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Investment Solutions: Is the party over?

12 July 2006 Glenn Silverman, Global CIO, Investment Solutions

In February this year I discussed the amazing global prosperity boom taking in place in the world and how this was benefiting emerging markets in general & SA in particular. I then described the 3 Cs driving SA growth: the Commodity cycle, the Consumer cycle & the Construction cycle. Finally I asked when the police (central bankers) would be called in to control the party and cautioned that the party was close to or beyond midnight ie. the party was long in the tooth and cautioned about excessive optimism, especially in SA where equity valuations were looking a bit stretched.

It would seem that someone was listening. In the space of the past 12 months no fewer than 32 central banks have raised their official interest rates, with SA being one. Increased global inflation concerns and a wave of hawkish central bank responses have unsettled markets. The US Federal Reserve has now raised rates by 0.25% at each of the last 17 consecutive meetings, taking policy rates to 5.25%.

Expectations for synchronized global monetary policy tightening have unsettled investors. Rising equity markets both developed and emerging came under pressure, but the emerging market index has fallen far more sharply 20% from their peak vs the 10% of the developed markets. Equities have since recovered marginally from these levels. Those perceived to be higher Beta (more geared to economic growth) or closely tied to the commodity cycle, especially those with perceived over-valued currencies and large current account deficits, like SA, have been amongst the harder hit.

The alcohol (ie. excess stimulation in the form of low interest rates) is slowly being withdrawn from the party (world economy) in an attempt to calm the revelry and noise making. At present this is simply in the form of less alcohol being supplied ie. excess liquidity is being drained from the system, as opposed to a total withdrawal of alcohol in total ie. overtly tight/restrictive monetary policy.

The problem is that the transition from the one to the other can be quite subtle, but the impact quite dramatic. The US remains the lead player, with other central bankers necessarily taking a lead from Bernanke. What is clear is that a co-ordinated programme is in place and that higher interest rates globally seem on the card for some time into the future. Rising interest rates are rarely ever supportive of economies or markets and concerns are growing about future growth prospects especially into 2007. Interest rate hikes take some time before they impact on the real economy and hence the seeds are already being sown for the slow-down, and the key question is whether there will be a policy error resulting in too high interest rates and a sharp fall in growth and company earnings.

The valuation of international equities seem to already imply this as the most likely outcome. The MSCI 12-month forward PE ratio is currently 13.5 times, cose to its best level since the early 1990s and well below the peak levels of 25 times at its peak in March 2000. This seems to be a bit extreme giving neither central bankers nor corporates much credit for the recently delivered impressive growth levels.

We have often commented that SA is a small boat in a vast ocean. Global forces create waves that knock us about. We need to ride and react to these rather than thinking we can steam our way through. Will our oft quoted virtuous cycle be able to withstand the shocks ie. will the current global turmoil which has engulfed emerging markets and SA, undo all the good work seen overt the past few years ? We strongly think (and hope) not.

SA has undergone much structural change. It is in a far healthier position in so many respects low government deficits, low borrowings (corporate, government and corporates), $20bn net reserves (vs deficit of $23bn as recently as 1998). SA is better positioned today than in any time in its history to deal with the inevitable exogenous shocks emanating from the global environment.

There are though some excesses and imbalances in the system and these do create some risks. SA too shows some signs of excessive risk taking and over confidence. Our property market has run hard, as has the stock market. Consumers have taken debt levels up significantly (from 52% in 01 to 68% in 06). A period of lower growth or even some retrenchment is called for. The SARBs response of raising interest rates in 8th June (note: along with 4 others on the same day) seems entirely appropriate, importantly to sustain rather than to abort the cycle!

Nothing goes up in a straight line, the economic cycle still exists and periods of ocean turbulence are guaranteed. It is simply our ability to withstand the waves which has been enhanced. Whilst the growth in consumer spend will of necessity slow, the construction spend (infrastructure rather than housing) will continue for some years to come. Welcome to the global village. Hold tight its going to be a helluva ride !

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