Inside Insights 29 Nov 2010

Investment Intelligence|Inside Insights

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

Added on 29 November 2010 @ 9:49 AM

Risk off again

Since the end of the credit crisis and the start of the recovery phase almost 2 years ago, world markets have been gripped by bouts of alternating euphoria and despair. Some financial journalists have referred to these as period of "risk on" and "risk off." During "risk on" phases, equities, commodities, emerging markets and other riskier assets rally. During the "risk off" phases, volatility rises and US Treasuries, the dollar, gold and other "safe-haven" assets are sought-after. Three factors have caused the recent days to be a "risk off" phase on world markets.

Firstly, geopolitical tensions flared when the unpredictable North Korean regime attacked South Korea, a close American ally. North Korea's closest ally is China, although it is not always clear how far the Chinese will go in backing Pyongyang. Needless to say, the last thing global markets want to see now is the world's two largest economies squaring off.

Perhaps the biggest contributor to market jitters remains the European sovereign debt crisis, with the yields on Irish and Portuguese bonds rising, and the difference or "spread" between these yields and safe German government bonds remaining high. The Irish bailout was not met with the full confidence of the market, partly because of fears that the Irish government might fail to secure the parliamentary majority necessary to pass the harsh austerity budget, and partly because the Irish government's liabilities with respect to its guarantees of the Irish banks remains dauntingly large. And even if the Irish bailout is successful, urgent questions are already being asked about the Portuguese government's ability to service its large and growing debts. The easiest way for a country to deal with a debt burden is simply to grow its economy, but there is no obvious source of growth for the likes of Greece, Ireland and Portugal, countries that have no control over monetary policy and without the option of weakening their currencies.

Thirdly, the market remains concerned over China's policy of constraining bank lending and the possibility of further interest rate hikes. China's growth was of course a major source of optimism for global investors over the past few years. If the Chinese authorities continue to tighten policy to cool their economy, it might turn out that this optimism was overblown.

Growth slides

New data out last week showed that the Reserve Bank was justified in cutting the repo rate to record low levels. Economic growth slowed in the third quarter to 2.6% quarter-on-quarter (after inflation and seasonally adjusted and annualised), below analysts' expectations. The second quarter's gross domestic product (GDP) growth rate was also revised down to 2.8% from 3.2%. While there was a strong recovery in mining activity (28.1%) off a low base in the third quarter, the manufacturing sector contracted by 5%, hampered by strikes and a strong rand. The finance, real estate and business service sector - the country's largest - grew by only 1.5%. The retail, wholesale and motor trade sector - accounting for about 13% of GDP - grew by 3.3%, supported by lower interest rates. All in all, the GDP numbers support the view that local economic growth is running out of steam, although it is pleasing to know that the size of the economy has passed its previous peak in real terms (see graph). The big concern is if the global economy weakens over the next few quarters. South Africa's fortunes are very much tied to those of the world's leading economies, and premature fiscal tightening and large debt burdens pose a risk to developed world economies.

Headline consumer inflation rose slightly in October, but remains very close to the bottom end of the Reserve Bank's target range. CPI increased by 3.4% year-on-year, from 3.2% in September. This number was slightly higher than most economists expected, and suggests that the inflation cycle might have bottomed out. However, inflation is likely to remain within the 3% - 6% target range until end-2011, allowing the Bank to keep interest rates low for at least the next 12 months. As we've said before, further interest rate cuts will depend on the strength of the rand.

The Week Ahead

• The Reserve Bank releases October money supply growth and private sector credit extension numbers on Monday.

• On Tuesday, SARS releases October trade balance numbers.

• The Kagiso manufacturing purchasing managers' index (PMI) for November will be released on Wednesday. The PMI, a gauge for the health of the manufacturing sector registered 49.8 in October, below the 50 points level that separates expansion from contraction. The consensus expectation is for the index to improve slightly in November, moving above 50 points. PMI data for other major economies will also be released this week.

• On Thursday, Naamsa releases new vehicle sales for November. Sales of new vehicles grew 18.3% year-on-year in October.

• Global data releases and events of note: UK October money supply; Japan October unemployment, household spending, industrial production and housing starts; eurozone November consumer confidence and inflation; US September Case-Shiller house price index, pending home sales, consumer confidence, ADP private sector employment report, November non-farm payrolls and unemployment rate. The Federal Reserve releases its ‘Beige Book' of economic conditions.

Fairbairn Capital | Old Mutual

Investment Intelligence|Inside Insights