Market Wrap May 2010

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Added on 03 June 2010 @ 3:57 PM

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May was not a good month for global markets and many investors will feel they should’ve “sold and gone away.” In fact for many markets, particularly in Europe, May was the worst month since February 2009, the low point of the credit crisis-related crash. The reason for the anxiety remains the outlook for the global economy, but more specifically investors were looking at the eurozone and wondering if the centre would hold. The nations on the physical - and in many ways economic - periphery of Europe are suffering from an epic hangover of too much government debt, as budget deficits exploded during the recession due to falling tax revenue and increased unemployment benefits and other stimulus measures. In places like Greece and Italy, this deterioration in government finances came on top of existing mountains of debt. In other words, these countries did not use the fat years of 2003 – 2007 to reduce government debt; they added to it. Now with the existing debt needing to be rolled over and the new shortfall needing to be financed, the bond market made its dissatisfaction known by pushing up borrowing costs dramatically, a situation that of course worsens the financial position of the borrowers. Markets also fretted that European banks, which were much slower in writing off dodgy property loans than their American counterparts and thus have much more fragile balance sheets, hold large quantities of potentially wobbly sovereign debt on their books.

Into the breach stepped the eurozone countries, with backing from the International Monetary Fund, with a €750bn support package to help struggling countries meet their debt obligations and hopefully calm markets. In return, the recipient countries would have to make harsh cuts to their spending commitments and raise taxes. While the market initially jumped on the news, delivered in the early hours of 10 May, reality soon set in: it is normally political suicide for any government to implement austerity measures, how would the current incumbents manage? In other words, is the inevitable not just being delayed? And if they do successfully cut back spending, what happens to the economic recovery, which thus far seems to have largely been on government-sponsored life support.

And while Europe stares years of slow growth in the face, with the future of the single currency uncertain, China has the opposite problem. Its economy might be overheating. Bank lending and property speculation seem to have run riot, and the authorities in Beijing are trying to cool things down. Again the dilemma for investors: if the authorities succeed, it means slower growth and lower demand for commodities. If they fail, bubbles could form and pop with serious consequences.

It is thus no surprise that markets, including our own, were jittery (and that the gold price hit all-time highs). Apart from everything else, the sharp run-up from March 2009 left valuations (such as price: earnings ratios) generally in fair to slightly expensive territory, meaning that value investors won’t necessarily be using the pull-backs to pile in. Nonetheless, most economic data suggests that the world’s economy is slowly improving, though the pace varies significantly from country to country and region to region. Also, corporates are showing healthy earnings increases which, combined with current ultra-low interest rates, suggests the environment for equities is not terrible.

Our own economy grew surprisingly strongly in the first quarter, according the latest data released during the month. Real gross domestic product (GDP) grew by 4.6% quarter-on-quarter (seasonally adjusted and annualised) in the first quarter, up from 3.2% in the fourth quarter of 2009. The consensus expectation was for 4.3%. Mining and manufacturing once again led the way (15.4% and 8.4% respectively), driven by improving global demand for coal, iron and steel, chemicals and machinery. Importantly, all the key sectors of the economy expanded, suggesting a broadening of the recovery. As growth accelerates, it is important not to get carried away. A strong V-shaped rebound is quite typical historically, and we’ve seen it occur in many countries around the world recently, partly reflecting the low base and partly the way growth is measured (annualising the quarter-on-quarter growth rate). Real GDP levels – in other words the quantity of goods and services produced and consumed – remains below the peak reached in 2008 (R1.811 trillion vs. R1.824 trillion in Q3 2008). On a year-on-year basis, the economy only grew by 1.6%. The growth momentum is likely to fade later this year – similarly to elsewhere in the world - but that is not the same thing as saying the economy will slip back into recession. South Africa is also lucky (unlike other countries) to have a number of growth drivers, from the Fifa World Cup around the corner, to a recovery in consumer spending spurred by low interest rates. Government has also committed itself to spending close to a trillion rand on infrastructure upgrades over the next 5 years. But what happens elsewhere in the world will remain very important though: weaker growth in Europe, our main trading partner, could put a dampener on export performance, while China’s ongoing demand for our commodities will be vital.

The Reserve Bank’s Monetary Policy Committee left the repo rates unchanged at 6.5% at its May meeting. Even though inflation is still falling - CPI inflation in April was 4.8% year-on-year, down from 5.1% in March and below expectations for a 5% reading – the MPC cited the global turmoil as a reason for its decision. More specifically, it noted how sharply the rand reacted, with implications for the inflation outlook. The committee also noted the rise in administered prices (electricity etc.) as reason for caution. But with no sign of other inflationary pressures in the economy at the moment, interest rates could remain low well into 2011.

Fairbairn Capital | Old Mutual

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Market Wrap May 2010

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