

Deloitte, a City consultancy, do not agree with this view. They are forecasting a growth rate of 2% in 2005, which is well below the 3% to 3,50% forecast by Gordon Brown. They believe that interest rates should end the year at 4% and decline to 3,50% by the end of 2006. Substantiating this view is the slowdown in the housing market, which they believe could lead to a rise in unemployment and a drop in consumer spending.

According to Roger Bootle, Deloitte's chief economic advisor "whereas the main driver of the economy in recent years has been robust household spending growth, this is likely to suffer as the housing market slowdown gathers pace."

The latest mortgage figures released by the British Bankers Association indicate that the number of mortgages approved during December 2004 (40 201) fell by 38% when compared to December 2003 (64 563). Figures released from the Bank of England indicate, however, that new loans in December increased to 83 000, representing the first increase in loans since May. The contradictory figures released by the British Bankers Association and the Bank of England are concerning.

Slower capital spending in China, together with yen appreciation and a slowdown in consumer spending during the second half of 2004, contributed to a slowdown in exports over this period. Consequently, GDP declined by some 0,10% during the last quarter, pushing the Japanese economy back into recession (for the fourth time in 10 years). Typically, a recession is defined as "two consecutive quarters of negative growth". According to Heizo Takenaka, Economic and Fiscal Policy Minister, "the economy has some soft patches but if you look at the bigger picture, it is in a recovery stage. The economy must be assessed comprehensively and we cannot look at GDP alone".

A "soft landing" is expected in the Chinese economy in 2005 and this should be good news for Japanese exports. It is also anticipated that in 2005 Japan will see the end of deflation, which has prevailed for some eight years in the region. This would be positive for consumer spending. The positive impact of cost cutting and restructuring measures that have been underway for some time is expected to come through in corporate profits growth. While analysts were disappointed with the most recent figures, they remain upbeat, explaining that capital spending is on the increase and that "Japan's largest companies had been recording healthy profits". Driven by strong performance in the first half of 2004, Japan's economy grew by 2,6% last year and is expected to grow by some 2,1% this year, despite the negative numbers for the last quarter of 2004. A lot will depend on an improvement in global economies, combined with a fall in value of the yen and an increase in consumer spending. Interest rates are not expected to change in 2005.

The Reserve Bank Monetary Policy Committee (MPC) kept interest rates on hold at their most recent meeting in February. This was the third consecutive meeting that rates have remained unchanged. Following on from the announcement, the Governor said "the MPC will continue to monitor developments in the economy and the factors affecting inflation very closely and will stand ready to adjust the stance in either direction if necessary depending on the outlook for inflation." The following factors could impact negatively on the inflation target: "sustained strong growth in domestic demand, continued increases in money supply last year, the strong demand for bank credit, and the likely impact of external developments." According to the Governor, "the commitment by the government to fiscal prudence and of the public authorities to low administered price increases, moderation in the increases in food prices, and continued low inflation internationally" are all factors that are likely to contribute to the maintenance of low inflation over the next two years.

South Africa achieved GDP growth of 3,70% in 2004. CPIX averaged 4,30% for 2004, which is well within the target range of between 3% to 6%. CPIX has remained within this targeted band for the last 16 months.

The fundamentals in the domestic economy are looking favourable for respectable growth this year. GDP is expected to rise to 4,3% this year (from 3,7% in 2004), fuelled by low interest rates (at 24 year lows), low inflation and strong consumer demand. The strong consumer demand in the last quarter was primarily for imported goods (which have become cheaper due to the strong Rand) as well as the services sector of the economy, which is largely insulated from Rand movements. It is no secret, though, that the strong Rand has impacted negatively on the manufacturing sector, which has to operate in an environment of less profitable exports and cheaper imports.

The Rand ended the quarter at R5,81, R7,69 and R11,15 to the US Dollar, Euro and Sterling, respectively.

The annual budget speech held few surprises. The primary focus on spending "remains on uplifting the poor through strong welfare spending combined with improving delivery and infrastructure"

Moderate personal tax relief was announced, with the majority of this relief being focussed on the lower to middle income groups. The interest exemption for under 65's increases from R11 000 to R15 000, while for taxpayers over the age of 65 the exemption increases by R16 000 to R22 000. The foreign dividend exemption increases to R2 000. The tax brackets have been adjusted, with the top threshold increasing from R270 000 to R300 000. The top marginal tax rate (currently 40%) remains unchanged. The Primary Rebate increases to R6 300. The tax threshold for under 65's increases to R35 000 (an 8,6% increase), while for over 65's the tax threshold increases to R60 000 from R50 000 (a 20% increase).

Many were disappointed that retirement tax is to remain at 18% and that exchange control relaxation remains on hold. In a surprise move, company tax rates have been reduced to 29% from 30%. This should improve competitiveness over the medium to long term. The threshold for transfer duty increases from R150 000 to R190 000 effective 1 March.

The oil price edged higher during the quarter under review. On 28 February 2005 the oil price was $50.14 a barrel, compared to $44.87 at the end of November 2004. At a meeting on 30 January 2005 OPEC agreed to keep output levels unchanged (currently at 27 million barrels a day). In addition, it was agreed at the meeting to abandon the $22 to $28 target price band set in 2000. According to Yasser Elguindi of Medley Global Advisors, "oil prices are high but the US economy hasn't skipped a beat and the weaker dollar has insulated many growing economies from the shock." Saudi Arabia, on the other hand, have indicated that they are planning to increase capacity by a further 1,5 million barrels per day within the next 4 years. It is interesting to note that Chinese imports of crude oil, which in 2004 played a key role in the rise in the oil price, decreased by 24% in January compared to the same time last year.

The gold price ended the quarter significantly lower at $435-85 compared to a close of $453-25 at the end of November 2004. In a Commodity View report written in January, HSBC expect gold to be the only metal to have a higher average price in 2005 ($455/oz) than in 2004. In fact, in the second half of the year they indicate that it is possible for the gold price to exceed $500/oz at times. Improving fundamentals and the fact that gold is seen to have the "strongest negative correlation with the dollar" supports their view.

On the whole 2004 was a good year for equities both locally and internationally. The local FTSE / JSE ALSI returned 20.42% in Rand terms, while on the international front, the MSCI World index returned 15.30% in US Dollar terms. The S&P 500 and the FTSE 100 posted returns of 10,90% and 19,30%, respectively, in US Dollar terms. Bonds, on the other hand delivered mixed performance. World growth is expected to slow to about 3,1% in 2005 in an environment where global imbalances are likely to remain.

In the UK and the US interest rates appear to be in an upward trend, while in the Eurozone and Japan interest rates remain on hold. Back at home, there is a strong call for a further cut in interest rates this year.

Again we stress the importance of diversification, and, as pointed out in our lead article, when one asset class is clearly outperforming the rest, it is never wise to "tilt" your portfolio in that direction at the expense of your personal risk profile.

QUARTERLY QUOTE
"If all economists were laid end to end, they would not reach a conclusion"
George Bernard Shaw

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.