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ABSA Investment Overview 2005 - 2nd Quarter
By Christo Luüs - Absa Group Economic Research

The outlook for global growth has been lowered further since the beginning of 2005 - mostly due to international oil prices reaching record highs during the first quarter of 2005. However, inflationary pressures are likely to remain fairly subdued in Euroland, with only moderate price pressure expected in the United States. Interest rates are nevertheless expected to rise in the USA, while bond markets continue to look expensive in most of the major markets. The outlook for equity markets remained mixed, with further gains possible in Europe and Asia, and risks remaining high in the USA.

Equity market
he very high equity market returns observed during the final quarter of 2004, made way for substantially weaker returns during the first quarter of 2005. The average month-on-month returns (annualised and expressed in US dollar) amounted to -27,8% during the first quarter, but the average returns for the latest 12-month period was still at a very acceptable 32,6%. In rand terms, the JSE all-share index also managed a positive annualised return of 7,5% during the first quarter.

The weakening in USD-returns during the course of 1Q2005, was mainly attributable to a weakening in the ZAR/USD exchange rate during January and the early part of February, while the all-share index ended March much weaker compared with its record highs reached at the end of February and early part of March 2005.

Market valuations for some major indices – such as banks and industrials – on the JSE improved marginally to above their one-year average levels in the first quarter, while the PE ratios for the IT and real estate sectors showed significant increases. Valuations for the mining and resources sectors remained fairly stable compared with their one-year average values, while insurance declined further. During the first quarter, the weakening equity market trend was clearly discernable from the movement in the JSE all-share PE ratio. From its lower turning point of just more than 13 in mid-2004, the ALSI PE ratio moved up to a high of 15,6 in February 2005, before falling back to below 14 by end-March.

The JSE suffered some losses mainly in sympathy with outflows that occurred in most emerging markets during the last part of the first quarter. Investors pulled out some USD2 billion from emerging market funds during the last two weeks of March, although the net cumulative selling by foreigners on the JSE was limited to some USD110 million for the period 11 March through 1 April 2005. For the first quarter as a whole, net foreign equity purchases on the JSE still amounted to more than USD1,5 billion.

In an international context and measured in US dollar terms, the South African equity market performance was also well below that of most other emerging and developed markets in the first quarter of 2005. Emerging equity markets registered an 8% (annualised) return, while world equity came in at -3,9%. However, measured over longer periods, the South African equity market performance was much higher at 32,6% over a year and 39,4% over three years, compared with emerging market equity returns (respectively 17% and 19,2% over one and three-year periods) and world equity returns (respectively 11,1% and 6,9%). Over the past twelve months, South African equity as an asset class was hard to beat, with only South African property putting up a better performance.

Over the next twelve months, domestic interest rates should remain relatively stable while commodity prices are expected to remain strong on the back of solid global growth – especially in Asia. South Africa’s gross domestic expenditure could rise by more than 5% in real terms, which should have a positive effect on companies’ earnings growth rates. After a slump of more than 30% in the earnings of resources shares for the year ended March 2005, some recovery is also expected in this sector and a rise of around 30% in the ALSI earnings growth might be possible for the next twelve months. This could facilitate a total return of some 27% for equity in rand terms over this period.

Globally, equities are once again expected to perform better than bonds. The performance of equity markets in various countries are nevertheless expected to be disparate. In the US, corporate profit growth is bound to slow fairly sharply while high valuations and a strong possibility of higher interest rates are additional negatives for this market. In Europe, economic growth prospects look fairly bleak, but corporate restructuring and attractive dividends could have a positive effect on equity returns. Japanese growth is expected to resume, while relatively low valuations and positive earnings growth prospects should underpin the equity market. Most of the leading emerging equity markets have already had a good run, but high commodity prices, low interest rates and relatively sound economic policies could extend the positive performance of equities.

Bond market
Bond yields have been in a bull market since mid-June 2004, which brought yields on the benchmark R153 government stock down from 10,25% to 7,4% by end-February 2005. However, this trend seems to have been broken in March when yields increased substantially, ending the first quarter at around 8,2%.

The weakness in the South African bond market coincided with reports that global funds were reducing their exposures to emerging markets. In addition, bond yields reacted to higher international oil prices and a jump in domestic fuel prices, which ignited fears of higher domestic inflation and the possibility of interest rate hikes. Consequently, foreigners sold some USD0,2 billion worth of bonds during the period mid-February to mid-March 2005. However, towards the end of March, foreign buying interest in the SA bond market resumed.

The annualised dollar return on South African bonds amounted to -33,8% in the first quarter of 2005. This compared quite unfavourably with a -4,7% on emerging market bonds and -9,9% on world bonds. Measured over longer periods, the structural decline in inflation over the past few years together with sound fiscal policy management, nevertheless contributed greatly to higher bond prices and therefore solid returns over one year (16,7% annualised dollar terms) and three year (44,6%) periods. These figures compare very favourably with both emerging market bond returns (6,9% and 15,1%) and world bond returns (5,5% and 14,5%) over periods of one year and three years respectively.

Inflation expectations for the remainder of 2005 – a major determinant of bond yields – will evidently be heavily influeced by the future course of the exchange rate, food prices, and fuel prices. The strong rand and benign food price inflation pressure are presumably both candidates for a shock in a negative direction, while higher oil prices have already given rise to slightly higher inflation expectations. However, given the view that the US dollar will remain under pressure as well as the possibility that oil prices will soften in coming months, inflation pressures will most likely be contained so that short-term interest rates are unlikely to rise in 2005. As far as the potential impact of government finances on bond yields is concerned, it would appear that the budgeted deficit-to-GDP ratio of 3,1% for 2005/06 will once again be lower, so this too could be supportive of the bond market. Long bond yields are expected to fluctuate within the 7,5% to 8,5% range during the next twelve months, and the rand returns on bonds should remain substantially positive – at around 15% – during this period.

Government deficits have edged higher in many of the world’s biggest economies and some inflation may start to emerge during the course of 2005, while economic growth rates are expected to moderate slightly. All of this would imply weakness in global bond markets. However, it would appear that any negative movement in bond yields will be limited, owing to the apparent willingness of many institutional investors to pay higher prices for high quality bonds. High levels of debt and some risk aversion following the bursting of the stock market bubble are some of the reasons why “fair value” yields on bonds be somewhat lower than would be suggested by historical real yields. Bond yields over the next year should rise by some 50 basis points in the USA, UK and Euroland and by somewhat more in Japan. Emerging market bond yields are expected to remain fairly stable.

Cash was the best performing South African asset class in the first quarter of 2005, registering -9% in annualised dollar tems. Over a year, SA cash investments in dollar terms remianed attractive, recording an increase of 18,6% in dollar terms and 8,2% in rand terms.

International oil prices remain a very important factor for domestic (and global) inflation. The benchmark Brent crude oil price soared from just below $40/bl in early January 2005 to more than $55/bl in March, prompting increases in domestic fuel prices of around 10% on average for the first four months of 2005. Although the direct impact on inflation should not endanger the inflation target of the SA Reserve Bank, rand weakness or higher oil prices may prompt a much earlier interest rate increase. Other issues which should remain of some concern to the Monetary Policy Committee (MPC) as it conducts its meetings during the course of 2005, include the high levels of household consumption expenditure and credit growth; high asset price inflation (especially property); a widening current account deficit; rising level of household indebtedness and steep increases in unit labour costs.

It would therefore appear that the current domestic interest rate cycle is at or close to its lower turning point. Technical factors will work in favour of lower CPIX numbers during the early months of 2005, but for most of 2005, short-term rates are predicted to remain fairly stable, rising by the second half of 2006. Our forecast for total cash returns over the next twelve months is 7,5%.

Despite the weaker dollar and strongly growing economy, the USA has not really been subjected to excessive inflation worries. The reason for this is to be found in some deflationary forces still at work in many sectors and regions, rising levels of productivity, and low capacity utilisation. The expectation is nevertheless that the Fed will continue to tighten in 2005, with short-term rates reaching around 3,5% in early 2006. Elsewhere, interest rates could remain on hold as the European economies continue to grapple with a strong euro and Japan moves only gradually out of deflation.

The return on the JSE Listed Property Index measured -49,5% (annualised in dollar terms) in the first quarter of 2005, although in rand terms the negative return was only -1,1%. Over the past three years, total listed property returns averaged 69% per annum in dollar terms and 36,9% in rand terms, making this the best performing asset class over this period.

Residential property market values have increased very strongly over the past three years and are set for another year of positive – albeit lower – real growth in prices. However, it would appear that affordability issues could be limiting any further capital gains in house prices, while the buy-to-let market also seems to becoming saturated.

According to Rode’s Report on the SA Property Market, low vacancies and almost 4% growth in manufacturing volumes since the last quarter of 2003, resulted in robust growth in industrial rental and stand values during 2004, and real industrial rentals are still growing at a rate that beats building-cost-inflation. Also according this report, the office market still appears to struggle in certain places, especially in the Johannesburg CBD. Vacancy levels have generally been declining and are now at their long-term average levels. Retail property space has been in huge demand and has led to a substantial decrease in capitalisation rates (the equivalent to the earnings yield on shares).

Given the positive outlook for inflation and relatively low interest rates, both the listed property sector and directly held property should continue to perform well over the next twelve months. Other factors such as declining vacancy rates and growing real rentals should also underpin the market. Property returns (JSE-listed) are expected to average some 35% in rand terms over the next twelve months.

Note: Calculation of returns
In accordance with the international convention, returns on asset classes in this section were consistently based on the monthly changes in indices in which income (interest or dividends) were included. The geometric averages obtained for, for instance, the three months of a quarter, were then reduced to an annualised figure. Month-end figures were used for indices and exchange rates.

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