Global CIO comment

It seems that, more often than not, one writes an article at a time when the world economy or financial markets appear to be at some delicate or critical “turning point”. However, with the benefit of hindsight, it is rare that the “world ends” and, with few exceptions, some months later it looks not so dissimilar to what it was before! Nevertheless, as a strategist, which I partially regard myself to be, laying yourself open to possible future ridicule comes with the territory, so here goes:

In the international arena, the key issues are:

· Does the US housing cycle turn vicious, driving down all world property markets and possibly tilting the US into recession?

· How bad does the banking “crisis” get, sub-prime or other, and how global is its spread?

· If things do worsen in the West, can the East and emerging economies, currently driving world growth, “de-couple” and party on? How do commodities react to this?

· Just how much froth/exuberance is there in financial markets and how are markets priced for the above?

· How do managers position themselves and fare in this environment?

I won’t necessarily respond to each point, and my crystal ball is no more reliable than others, but here are my key take-away points on the issues:

· The US housing downturn will continue for some time -- it is a multi-year event. It will likely affect other property markets, but the effect will lessen as the distance from the “epicenter” increases. The UK market does seem one that is more at risk.

· It seems more probable that a US, and hence a global recession, can be avoided. Central bankers have been fighting tooth and nail to prevent it happening by cutting interest rates and injecting more liquidity into the system. This is set to continue.

· My take is that the extent of the banking crisis will be better assessed by about mid-2008, by which time most of the adjustable-rate mortgages in the US will have kicked through. Until then, it’s premature to think there is no further bad news ahead. Banking stocks globally look cheap but much uncertainty remains regarding the size, scope and depth of the problem. Certain credit markets have “frozen”.

· It appears de-coupling is already occurring with, for example, more Chinese exports going into the rest of Asia than to the US! It looks like there is some margin of safety, and that emerging markets won’t come crashing down as they did in 1997. The fundamentals are much stronger now.

· There is increasing evidence of froth in the global system -- Chinese “A” shares, i.e. the local retail shares, some on 100x price: earnings multiples, housing prices in certain regions (though increasingly under pressure), excess credit extension/indebtedness in the West, possibly some commodity prices, the over-use (abuse?) of leverage/derivatives in certain areas etc.

· The global equity markets, though, with few exceptions, don’t yet look “over-cooked”, though the risks are clearly rising. While there has been a spectacular bull market for more than four years, the primary driver has been the huge growth in corporate earnings and margins. Hence, we have an averagely priced market, but on peak earnings/margins, which could still make it vulnerable. Current sentiment very much favours a “don’t fight the Fed” approach, i.e. when central bankers cut interest rates, as is the case in the US at present, equity markets tend to do well. We maintain an overweight equity position, locally and globally, but stick with our view, that the risks are increasing, and that the “easy money” has unquestionably been made. We are well into this bull market.

Now what about South Africa? What is discussed above will clearly have consequences for this country, and there are some signs of excess, too. The economy is in great shape, consumer and business confidence is high, property prices have been soaring (though, as in other regions, are now starting to stall), the tourists are coming (and staying) and we even brought the Webb Ellis trophy home. The party is getting a bit late in the day, though -- there is an inflation wobble (though we view this as a short-term, cyclical one), and although the effect of the recent interest-rate increases still has to be fully felt, the consumer is undoubtedly under pressure, as is the residential housing market. At the same time, this is most likely a cyclical downturn in a structural upturn -- the construction-led boom will play out over many years, the unleashing of the full human capital inherent in South Africa, post-apartheid, the opportunities for the South Africa economy throughout emerging Africa etc, should sustain the country for some time to come. And that’s before the Chinese spend the $1 trillion of reserves in Africa and elsewhere!

As for the local equity market, we, too, are well into our bull market, though it’s hard to say if we are 60%, 80% or 95% of the way there -- I certainly think it’s over 50%. We have been taking profits whenever the climb becomes too “vertical”. In the company’s key private-investor offering, the hedge that provides much market downside protection has been extended.

Predicting manager performance, as opposed to manager quality, is becoming an increasing challenge. The former is becoming increasingly binary. For example, we track certain quality global managers, typically Value managers, which on valuation grounds have gone very overweight global financial stocks and seen their performance fall dramatically behind benchmark, sometimes by 10% and more in just six months, as these shares have been hammered. Is it a case of bad manager or bad portfolio? Very few clients give them the benefit of the doubt, though we and our manager-assessment system try to look through this, though it’s become an increasing challenge. In South Africa, this is most notable in the portfolios, again typically high-quality Value ones, which are well represented in our portfolios, yet which have not held, or been very underweight, Resource shares. Solid, very defensible arguments are made to support any view!

The company is seeing some divergence in the views of its local managers, with some staying fully invested for the “last dance”, while others have started reducing their exposure -- though still cautiously at this stage. Assets under management across the industry have grown strongly, as have profits, so bonuses have been good. Some have decided to “hop it on their own” and start their own investment-management firms, often in the form of hedge funds. We have tracked 27 new “long-only” start-up firms in the past three years alone. Growth in assets is great for profits but can retard good alpha (outperformance of the benchmark), so it is necessary to be more vigilant than ever in this regard. This will be a key focus.

The assets under management of the UK business continue to grow strongly. We are embarking on a number of new product launches that should be of more than passing interest to UK and SA clients and consultants.