The global economic environment remains troubled. In its latest World Economic Outlook Report, the International Monetary Fund (IMF) cut its expected global growth forecast from 3.5% to 3% for 2012 and highlighted a number of downside risks to the global economy. In the US, Ben Bernanke committed the US to a further round of quantitative easing in September (QE3) and committed to keep short-term interest rates at record lows until mid-2015.
The themes described above continue to exert a major influence on the investment environment for South African investors. Notably, record low global interest rates have allowed the South African Reserve Bank to keep cash rates lower for much longer than would have been possible in a "normal" local interest rate cycle: having been cut by 0.5% to 5% on 20 July, 2012, the Repo Rate has now been reduced by a cumulative 7% since December 2008. Despite the upturn in Consumer Price Index (CPI) inflation to 5.5% year-on-year in September, the market continues to price in the prospect of a further interest rate cut in the next six months.
A weakening South African and global economy
It is clear that the risk of a weakening South African and global economy, rather than the prospect of higher inflation, is driving the market expectation of the direction of short-term interest rates. Here the risks are delicately balanced. Despite stronger than expected second quarter Gross Domestic Product (GDP) growth, the South African economy is under significant pressure as both our major trading partners (Europe and China) slow significantly. What is equally worrying is that local demand appears increasingly driven by debt: according to the South African Reserve Bank's September Bulletin, the average debt held by households increased from 75.6% to 76.3% over the quarter, despite interest rates being kept at multi-decade lows.
Against this backdrop, there is pessimism about the ability of cash to deliver inflation-beating returns and while short-term interest rates may stay low for an extended period our valuation models indicate that there is significant risk to holding longer-dated fixed interest assets. The search for yield is a crowded trade and sentiment could change quickly. In addition, while South African equities have experienced stellar returns over the past three years, despite the unfavourable economic outlook, investors should bear in mind that this trend cannot continue indefinitely.
In such an environment it is important that investors have realistic expectations of the kind of returns that the asset classes they have chosen to invest in can generate, given how they are currently priced. It is also imperative to invest with quality managers who can strike the appropriate balance between protecting capital and taking advantage of opportunities when they materialise.
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