The investment horizon – A review of 2010 and the anticipated road ahead for 2011
As the end of 2010 draws near, the cyclical bull market for equities remains intact despite very obvious risks to the trend. Globally, equity markets continued a cyclical recovery in 2010 amidst fears of a double-dip recession and sovereign debt problems. Although equity markets started the year sluggishly, traction came in the second half of the year as companies globally produced better than expected earnings and fears of a double dip recession started to fade.
As we enter the new decade many of the unresolved economic concerns are still relevant and will continue to weigh on investors’ minds. The impact of the fiscal deficit of many first world economies, the unwinding of the US stimulus packages, the very sluggish recovery in the US labour market and ongoing currency wars are all issues that are likely to impact investor sentiment and therefore the direction of share prices generally.
For South African investors the trend in local equities remains crucial as it constitutes the bulk of the growth assets in their investment portfolios. Hence, it is critical to understand the drivers of local equity performance. Our own equities shared the cyclical recovery since March last year. Many investors question the wisdom to remain invested in an asset class that many commentators brand as expensive.
In my opinion, looking ahead, local equities will remain the preferred asset class on a three-year investment horizon. Firstly, local interest rates are currently low and are likely to remain low. Low money market yields do not provide a long-term solution for investors. Traditionally there was a very good inverse correlation between equities and interest rates. A low interest rate environment is generally good for equities.
However, the two most important variables for equity performance are the earnings growth that companies record and, of course, the rating of the local equity market. Sanlam Private Investments (SPI) expects a continued recovery in the earnings trend of locally listed companies. Although the trading conditions remain tough, companies are generally expected to grow earnings from a low base. A recovery in the business cycle is expected to aid the recovery.
The toughest call to make for any investor is to forecast the future rating of the market or investor sentiment. However, we believe that the rating of the market will trend back to the long term average over time. Since the market is currently expensive in terms of its own history, it is safe to say that it is likely to de-rate over the next three years. We have assumed that the market will de-rate by following the most likely path based on its own history. This approach reduces the guess work. Based on this expected de-rating and simply applying the consensus earnings forecast twelve months out, the All Share is likely to record double digit returns over the next twelve months. The expected out-performance over cash and local bonds is enough to justify an overweight position in this asset class despite the higher risk associated with equities.
Within the local market, consumer shares stole the limelight in 2010, since low interest rates, a recovery in real disposable income and lower debt servicing costs provide a healthy backdrop for the sector. We still perceive selective value in the sector. Resource shares, generally, look cheap on a forward basis. Value investors might start to show interest in construction shares. However, the prevailing tough conditions in the sector would make an investment in this area premature.
