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Momentum Investment Houseview

21 April 2006 The Momentum Group

Second Quarter 2006 18 April 2006

LOCALEquities

  • The ALSI returned 13.25% for the first quarter of 2006 and 57.40% for the 12 months ending 31 March 2006.
  • SA continues to enjoy uninterrupted growth as a result of pursuing sound macro-economic policies.
  • The equity bull market that began in April 2003 is set to continue through 2006, although the pace is expected to slow down materially.
  • Emerging markets continued to attract capital during the first quarter of 2006, with South Africa being no exception. This favourable environment enabled the local bourse to advance to record levels during the quarter.
  • The drivers of this most recent expansion included high commodity prices, robust domestic earnings growth and a low interest rate environment all of which look likely to remain in place for the foreseeable future.
  • The strong surge in commodity prices in response to growth demand from the East is not showing signs of slowing down yet.
  • The valuations of many resource companies remain stretched so that even an optimistic commodity price outcome may not translate in outperformance of the resource sector, but share prices should at least remain high.
  • On a valuation basis, financial and industrial stocks remain cheaper than their resource counterparts.
  • Stable interest rates, a firm local currency and benign inflation continue to combine to support the local economy.
  • The spectacular returns from the local equity market in recent years are unlikely to be repeated going forward and significant gains from equities are unlikely, as the commodity cycle appears extended in the short term.
  • The local equity market is now slightly above fair value. Some profit-taking/consolidation from equities may take place in the short term. Investors should consider rebalancing portfolios following a superb equity market run.

Bonds

  • The ALBI returned 1.51% for the first quarter of 2006 and 12.85% for the 12 months ending 31 March 2006.
  • A hawkish tone to the international monetary policy backdrop, together with exuberant economic conditions in SA saw the SARB hold rates steady in February and April, while maintaining a cautious policy bias.
  • Bond yields have rallied to expensive levels and continue to apathetically discount a continuation of the current benign inflation environment.
  • Further strength in bond yields would only occur on the back of another interest rate cut and this is improbable for now.
  • SA bond yields have largely priced in the good news on inflation and are considered expensive. Bond yields at these levels require a further cut in rates in order to validate the strength in this asset class. The possibility of capital losses from this asset class exists.
  • Current long bond yields are too low and should increase in order to reach a level that is commensurate with true underlying inflation.
  • Cash is currently preferred to bonds on a risk/reward basis.

Cash

  • The STEFI returned 1.69% for the first quarter of 2006 and 7.03% for the 12 months ending 31 March 2006.
  • Local interest rates were left unchanged at both the February and April meetings of the MPC, in line with expectations. The 3-month interbank rate increased marginally to 7.09% from 7.05% and the 12-month interbank rate hovered around the 7.30% mark.
  • The SA repo rate is currently 7%, while the prime lending rate is at a two-decade low of 10.50%.
  • Local interest rates appear to be at the bottom of the interest rate cycle but may remain lower for longer, before rates begin gradually increasing.
  • The next move for local interest rates will probably be upward. Rates are only expected to begin increasing toward the end of the 2006 calendar year, if inflation begins the moderate rise that is currently anticipated in the market.
  • Some money market instruments are broadly yielding in the region of 6.5%. The after tax return on these instruments may be as low as 4.0%.
  • Investors are being rewarded with a very low risk-free rate at the end of this round of easing of the interest rate cycle and relaxed monetary policy.

The rand
(Reproduced with permission of Advantage)

  • The rand strengthened against the US dollar for the first quarter of the calendar year and gained almost 3% from R6.32/$ to end the quarter at R6.13/$. The local currency has gained just over 1.50% against the greenback over the 12 months ending 31 March 2006.
  • Currency volatility will always occur in the future and continued and sustained rand strength is not likely.
  • Recent rand weakness last year has removed some of its overvaluation, but further currency weakness down the line is expected.
  • Every possible factor has been supporting rand strength over the last three years.
  • These factors include the rands cheap valuations three years ago, an overvalued US dollar, a very strong commodity cycle and a large interest rate differential.
  • The rand, like the Australian dollar, also tends to be strong when global commodity prices rise. A turn in this global commodity cycle will probably exert pressure on the rand to weaken. When commodity prices fall, the rand has historically shown to depreciate by more than inflation differentials.
  • The rand should therefore remain firm (even stronger) in the short term as commodity prices remain high.
  • Rand-supporting factors will probably not be the same over the next three years or so and investors are advised to consider taking advantage of a very strong rand in the short term.

Summary

Asset class 6 to 12 months 12 to 24 months
Equities Neutral Overweight
Bonds Underweight Underweight
Cash Neutral Overweight
Sector
Large cap Neutral Neutral
Mining resources Underweight Neutral
Consumers Overweight Neutral
Financials Overweight Overweight
Gold Neutral Underweight
Industrials Overweight Overweight

GLOBAL

  • The MSCI World Index returned 6.12% for the first quarter of 2006 and 15.99% for the 12 months ending 31 March 2006 (in US$).
  • An environment of sustained excessive global liquidity and accelerating global growth continues to favour global equities.
  • Europe, the Pacific Rim and Japan are currently preferred to the US, although the US market is considered fairly valued (not expensive).
  • Japanese and certain Asian country economic activity continues to improve due to stronger exports, whilst continued strong earnings growth and a recovery in Japanese internal consumption bode well for equity markets.
  • A slowing of US consumer spending on the back of higher interest rates and a US growth deceleration toward year-end is anticipated.
  • The positive returns posted by the MSCI World Index for the 2005 calendar year marked the third consecutive year of gains for the index, following the disappointing three years when markets fell in 2000 to 2002.
  • Global equity markets are fairly valued following improvements in the 2003, 2004 and 2005 calendar years. Returns from fairly valued markets generally move to within long-term averages.
  • Headwinds on the horizon, however, include decelerating global growth on the back of a peaking commodity cycle and further increases in global interest rates. Higher international oil prices have also raised inflation concerns and the dampening of higher prices and inflation on broad consumer spending.
  • Returns from global equity markets are expected to be more muted going forward (single-digit territory), but are expected to outperform global bonds and cash on an average two-year return basis.

Bonds

  • Global bond yields continued to spike higher during the quarter as economic indicators point to robust global economic activity.
  • Although global inflation remains stable at a low level, with the opening of trade and labour markets, continued strong global growth is expected and is likely to result in the rise in global short rates becoming more synchronised. The US economy is already running at full employment, capacity utilisation is increasing and corporate profitability is at historical highs.
  • This environment encourages interest rate hikes and the US Federal Reserve and European Central Bank duly obliged by hiking interest rates.
  • Bond yields are expected to trend higher from current levels. There is very little margin of safety investing in global bonds as an asset class.
  • An increase in bond yields broadly represents a fall in the asset value or price of a bond. Conversely, a decrease in yields leads to an increase in the asset value or price of a bond.
  • Bonds are not expected to deliver a higher return than cash over the next 12 months.

Cash

  • The US Federal Reserve continued its measured approach to monetary policy during the quarter and raised the federal funds rate by 50 basis points over the quarter to 4.75%.
  • The US federal funds rate is expected to continue its upward trend. As a result, the 2007 calendar year is expected to be an even softer year for the US economy as consumer expenditure slows and the impact of higher interest rates is more far reaching.
  • The European Central Bank (ECB) raised its base-lending rate from 2.25% to 2.50% on higher inflation concerns and stated price stability as the main reason behind the move.
  • The Bank of England left rates unchanged at 4.50% in line with expectations.
  • Major global regions continue to enjoy low interest rate environments, but appear to have entered a period where rates may be tightened. Market watchers are already talking about a 5% US federal funds rate and a 3% base lending rate in the euro area by the end of the 2006 calendar year.
  • Base lending rates in the US, euro area and UK are currently 4.75%, 2.50% and 4.50% respectively.

Summary

Asset class 6 to 12 months 12 to 24 months
Equities Overweight Neutral
Bonds Underweight Neutral
Cash Overweight Overweight
Region
US Underweight Underweight
Japan Neutral Neutral
Europe Overweight Overweight
UK Overweight Overweight
THE SA ECONOMYInflation

  • Local CPIX inflation decreased to record lows during the first quarter of 2005. February CPIX inflation fell to 3.1%, while February CPI inflation measured 2.6% (both y/y).
  • Local inflation has since increased. February CPIX inflation was 4.5% year-on-year (y/y) and February CPI inflation was 3.9% (y/y).
  • Average annual CPIX inflation was 3.9% in 2005, while average annual CPI inflation came in at 3.4%.
  • CPIX inflation is expected to trend higher and reach 5% in the first quarter of 2007.
  • While inflation is expected to edge higher, it is likely to encroach on, but not breach, the top end of the SARB inflation target range of 6%.
  • Local inflation is benign and is under control at current levels, but increasing domestic demand and a higher international oil price may exert upward inflationary pressures in the near term.
  • Buoyant commodity markets have further supported the rand, which in turn has capped inflationary pressures from imports (imported inflation).
  • The lower turning point for CPIX inflation is behind us and the underlying inflation trend is upward from here.
  • Food prices and a higher international oil price are expected to be the main culprits as inflation edges higher.

Interest rates

  • The ruling repo rate and prime rate are presently 7% and 10.50% respectively (mid-April 2006).
  • Money market yields remained stable during the first quarter, with the 3-month interbank rate rising moderately to 7.09%.
  • Local interest rates are at the bottom of the interest rate cycle and rates may remain flat at these levels for some time before increasing. Interest rates are expected to remain flat and on hold for most, if not all, of the 2006 calendar year provided that inflation numbers meet expectations and that the rand remains firm against leading international currencies as it is currently doing.
  • The easing cycle and resultant rate cuts initially expected by market watchers have been met as interest rates have now fallen 650 basis points since June 2003.
  • The SARB MPC meet again on 07 and 08 June 2006 to discuss monetary policy no change in interest rates is anticipated, despite recent hawkish comments from the Reserve Bank Governor a period of stable interest rates is expected over the short term.

Compiled by the Momentum Investment House Marketing Team April 2006 The content of the view stated in this paper does not constitute a commitment by Momentum or its subsidiaries. Momentum or its subsidiaries do not accept any liability or legal responsibility or give any warranty for any decisions taken based on the views stated. Any persons who rely on these views do so at their own risk. Momentum or its subsidiaries do not accept liability for any loss or damage howsoever caused arising as a result of relience on the contents of this paper.

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