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Investment professionals flounder through unknown territory

21 May 2010 Gareth Stokes, FAnews Online Editor
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

South Africa’s last recession was 17 years ago. For many of the country’s financial advisers and fund managers the 2008/9 hiccup is the first economic downturn they’ve experienced – or at the very least the first time they’ve had to manage investor funds

“With South Africa still in a post-recession phase, the investment landscape has changed considerably,” observes Pearse, adding that many investment professionals are operating in ‘virgin’ territory. What can they expect going forward? A Reinhart and Rogoff paper (published January 2009) provides frightening post recession statistics. Recession causes house prices to decline an average 35% over six years, unemployment spikes and average 7% over five years, output slumps 9% over two years and the real value of government debt explodes. IF you were among those who clapped excitedly when Statistics SA announced the technical recession was over, you might be less excited today. The challenge faced by fund managers is where to find value in the ‘new normal’, where growth likens to the mythical unicorn.

Consumers and recovery

The first thing investment professionals need to understand is the impact of the consumer on the economy. Approximately 65% of the country’s gross domestic expenditure lies in their hands. “Consumers were unstoppable over the five pre-recession boom years,” notes Pearse; but their spending meant they entered recession with massive debt. House prices and motor vehicle sales aren’t bottoming only because of recession, but because the consumer is simply unable to stomach additional debt! This is part of the reason the SA Reserve Bank’s repeated interest rate cuts had such limited effect.

Although most statistical measures of consumer health are showing signs of improvements, we doubt the consumer is in a position to super charge the post-recession recovery. Debt levels remain high, savings remain low, the National Credit Act looms over the lending landscape and inflationary pressures are again appearing on the horizon. Pearse puts things in perspective: “Unit labour costs are increasing 8.7% per annum (services account for 44% of the CPI basket), the rand petrol price continues to drift upwards and we have massive electricity price hikes scheduled for the next three year which will have a domino effect on much of the CPI basket.”

To make matters worse the country’s larger trade unions are striking for ridiculous annual wage settlements, confident in the state’s desire to keep the country running through the 2010 FIFA World Cup ™. Transnet workers are demanding 15%, PRASA 16% and Eskom’s workers seem intent on an 18% hike. Incidentally, a basic calculation using Eskom’s employee numbers and total annual salary bill (from its latest annual report) points to an already healthy average monthly gross of R30k per employee! As CPI climbs – and it will for all the above reasons – the Reserve Bank will soon have to hike rates again, impairing the consumer’s ability to service existing debt or take on new debt.

Investing in an ‘expensive’ South Africa

“We believe that the South African investment market is generally expensive at present,” says Pearse. The market is overpriced in part because of the phenomenal growth we experienced between 2003 and 2008. The All Share index delivered 337% over those five years, with resources (+412%), small cap shares (+554%) and listed property (+358%) surging over the same period. You’d be crazy to expect similar acceleration over the next five years, and some analysts even warn to expect a long period of sideways movement, similar to stocks in the US over the first decade of the new millennium. Where should you invest then?

Forget listed property. Approximately half of the total return from listed property is generated from yield, and the current 7.8% means the asset class is vulnerable right now. “In the past there have been periods where listed property has suffered extensive setbacks over a relatively short period,” notes Pearse. The sector lost 35% over five months in 1998 and fell by 34% over eight months in 2007. The big property funds haven’t yet felt the impact of recession through rental vacancies, but when they do you might be caught in another listed property slump late in 2010 or early 2011. Risk aside – returns from listed capital will be modest – due to low anticipated earnings growth.

This yield conundrum uproots confidence in the bond market too. Pearse says South African bonds have experienced an 11½ year bull market. The trend is unsustainable due to a ballooning fiscal deficit and risks to the inflation outlook. With bond yields (currently 8.8%) well below the 13% long-term average, investors shouldn’t be rushing in.

Not much ‘low fruit’ for the picking

The outlook for equities is similarly downbeat. Investors too often forget how much of the total return derived from this asset class stems from the starting dividend yield. “With a long-term average yield of 4%, local equities are currently looking expensive on a dividend yield of just 2.2%,” says Pearse. Corporate earnings (and by implication dividends) aren’t likely to grow strongly through 2010/11 – so if you have to be in equities stock picking will become critical.

There are two areas where investors can generate market beating performance. These include preference shares and inflation-linked bonds. Investors have the opportunity to invest in preference shares yielding higher returns than cash! And with income from these instruments being classified as dividends, they are tax free. The group expects capital gain from this asset class as the spread between cash and preference share dividend yields narrows. Inflation linked bonds make sense because both income growth and capital gains are hedged against inflation. “With a yield of 3% and an expected capital growth of 6%, together with re-rating potential given our inflation outlook, these instruments are offering good value to investors!”

Editor’s thoughts: Financial advisers must consider numerous scenarios when structuring long-term investment portfolios. Although sensible asset allocation will reward over time, it makes sense to reassess the split to equities, bonds, property and cash on a regular basis. And at times it makes sense to bump up your weighting to less conventional instruments. Do you use inflation-linked bonds or preference shares in your portfolios? Add your comments below, or send them to


Added by Ray, 27 May 2010
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