The state we are in – and the year ahead

Adrian Saville, CIO of Cannon Asset Managers, looks back over the economy and investments in 2010 and ahead to 2011

Tough conditions prevail, but the worst is behind us

Since the start of 2009, South Africa has lost almost 1.2 million jobs. While the rate at which jobs have been lost has reduced dramatically, the trend has remained negative this year. In 2011, I expect the economy is likely to tread water with regard to job creation as economic recovery will be muted and some sectors continue to shed jobs rather than create them. Evidence of this is the example of Standard Bank, which recently announced that 2,500 people are to be retrenched. Notwithstanding Standard Bank’s global footprint, most of the employees that will be retrenched are based in South Africa.

This economic environment is being driven by a number of forces including competitive pressures; positive but sluggish economic growth; an absence of proposed public sector infrastructure spend; and wage hikes that are significantly ahead of the rate of consumer price inflation and productivity gains over the past two years. These forces are likely to persist.

There are, however, a number of positives which will have a growing impact as we move into 2011:

a) a low and stable consumer price inflation environment;

b) despite the controversy surrounding the strength of the South African currency, sustained rand strength will sustain the low consumer price inflation outcome;

c) low and stable interest rates that flow from the above will help to further bolster household and company balance sheets;

d) an extension of the recent shift in foreign investor interest from indirect to direct foreign investment in South Africa. For example, we have seen foreign entities buying stakes in Massmart, Freeworld Coatings and Dimension Data; and

e) effective and constructive fiscal and monetary policies.

Despite these observations, the disturbed condition of the world’s biggest economies makes forecasting global economic events for 2011 more complex than is normally the case. However, it is reasonable to conclude that if the global environment resembles that of 2010, then 2011 will be a year in which we experience an improvement in economic circumstances, but in all likelihood this improvement will be muted or modest, at best.

So what can investors do to protect themselves?

Regardless of the given economic conditions, I think that investors are best equipped by reminding themselves that emotion is the greatest enemy of investing, with emotion presenting itself most dramatically in the forms of fear and greed. These evils will not go away during 2011. A current example of greed is the euphoria being applied in some capital markets. For instance, equities appear richly priced in places such as China, India and Indonesia, underpinned by investors’ enthusiasm about economic prospects in these countries. In the case of gilts, Indonesian government bonds are trading at a mere 1% discount to US government bonds. In Hong Kong, property prices have risen 60% in the past 12 months; and commodity prices have risen remarkably in the past year and a half. The oil price, for instance is up more than 100% over the period, and the prices of platinum and copper have risen by similar amounts since early 2009.

Recent currency strength in emerging markets, including the South African rand, the Brazilian real and the Peruvian nuevo sol, driven overwhelmingly by a voracious investor appetite for yield, if allowed to run to extremes, translates into greed. What we have seen thus far in terms of currency strength, may turn out to have been modest in its extent if emerging market currency bulls are allowed to rampage unchecked.

However, there comes a point at which the appetite is sated and investors reverse decisions or actions with a severe impact on the exaggerated prices. This is where fear takes hold with the potential to inflict massive capital damage on portfolios.

Investors should therefore recognise the dangers of allowing emotion to influence their investment decisions and, as far as possible, act to shield themselves from the effects or impacts of the emotionally-charged investment decisions made by others which have the capacity to push prices to irrationally high levels and seduce investors to buy into surging markets and, by the same convention, cause a collapse in asset prices should sentiment turn from unchecked optimist to depression.

Investors should also keep reminding themselves that investing is just that: investing. It isn’t speculation, or trading. Investing is about buying the right quality asset at the right price. Investors, by nature, should own their investments in the same way that they would think about owning a business.

In short, investment success comes from applying a sensible philosophy in a disciplined manner and in a consistent fashion.

For longer-term performance, equities offer the best prospects for higher returns than other asset classes. Looking at specific stocks to be held within equities, investing according to a value philosophy has demonstrated to be the best way to manage the equity portion of one’s portfolio. Interestingly, the same approach is also effective in investing in other asset classes, such as property and bonds.

The Building & Construction and IT sectors are offering the best value

Using a value philosophy and approach to investing, two South Africa sectors stand out for attention: building and construction; and information technology. There are some very exciting opportunities in these sectors. By contrast, cash retailers and healthcare firms appear to be richly priced.