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Equities will continue to benefit from low interest rates and reasonable valuations

01 August 2012 Francois van der Merwe, Head of Macro Research at Novare Investments
Francois van der Merwe, Head of Macro Research at Novare Investments

Francois van der Merwe, Head of Macro Research at Novare Investments

While similarities have been drawn between the current global economic slowdown and the one that took place last year causing equity markets to tumble going into the second half, there are major differences that might explain why we are not heading down

Commenting on his economic report for the second quarter of 2012, Francois van der Merwe, Head of Macro Research at Novare Investments, said: “Firstly, there is no major central bank currently engaged in tightening monetary policy. Last year, many emerging market banks were tightening policy to combat rising inflation.

“Today, these banks are cutting interest rates and, in developed economies, central banks continue to apply unconventional measures to keep monetary policy accommodative. Secondly, commodity prices are off the highs reached in 2011 with the reduction in the oil price bringing welcome relief.”

Novare Investments continues to hold the view that three key issues will shape markets in 2012: the European debt crisis, the fiscal position and strength of the US economy, and the Chinese economy’s ability to avoid a severe slowdown. None of these have escalated, but they have also not yet seen a vast improvement.

There are signs that the Chinese economy will be on a firmer footing in the second half of the year. And European officials have been making the right noises in terms of credible solutions to the sovereign debt crisis which has the economy in the grips of recession. For this reason European equities are trading at an all-time discount to US equities.

The US economy has shown some signs of weakness due to the European crisis, as well as fear over the looming “fiscal cliff”. The latter will involve politicians either allowing current policy to go into action at the end of this year, including spending cuts and tax increases, or to negotiate a cancellation of some of these provisions, which would add to the deficit and potentially cause the US to go the same route as Europe.

Said van der Merwe: “If current policy proceeds as planned, it could shave as much as 4% off of US GDP growth next year. The political background makes it unlikely that politicians will agree on the necessary steps to be taken, and there is the uncertainty over presidential elections in November.”

He added that the slowdown in employment, retail sales, manufacturing and inflation might force the US Fed’s hand in announcing quantitative easing in the second half of this year. That would provide a temporary boost to asset prices.

The good news out of the US includes a turnaround in the housing market and a healthy corporate sector benefitting from record low borrowing costs. Although the economy is not expected to perform strongly, Novare does not foresee it going into recession.

“The global environment of low interest rates, low inflation and reasonable valuation levels should benefit equity prices, but many risks remain that will create near term volatility in financial markets. With the risk for policy error high, the imperative is for decision-makers to make the right choices.” said van der Merwe.

“Within the fixed interest environment, we continue to favour corporate bonds that are trading at attractive spreads over government issues. Corporate health is improving and the excess return adequately compensates for the level of risk being taken.”

Although the domestic growth outlook remains bleak and confidence levels low, company profits are growing at a healthy pace and equity valuations remain undemanding. Domestic equities are under-owned by both international and local institutional investors.

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