Inside Insights 12 July 2010

Investment Intelligence|Inside Insights

A weekly, in-depth yet concise report on the most important recent market movements and economic developments.

Added on 12 July 2010 @ 10:33 AM

The gloom lifting?

Neither pessimism nor optimism lasts forever. Global equity markets had a positive week, while demand for safe-haven assets fell. This was due to economic news being less gloomy – for a change - and the US corporate earnings season starting off well. Share prices, history tells us, follow earnings over the long run. Sentiment will move markets over shorter periods, but in the end its all about the ability of companies to grow earnings, and by all accounts US companies are still very profitable. Short-term US jobless numbers were more encouraging, as were retail sales data, while in Germany, Europe's biggest economy, industrial production, imports and exports rose strongly in May. But the biggest economic boost came from the International monetary Fund (IMF).

In contrast to much of the world that has spent the last few weeks been worrying about a fresh recession and deflation, the IMF upgraded its 2010 growth outlook for the global economy to 4.6% from 4.2%. How do we make sense of this, given the uncertainties that abound? For one thing, this number hides large discrepancies between countries and regions: China and India (10% and 9.4% forecasted growth respectively) will continue to grow strongly, while the eurozone will battle to grow at all (1%); the US is somewhere in between (3%). Secondly, the IMF’s numbers are for the year as a whole. Growth rates will probably slow down substantially in the third and forth quarters, while growth rates early in 2010 were surprisingly high.While the IMF did not expect the world to slide into recession again, it did warn of the risks of the European sovereign debt crisis. The market thus took it as a positive that the committee responsible for the stress tests on Europe’s biggest banks expanded the factors used in determining their financial health. Analysts were worried that the tests would not be rigorous enough to be meaningful.

Finally, its worth making the point that, while the stock market has been very worried about a double-dip recession, bond markets - which are far larger - seem less concerned. Recessions are normally preceded by periods where short-term interest rates exceed long-term rates. This is reflected in a so-called inverted or negative yield curve. High short-term rates slow down economic activity, while longer-term rates respond to a weaker economy by pricing in lower future inflation. Currently, South Africa’s yield curve is positive, as is that of the US, the world’s largest economy. This of course reflects central banks’ determination to support economic recovery by keeping interest rates low for the foreseeable future - practically zero in the case of US short-term rates.

“Hesitant, fragile, uneven”

The IMF also upgraded SA’s growth outlook for 2010 to 3.2% from the earlier forecast of 2.8%. However, in a speech last week, Reserve Bank governor Gil Marcus said that SA’s economic recovery was “hesitant, fragile and uneven.” She was particularly concerned over the impact of an economic slowdown in Europe on South Africa, saying that the “reality is that we probably never really emerged from the crisis, which is now entering its next phase. These developments have serious implications for the domestic growth outlook.” Her words have led to speculation that another rate cut is on the cards, but the governor herself emphasised that she wasn’t giving “guidance” on future rate movements. The Bank’s Monetary Policy Committee meets later this month, and could cut the repo rate again if the rand remains strong and inflation continues to come in lower than expected. However, the MPC has already provided significant monetary stimulus, with the repo rate 550 basis points below its 2008 peak.

SA manufacturing production rose 7.6% year-on-year in May, below market expectations of 8.4%, after the revised 8.6% increase in April. While manufacturing staged a strong recovery from the bombed-out levels of early-2009, the volume of output in the sector (see graph) is still well below the peak of 2008, meaning there is a lot of idle capacity, and also explaining why job creation is so slow. The recovery has also largely taken place in export-orientated industries, as was the case again in May with output of ‘motor vehicles and parts and ‘basic iron and steel’ rising by 27.1% and 9.8% respectively over the previous 12 months. The sectors that are exposed to local demand showed the weakest growth, such as ‘textiles and clothing’ which declined by 4.3.%, supporting Ms. Marcus’ view.

The Week Ahead

· The key local data release this week is May’s retail sales numbers, which are expected to have increased as spending accelerated ahead of the World Cup. Retail sales rose by 3.2% year-on-year in real terms in April after several negative months as the impact of lower interest rates and inflation have gradually boosted household balance sheets.

· The price of petrol will drop by 15c to 18c per litre on Wednesday.

· Global data releases of note this week: Chinese Q2 GDP data, industrial production, retail sales, foreign exchange reserves and trade balance; the results of Japan ‘s Tankan survey of large manufacturing companies are released; US trade balance for May; Germany’s ZEW economic sentiment survey; inflation numbers from the UK, US, eurozone and China.

Fairbairn Capital | Old Mutual

Investment Intelligence|Inside Insights