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SA equities still offer good returns despite strong bull run

30 January 2007 Old Mutual Investment Group SA

Although South African equities are no longer offering excellent value after a strong four-year bull run, this asset class is still likely to provide superior returns in 2007 and beyond relative to other local asset classes, and so should certainly comprise part of a diversified investment portfolio, according to Peter Brooke, head of Old Mutual Macro Strategy Investments.

Last year the FTSE-JSE All Share Index (ALSI) returned 41.2%, exceeding all forecasts as most commentators had expected a slowdown after three years of vigorous growth. The market rerated substantially versus its offshore counterparts, attracting record foreign inflows and finishing the year at a price-earnings ratio (PER) of 17.3 times versus 15.8 times at the end of 2005.

"The bull market we are experiencing is already the second longest and second strongest in SA history. On both an historic and forward basis, our market PER is high and it could go even higher - everything depends o­n global market sentiment," says Brooke. 

"This rerating is likely to point to lower returns ahead. Based on our own research and analysis and prospects of a slowdown in corporate earnings growth, going forward we expect equities to record a return of around 12% o­n a sustained, longer-term basis."

Although this may seem disappointing compared with the returns delivered over the past four years, it is still attractive relative to the longer-term returns likely to be generated by the bond and money markets, Brooke points out. "Over the longer-term we expect cash to yield 6% to 7%, while bonds should yield about 8%, as inflation continues its structural decline. Equities will certainly outperform these numbers."

He notes that, given the low savings rate, South Africans do need the higher returns offered by equities but they actually have much lower exposure to equities than their US counterparts. Whereas US unit trust investors have close to 60% invested in equity funds, SA investors have a much lower 29% invested in general equity funds.

Over the past few years, SA investors have preferred to go into asset allocation funds and, with market valuations relatively high at present, Brooke says these actively-managed, diversified investments are likely to provide the most appropriate risk-return balance for investors over the nearer-term.

Asset allocation funds offer the individual investor access to a fund manager's skill and ability to take advantage of market opportunities. For instance, last year the Macro Strategy Investments team increased offshore exposure early in the year, a position that benefited from later rand weakness, and, when listed property was sold off sharply, they increased exposure to the asset class, a decision that also paid off handsomely. "Strategically, the real value for investors came from maintaining a high allocation to property and equity throughout the year," says Brooke.

He believes the biggest single short-term risk to the SA equity market in 2007 remains the possibility of widespread foreign selling, which would not o­nly undermine market values but adversely impact the country's already large current account deficit and triggering a vicious cycle. However, longer-term prospects for emerging equity markets continue to look favourable given their stronger growth prospects than developed economies.

Old Mutual Investment Group SA (OMIGSA) Chief Economist Rian le Roux expects the current account deficit to narrow moderately this year, thanks to lower global oil prices cutting SA's import bill and a weaker rand boosting export receipts. 

In spite of an expected slowdown in global economic growth, he believes the global environment is set to remain SA-friendly in 2007. Some concerns exist over the possibility of aggressive central bank monetary policy tightening, but inflation remains structur ally low globally, so there is little likelihood of significant interest rate hikes.

"In the US, still a key driver of world economic growth, the net worth of consumers is still intact as the rise in equity prices has almost completely offset the fall in property market values over the year, meaning that consumer spending is not likely to be impacted as much as some commentators fear," says Le Roux. "Indeed, real personal income growth has been solid.

"The global risks to SA are that the potential deceleration in global economic growth has been underestimated, that central banks are overly aggressive, and that commodity prices collapse."

In SA, Le Roux says the key surprise during 2006 was the strength of domestic consumption and investment, while capital inflows also surprised o­n the upside. This spending boom led to a sharp widening in the current account deficit, a weakening in the rand and, in turn, higher inflation. These developments triggered the SA Reserve Bank's (SARB) tightening cycle but also contributed to the country's very healthy fiscal policy, he points out.

His forecasts for 2007 are for SA household spending to slow somewhat from the heady 7% increase seen in 2006 to 5%, still a robust level as growth in real disposable income remains strong at about 5%.

"Although many commentators are concerned about the rising interest burden o­n consumers, it is still not nearly at the peaks seen in the past," notes le Roux. "Meanwhile, consumer debt-asset ratios are actually lower, so households' net worth has actually improved. This indicates that households are not nearly in as much trouble as many think."

Le Roux expects SA's growth in gross domestic product (GDP) to slow to 4.5% in 2007 from an estimated 4.9% in 2006, while the current account gap should narrow to 5.2% of GDP from 5.8%. He is forecasting a moderate weakening of the rand over the year to R7.50/$ by year-end, and, after peaking below 6% in the next few months, CPIX inflation is set to drift lower to end the year at 4.8% compared with 5.1% in December 2006

As for interest rates, Le Roux says the SARB may hike the repo rate by 50 basis points at its February meeting, but that this is likely to be the last increase in the current cycle - providing global conditions do not deteriorate dramatically or that unexpected local cyclical balance of payments or inflation pressures do not force the SARB to take rates even higher.

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