Equities perform well in a volatile market
Although the global macro-economic backdrop remains uncertain, historically low interest rates will fuel investors' search for yield and cause assets deemed risky to continue performing well, but with high levels of volatility.
Commenting in his economic report for the third quarter of 2011, Francois van der Merwe, head of macro research at Novare Investments, said: "In an environment where markets react to daily data releases, one can expect volatility to remain. However, as investors move up the risk spectrum, we believe that equities will continue to perform."
Three key issues continue to shape financial markets - the European debt crisis, the fiscal position and strength of the US economy, and the Chinese economy's ability to avoid a severe slowdown.
The European debt crisis has improved, but is far from resolved. Political uncertainty clouds prospects and the economic outlook is anaemic. In China there are signs that growth might have bottomed in the first quarter with industrial production picking up and labour demand firm. Economic growth should stay well above the government target of 7.5%.
Inflation lookout is mixed
The US recovery has taken on more shape, but conditions remain fragile. The rate of job creation has been positive for consumer spending and banks are well capitalised. They have started easing lending standards and there are signs the housing market is stabilising. Monetary conditions should remain accommodative.
"Below-trend global economic growth should not put any pressure on inflation which has been decelerating. These factors should be supportive of risky assets, including equities," Van der Merwe said. "Equity valuations have rebounded after the strong bull run at the start of the year, but they remain attractive compared to historical levels. Although we don't foresee the emergence of a sustained bond bear market yet, the supporting factors that have kept government bond yields low are fading."
On the domestic economy, there were indications of a potential slow-down in consumer spending, but manufacturing should take up some of the slack. Money markets are pricing in the probability of one interest rate hike in the next 12 months. "The inflation outlook is mixed, but we fear that higher fuel and administered prices pose upside risks to consumer prices," he added.
Pressure on government's budget
Novare Investments expects company earnings, although elevated, to remain sufficiently firm to drive stock market returns over the next 12 months. "From a price: earnings perspective, the JSE is attractively valued. We are cognisant of the risks facing equities, but attribute a low probability to these scenarios. The domestic bond market might experience some support from foreign investors buying for the yield pick-up, but from a valuation perspective we find them unattractive. There is pressure on the government's budget as expenditure as a percentage of GDP is high in an environment where it will be difficult to boost GDP growth.
"Credit rating agencies have warned that economic and social problems may feed into the political debate, which will put pressure on the policy framework. And lastly, we are worried about upside inflationary pressures. The risk has increased that bonds will underperform cash over the next 12 months," said Van der Merwe.
