All of us, at some time or other over the past three years, will have questioned the rationale of being invested in local and international markets. The current bear market, which began in March 2000, has been fuelled by one event after the other. First there was the bursting of the TMT (technology, media and telecommunications) bubble in March 2000, followed by the horrific events at the World Trade Centre in September 2001. 2002 was the year marked with worldwide corporate and accounting scandals – although these scandals were most prevalent in the United States of America. So far in 2003, we have witnessed the American led war against Iraq as well as the outbreak of the much-talked-about SARS virus. Although the world is relieved that the war appears to have been resolved swiftly and without the use of weapons of mass destruction, the negative impact on investor sentiment leading up to the event was significant. Compounding these events, for those of us who are invested offshore, has been the strong recovery of the Rand from its lows of R13,85 to the US Dollar reached on 21 December 2001.
These events have provided investors and markets alike with continued uncertainty since March 2000 and, the one thing that markets and investors do not like is uncertainty. It is important therefore, that in volatile times like these, we to go back to basics. We should remind ourselves of the reasons for being invested, as well as the time frame determined at the inception of each investment. In addition, we need to establish whether our personal risk profile has changed since placing each investment. Most importantly, though, the benefits of a well-diversified portfolio need to be remembered (taking a holistic view of your entire portfolio, including assets such as your property and cash).
The diversification of an investment portfolio is key from an asset allocation, currency and global perspective. Global investment markets are constantly being impacted on by change (although the events of the last three years need to be viewed as being somewhat extreme), whether this is brought about by monetary or fiscal measures (eg tax cuts / interest rate movements) or an event (eg recent war against Iraq, the events of the World Trade Centre etc) – these changes will in turn impact in various ways on the asset classes (equities, bonds, cash, property and alternative strategies/hedge funds). Each of these asset classes will react to a change in the market, and because they will not all react in the same way, the benefits of a portfolio comprising all or most of the asset classes becomes evident. While bonds have generally posted respectable returns during the current bear market, equities have struggled. With interest rates offshore reaching lows not seen in decades, it stands to reason that offshore cash returns have become much less attractive, while domestic cash returns have been favourable due to the high interest rates currently prevailing locally. Alternative strategy funds / hedge funds, with their ability to make money in both bull (rising) and bear (falling) markets due to the various investment strategies used, have proved to be valuable holdings in portfolios over this volatile period.
To illustrate the dangers of being invested in a single asset class during the course of the current bear market, let us take domestic cash as an example. Cash is considered to be “king” in times of market volatility and many with hindsight will have wished that they had held their entire portfolio in cash over this period (this is often termed “a flight to quality”). The chances are, however, that your portfolio would still have delivered a negative return. For the purposes of this example, let us use a domestic money market rate of 12.50% and an inflation rate of 11.90%. Your “real” return would have been approximately 0.60%, which although positive, is not nearly as good as you would have first expected (based on a real return of 0.60%, it would take 120 years to double the value of your money). However, this return is before tax – once income tax has been deducted from your interest income, the probability is high (especially if your entire portfolio were invested in cash) that the overall net real return would have been negative. In addition to that, with markets having staged a brief rally over the last few weeks, your entire portfolio (which we assume to be in domestic cash for the purposes of this example) would have missed out on this upward movement in the market. Furthermore, there is the question of when to reinvest in the various asset classes in order that your portfolio can once again be structured toward either wealth enhancement or wealth preservation. I know that many will want to challenge this example for being too simplistic and quote the negative returns delivered by some of the other asset classes over the same period, but the purpose of this example is to simply illustrate that no single asset class would have delivered the desired returns and that cash, on its own, is not always the logical solution.
With a blend of asset classes (equities, bonds, cash, property and alternative strategies), currencies and international exposure that are in line with your personal risk profile, a diversified portfolio should serve as a buffer to the constantly changing international markets over the medium to long term.
UNITED STATES OF AMERICA
The Federal Reserve left short-term interest rates on hold at their meeting on 6 May. Rates are currently at 1.25% – their lowest level in 42 years.
The US Dollar remained under pressure during the quarter, despite the news from the United States of America not being “all bad”. A weaker US Dollar makes USA goods more competitive overseas, while at the same time it keeps prices higher in the United States. This in turn gives companies an element of pricing power (thereby boosting corporate profits). On the downside, however, a weaker US Dollar reduces the buying power of domestic consumers. The US Dollar experienced a seven-year rally from the middle of the 1990’s to early 2002, appreciating by some 47%. The currency was driven by the boom that took place in the United States during the mid to late 1990’s and into 2000, as well as the flight to safety (to USA assets by the rest of the world) prompted by the events on 11 September 2001. Since peaking in early
2002, the US Dollar has retreated by some 20% against the other major currencies, prompted to a large degree by the risk of further terror attacks, corporate and accounting scandals in 2002 as well as an attempt by the Bush administration to “talk the Dollar down”. Despite the recent weakness, many Americans remain confident about their currency. In the words of an equity strategist from BNP Paribas “The United States is the world’s leading country in terms of markets and economy. Even if the dollar continues to decline, the United States will continue to be the leader, and the US stock market will continue to lead European stock markets.”
First quarter GDP growth in the USA came in at 1.6% quarter on quarter, annualised, compared to 1.4% quarter on quarter in the fourth quarter of 2002. Corporate profits, which surprised on the upside over the quarter, grew on average by between 12% and 15% during 2002. More than half of the companies posted better than expected returns. The consensus forecast for GDP growth for 2003 is 2.5%, increasing to 3.4% in 2004.
The European Central Bank (ECB) reduced interest rates by 0.25% at their meeting in March, bringing rates in the Eurozone down to 2.5%. Despite European Central Bank President Wim Duisberg having been quoted at the May meeting as saying “looking ahead, we continue to expect a gradual strengthening of real GDP growth to start later in 2003 and to gather more pace in the course of next year”, it is expected that interest rates will be cut at the next ECB meeting in June. In addition, inflation is currently benign and within the target range, which should further support a rate cut in June.
During the quarter under review the Euro (largely as a result of US Dollar weakness) exceeded its launch value of $1.1747, despite certain areas of economic weakness within the Eurozone region (ending the quarter at 1.18 to the US Dollar). A stronger Euro, which results in exports from the Eurozone becoming more expensive, makes the region less competitive with its trading partners. This is not good news for exporters in the Euro-zone as this has a negative impact on foreign demand.
The Bank of England kept interest rates on hold at 3.75% at their May meeting, after cutting rates by 0.25% in February. Domestic economic expansion remains weak, following disappointing first quarter GDP growth of 0.20% for the region. The main reasons cited for this slowdown in growth are mediocre consumer spending, a fall in investment spending and a slowdown in the property market. Inflation, which is currently at 3% (and at a 5 year high), is above the Treasury’s target level of 2,5%. The 0.30% increase in inflation since last quarter can largely be attributed to the sharp increase in the price of crude oil preceding the war on Iraq.
In an interesting development towards the end of May, Chancellor Gordon Brown stated that, in his opinion, the United Kingdom is still not ready to join the Euro, indicating that the country has failed to pass the five economic tests for joining the currency. The key economic test was whether the “UK economy has converged sufficiently with the Eurozone and whether that convergence was sustainable”. The second test looked at “whether there is sufficient flexibility in the UK economy to cope with economic change”. The last three tests considered the potential impact on financial services, jobs and on foreign investment, should the United Kingdom join the Euro. A final decision is expected from Government on 9 June 2003 as to whether this issue will be delayed until after the next elections (2005/6) or whether a referendum is likely to be held
As stated in previous reports, the Japanese economy remains troubled and continues to be plagued by deflation. The recent appointment of Mr Fukui as Governor of the Bank of Japan, who is widely known for being a “moderate” in the ongoing debate about deflation, was not received well by the markets. Both the market and investors had hoped that the new Governor would have been a person who adopted a more extreme anti-deflationist stance.
An upturn in Japan is still largely dependent on exports and foreign demand, as this economy is almost solely reliant on foreign demand. Domestic spending is unlikely to be stimulated until the government and the Bank of Japan are able to successfully address the bad debts of the banks, while at the same time ensuring monetary expansion. The current GDP growth forecast for 2003 is 0.20%, increasing to 0.70% for 2004
SOUTH AFRICA
At the time of writing our last report, the consensus view was that domestic interest rates would be cut by some 3% during the second half of this year. While the market is still expecting an interest rate cut at the June meeting of the Monetary Policy Committee, views are now divided as to the extent of the cut. The one view is still that we are likely to see three 1% cuts between June and December this year. The other view is that, if there is a rate cut in June, it is likely to be less than 1% and that rates are expected to decline by 3% to 4% over the next 12 months.
Towards the end of May John Stopford of Investec discovered that rental inflation numbers, which form part of CPIX, may have been overstated. In his opinion, this could have had the consequence of overstating CPIX by between 1.5% and 2%. The ramifications of such a miscalculation are enormous – just think of the following. the majority of wage increases and corporate deals are based on inflation: the four 1% interest rate increases last year to stop rising inflation; the negative impact on domestic growth: the impact on the exchange rate as a result of foreign inflows (which fuel Rand strength) into our interest markets. It was announced on 29 May 2003 that the data would be revised back to January 2002.
In April, CPIX (which is used by the Central Bank for monetary policy purposes) came in at 8.5%, which is marginally lower than the revised March figure of 9.3%%. CPI slowed to 8.8% from the revised 10.2% in March 2003.
The Rand, which has rallied strongly off the lows of R13.85 to the US Dollar reached on 21 December 2001, touched a 32-month high (R7.05) against the greenback on 28 April 2003. One of the factors that have contributed to Rand strength has been the continued wide interest rate differentials, which have served to attract foreign inflows into our bond and money markets. In addition, the perceived delay in the reduction of interest rates (at the March meeting of the MPC) sent a message to investors that our interest rates may stay higher for longer, which in turn, served to attract further inflows into interest sensitive instruments.
Over the quarter under review (1 March 2003 to 31 May 2003) the Rand depreciated by 0.94%, 5.64% and 11.39% against the US Dollar, Sterling and Euro, respectively. In our last report, we listed some of the factors that could put pressure on the Rand in the coming months. In addition, following on from the latest budget speech, institutions were once again able to apply to remit funds abroad from 1 May. The Rand retreated by 2.8% on the first day on which these applications could be submitted to the South African Reserve Bank.
With the Rand having gained some 40% last year (and with every 10% gain having the same effect as a 1% increase in domestic interest rates), together with the 4% increase in interest rates, domestic consumers and businesses are feeling the pinch. A further consequence of Rand strength is the expected impact on South African GDP growth, which is expected to slow to 2.8% in 2003 from 3% in 2002. This is already evident in the 2003 first quarter GDP growth, which slowed to 1.5% quarter on quarter compared to 2.4% growth in the last quarter of 2002. Conversely, Rand strength has been one of the drivers in reducing domestic inflation
For those of us who have been concerned about our domestic inflation rate, spare a thought for our neighbours in Zimbabwe, where their forecast inflation rate for 2003 is 450% (up significantly from levels of around 58% in 1999). In addition, their GDP growth rate is expected to decline to levels of minus 15% this year, compared to a mere minus 4.1% in 1999.
GENERAL
The price of Brent crude declined by more than 20% during the quarter, primarily as a result of the speedy resolution to the USA led war against Iraq. The price of Brent crude oil ended the quarter at $26.51 per barrel.
The gold price rose by 5.54% during the quarter under review, increasing from $346.75 an ounce to $365.95 an ounce. The weaker US Dollar, together with renewed interest in gold as an alternative investment option (as a store of wealth) are some of the main reasons for the gold price reaching these levels.
Global markets, which ended the quarter on an encouraging note after posting good returns during April and May following the speedy resolution of the USA led war against Iraq, delivered the following performances:
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DOW JONES
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S&P 500
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FTSE 100
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EUROSTOXX 50
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NIKKEI 225
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NASDAQ
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+10.48%
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+13.42%
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+14.39%
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+9.81%
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+0.19%
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+18.80%
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During the next quarter (June, July and August) it will be interesting to see whether the Euro will continue its recent rally against the US Dollar should the European Central Bank decide to cut interest rates, and whether or not this news would serve to give the US Dollar a much needed boost.
The ALSI ended the quarter slightly up, after posting a return of 2.38%.
In conclusion, we are pleased to announce the launch of our website www.finlaw.co.za We encourage you to log on to the website where you will find a range of interesting information, including links to interesting articles that are updated daily. In addition, you are able to access and read our Quarterly Economic Reports.
QUARTERLY QUOTE
“To invest successfully over a lifetime does not require stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” preface to The Intelligent Investor, Benjamin Graham, (1973)
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.
