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Reflections on a new decade – will the sharp fall in interest rates lead to a repeat of last decade’s bull run?

19 July 2010 Marriott Asset Management
Duggan Matthews

Duggan Matthews

Duggan Matthews, an investment professional at Marriott Asset Management, thinks not.

2010 has arrived and with it, the start of a new decade. Much has changed in South Africa during the past 10 years and, on reflection, much has been achieved. The quality of life for the majority of South African has improved dramatically. Unemployment has been reduced from 36% in 2000 to 25% in 2010. The homes we live in have doubled in value and inflation has, for the most part, been successfully contained. The profits of small businesses and listed companies have grown at unprecedented rates and the value of the JSE All Share Index currently stands at around 28,000, an increase of about 235% from 8350 measured 10 years ago, despite the impact of a global recession.

Like the dashboard of a motor car keeps the driver informed about the engine’s condition, the stock market is a reflection of the state of our economy. It is therefore not surprising that the majority of sectors represented on the JSE have, until most recently, performed very well. Long term investors have generally been rewarded for the level of risk associated with their investments and volatility has (for the most part) been relatively low.

Investors now face the question of what to expect for the next 10 years, or at least five – the generally accepted period for “long term investing”. Is it reasonable to assume we will achieve a similar level of prosperity and wealth creation going forward?

On first glance the right ingredients seem to be in place. The beginning of the previous decade was characterized by high inflation and high interest rates, much like our recent experience. Monetary policy proved effective and inflation was quickly contained, with the corresponding rapid reduction in interest rates. What followed was a five-year period of extraordinary stock market performance. Investors were seldom disappointed and asset managers attained celebrity status. In 2000 there were 100 unit trusts, today there are nearly 900.

 (Click on image to enlarge)

Looking at the chart above, it is apparent that the reduction in interest rates by the SA Reserve Bank is almost identical in both periods. In 2003, the South African Reserve Bank slashed the repo rate by 550bps in the space of 6 months and in 2009 the Reserve Bank cut rates by 500bps over 9 months. Five years on from the first interest rate cut in 2003, bank lending in South Africa had quadrupled. Unemployment was 10% lower and the stock market had risen by a cumulative 350%. With a similar recent reduction in rates (both in magnitude and rate of decline) we must wonder if we are now in a position to predict what lies ahead for our investments with that much more confidence. Is the biggest risk facing investors currently that of missing out on “promised” returns?

These questions and conclusions are natural responses when faced with a similar significant event. However, apart from the similarity in monetary policy there are a number of fundamental differences between the 2003-2008 period and the investment outlook for next five years. These differences include:

  1. Reduced access to credit
  2. Reduced appetite for credit
  3. Slower job creation
  4. Higher cost of energy

Over the long term, the biggest driver of stock market performance is earnings growth. The importance of these four factors and their potential impact on investor returns should therefore not be underestimated as a result of their impact on companies’ profitability.

  1. Reduced access to credit

The National Credit Act (NCA) was introduced in South Africa in 2007 to protect borrowers from over-indebtedness. One and a half years after the act became fully operational in South Africa, the SA Reserve Bank began cutting interest rates in an effort to encourage borrowing and increase consumer demand in response to SA’s first recession in 17 years. We are now five months into 2010 and bank lending is less than it was a year ago! An unintended consequence of the NCA is that it has worked against our Reserve Bank’s best efforts to stimulate lending by making it harder for willing borrowers to gain access to credit.

  1. Reduced appetite for credit

In 2003, the average debt level of a South African household equated to 50% of the household’s annual disposable income. Just before the onset of the global credit crisis in 2008 that ratio had increased to 80%. With the impact of the increased financial burden of higher interest still fresh in the consumer’s mind, combined with increased job insecurity, this rising trend is likely to reverse.

The long-run implications of a more subdued credit environment on businesses is that debt fuelled consumption will be reduced. Private Sector Credit Extension averaged above 15% during the 2003-2008 period. This level of lending seems unlikely for the next five years which will affect all businesses profitability, none more so than our banks.

  1. Slower job creation

In 2003, unemployment in South Africa stood at 31.2%. Five years later, this number had been reduced by just under 10%. Never in SA’s history have jobs been created at such a staggering rate. Unfortunately, though, since the onset of the 2009 recession 400,000 formal jobs have been lost. A quarter of our labour market is currently unemployed – an unacceptably high number.

An unfortunate reality of a financial crisis is its long term implications for job creation. A Reinhart and Rogoff paper (January 2009) showed that the aftermath of a financial crisis and consequent recession resulted in the unemployment rate rising on average by 7% and taking between four and five years to recover. Although it is debatable whether this average trend in unemployment experience by countries recovering from a financial crisis will apply to South Africa, an expectation of a similar 10% reduction in unemployment over the next five years seems highly improbable. This will affect all businesses’ profitability.

  1. Higher cost of energy

Since 2003, the dollar price of oil has doubled in real terms. In 2012, the price of electricity is projected to be 65.85 cents per kilowatt, three times greater than the level South Africans paid for electricity in 2003. Considering that electricity and transportation costs are factors involved in the production of the majority of goods and services in South Africa, the impact on company margins needs to be considered, as smaller margins will result in reduced earnings growth.

As we progress into a new decade investment professionals, financial advisors and all those looked upon for their financial expertise have the additional responsibility of managing their clients’ expectations. It is important to remember that past performance is never an indication of future returns. When forming capital market expectations a careful analysis of investment fundamentals is unavoidable. After such an analysis it is apparent that the South African investment landscape has changed and an overly aggressive pursuit of “promised” returns should be guarded against.

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