Economic and market outlook for 2010: Absa Asset Management

Craig Pheiffer, General Manager: Investments at Absa Asset Management Private Clients writes that in the Absa January 2009 newsletter (in the middle of the recession and before Q4 2008 GDP had been published) Absa shared the view of their Barclays Capital colleagues that the global recession would technically end in Q3 2009.

At that time, three of the big four developed economies were forecast to show positive growth in the third quarter with UK GDP growth estimated to be flat. As it turned out, UK growth surprised all and sundry and came in at -0,3% q/q (-1,0% on a seasonally adjusted and annualised rate - "saar") to officially extend their recession by a further quarter. The current outlook, detailed in the table below, is for an ongoing yet modest recovery in late 2009 in the Euro area, the UK and Japan, with a much faster paced economic recovery in the US.

The enormous fiscal stimulus that has been applied to these economies has been supported by a two-pronged expansionary monetary policy (quantitative easing and low interest rates) and the bulk of the stimulus is expected to endure for most of 2010. In the US the target of the Fed Funds rate is only forecast to be increased in the latter half of the year (to 1,00% from 0,00% - 0,25%) while the UK Bank rate is similarly expected to rise from 0,50% to 1,50% by year-end. The Refi rate in the Euro area is not expected to be adjusted from its 1,00% level at any stage during 2010 while an increase in the Japanese overnight call rate from 0,10% to 0,30% has been pencilled in for the final quarter of 2010.

There are many fears of an inflationary backlash as demand recovers in an environment of cheap money but with much resource capacity available, that's not the central view (although gold bulls might tell you otherwise). Deflation in the Japanese economy is expected to persist throughout 2010 and 2011, while inflation in the Euro area is expected to remain below the 2,0% target range next year.

Apart from a pickup in consumer price inflation in the first half of 2010, growth in consumer prices in the UK is expected to end the year comfortably below the Bank of England's 2,0% inflation target. The fast-paced US economic recovery is expected to slow a little in late 2010 and inflation is forecast to decline from around 2,6% in Q1 2010 to around 1,6% in the final quarter of the year.

For the developed economies as a whole, Barclays Capital forecasts real GDP growth of 2,5% in 2010 from -3,4% in 2009. Coupled with expectations of the developing economies growing at a 6,3% pace next year (2009: +2,0%), global GDP growth is forecast to increase by 4,1% in 2010 from an estimated decline of 1,1% in 2009. Among the developing economies the big four BRIC countries (Brazil, Russia, India, China) are estimated to collectively grow at 7,7% in 2010 (2009: +4.8%) with China itself almost back to double-digit growth at 9,6% next year (2009: +8,6%). Forecasting is a dangerous job at the best of times and one must consider that there will still be much uncertainty and volatility over the next year or two as the enormous expansionary policy that has been applied almost universally by the fiscal and monetary authorities is gradually withdrawn.

The South African economy

South Africa technically exited recession in the third quarter with real GDP growth of 0.9% q/q (saar) although on a year-on-year basis real growth declined in Q3 by 2.1%. Economic activity is expected to improve modestly next year (+2,3% y/y) but even this rate of growth is more upbeat than the forecast of 1,5% published by the National Treasury in its recent Medium-term Budget

Policy Statement ("MTBS"). At 5.9% the current level of consumer price inflation rests just below the target range of 3% - 6%. A shallow dip into the range was expected in the short-term but overall consumer price inflation is expected to hover around the key 6% figure over the next six months. The South African Reserve Bank ("SARB") is forecasting a more sustained dip into the range in Q2 2010 but this move is already reflected in its current interest rate stance. For this reason no further interest rate cuts are envisaged in this cycle and a modest tightening of policy is pencilled in for the latter part of 2010.

With pressure from administered price increases and more specifically the threat of higher electricity prices (and the resultant knock-on effects), the risks to inflation are on the upside and that must ultimately place the risks to official interest rates to the upside as well.

The sharp improvement in the current account deficit witnessed more recently is expected to be sustained well into next year and that is the basis for a fairly positive outlook on the currency. Barclays Capital is forecasting an exchange rate of R7,63/$ in six months' time (with the dollar at $1,50/€) but some dollar strength in the following six months (to $1,45/€) is expected to drive the rand to around R8,00/$ in a year's time. Of concern for the currency is the growing deficit on the National Budget and the ongoing need to fund Eskom's expansion plans. Current expectations are for a deficit of 7,7% in 2009/10 and a deficit of 5,2% in 2010/11 (versus official MTBS estimates of 7,6% and 6,2% respectively).

Residents and investors the world over will be watching our politicians and policymakers very closely next year as they reconcile key policy issues. One question that needs to be answered relates to the body that should be driving and determining economic policy (National Treasury vs National Planning Commission). Some statements in that regard have already been forthcoming but we need to see the practical application thereof. Another key issue relates to the role of the SARB and whether it should simply be an institution safeguarding the internal and external value of the rand (i.e. a mere inflation targeter) or whether it should have a broader monetary policy mandate i.t.o. domestic growth.

The huge amount of liquidity in the US monetary system and the subsequent carry trade is seeing vast amounts of money currently being directed to emerging market economies such as our own. International investors often ignore some of the political noise while the rewards on their capital outweigh the investment risks but that is only up to a point. We need to continue to ensure that our macroeconomic policies remain sound and that all of the good work built up over the past 15 years is not undone. We should have the discussions about issues such as inflation targeting and a potentially broader role for the SARB as long as we don't meddle with the independence of the Central Bank. That could have repercussions for the balance of payments, the currency and domestic economic activity that would be "too ghastly to contemplate".

The Markets

Gazing into the market crystal ball never seems to get any easier. There are always myriad endogenous and exogenous variables that could go either way over the course of the year and that leaves the crystal ball hazy at best. Using the information that we have to hand at the present time though, we can construct a base case view. Looking into 2010 we would expect that domestic growth would pick up slowly and that local interest rates would start nudging slightly higher.

That starts modestly improving the outlook for cash but it's unlikely that we will see any dramatic rate increases from these low levels during 2010. At the start of the interest rate tightening cycle and with all of the funding pressures from Treasury, it's unlikely that bond yields will be moving lower (and prices higher) in 2010. The bond market does discount future official interest rate changes fairly far in advance but it would be unreasonable to expect the market to start discounting a decline in interest rates when we are only just anticipating the start of the tightening phase.

That just leaves the equity market. At a 17x historical price/earnings ("PE") ratio, it's already over one standard deviation above its ten year mean PE of 13,7x (and its level of 8,2x in March 2009). A lot of good news has already been factored into the market and the economics and the actual earnings still have to catch up. The market can sustain a higher PE as the earnings outlook improves and for as long as emerging markets stay the flavour of the moment but any withdrawal of foreign capital or major earnings disappointments could hurt all of the positive sentiment.

The market as a whole is not cheap and for that reason 2010 is very likely to continue to be a stock pickers' market. With that in mind, investors may start looking for value outside of the large capitalisation ("cap") blue chip stocks. The smaller mid-cap stocks and the small cap stocks that were neglected during the dramatic market rally this year might just have their day in the sun again.

Whichever way the markets turn, the Investment Team at Absa Asset Management Private Clients (ABAM PC) are constantly alert to opportunities that may arise that will contribute to growing and preserving our clients' wealth over the longer term.