Challenging investment markets Is investor confidence misplaced?

Given the string of challenges facing the global economy, is current investor confidence misplaced? Some respected commentators say the gains achieved will prove temporary as interest rates rise in developed regions, uncovering festering global imbalances

Investor and business confidence surveys indicate renewed confidence in global and domestic economies. Global equity, commodity and credit markets provided spectacular returns compared to the depressed levels during the global recession.

But plenty of challenges remain. Are we too positive too soon? What are the major challenges to South Africa’s economic recovery over the next three years?

Positive factors

A number of positive factors should sustain the global and local economic recovery in coming quarters. There is even a reasonable probability that global growth prospects could improve further.

Positive global developments include accelerating US job growth and the expectation of continued low interest rates in developed regions. Locally, positive terms of trade shock and complementary capital inflows provide a strong basis for a positive prognosis on the rand, inflation and interest rates.

US job creation

The global economy should be underpinned by gathering momentum in the US economy as job creation picks up, boosting incomes and confidence. The risk of a severe slowdown remains in China as interest rates are increased to control inflation, but the authorities will possibly engineer a soft landing, where after growth will accelerate again.

Low interest rates

While interest rates are being raised in emerging markets, they are expected to remain low in developed regions. The second round of quantitative easing in the US will come to an end in June, but the first interest rate increase is only expected in 2012. Rates remain on hold in the UK despite stubborn inflation. The Eurozone has raised interest rates by 25 basis points, but they remain historically low at 1.25%.

Further interest rate increases are expected to be modest. This wall of liquidity should ensure a sustained recovery in these regions.

Positive domestic outlook

Capital continues to flow to emerging markets, South Africa included, in search of higher yields. The consequent strengthening of the rand, supported by elevated commodity prices, is suppressing inflation and offsetting rising food and oil prices. The interest rate outlook in developed regions suggests that capital flows to emerging markets will be sustained in coming quarters. The rand is expected to stay stronger for longer, keeping inflation in check and delaying interest rate increases. Credit extension remains muted, suggesting that this will still accelerate and underpin domestic consumption.

SA’s terms of trade - a positive sign

With gold at record highs and platinum elevated, the ratio of our exports to imports is very favourable, despite the high oil price. This has positive implications for the current account deficit and should see South Africa continue to attract capital.

Risks to the global economy

A number of risks - including rising inflation and interest rates in emerging markets - could undermine this positive scenario.

Moderate and measured interest rate increases are expected in developed regions, but it remains an open question how still-fragile economies will be impacted. The end of quantitative easing in the US in June is viewed with trepidation as commodities and equity gains have been closely correlated with the extent of cheap money.

The impact on growth of budget deficit cuts in developed regions, an escalation in the Eurozone sovereign debt crisis, and fragile housing and financial markets in the US , UK and Europe, also shadow the markets. There is also some concern that the US dollar could come under sustained attack if it fails to bring its budget deficit under control. This would force rising interest rates, possibly rapidly undermining global confidence and risk assets including equities.