EDITOR HANNES BARNARD BLOEMFONTEIN STOCKBROKERS

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1 Bloemfontein Bloemfontein Stockbrokers 1 st Floor 200 Nelson Mandela Drive Brandhof Bloemfontein EDITOR HANNES BARNARD BLOEMFONTEIN STOCKBROKERS Hannes.Barnard@psg.co.za Quote of the Month History does not repeat itself but it does rhyme. - Mark Twain - Global Economy Services: Stockbroking Financial Planning Investments Portfolio Management September 2013 BOFA Merrill Lynch has produced a wonderful report called, The longest pictures. US GDP & Debt since 1952 Source: BOFA Merrill Lynch Investment Strategy, Haver Since financial markets are trading at, or near all-time highs, perhaps it is time to reflect, not only on the historic path that brought us here, but also on the challenges still lying ahead. Currently, total credit extended in the US is 3X the size of the economy - a GDP of $16.6trillion supports total debt outstanding of $57trillion. Sixty years ago, debt was no higher than GDP. It should therefore be expected that years of excess debt, followed by the Great Recession, would lead to deleveraging and the thread of deflation. 1

2 The below graph reflects an average nominal US GDP growth rate over the past 5 years of just 2.3%, its slowest pace since US Nominal GDP growth (5year moving average) since 1795 Source: BOFA Merrill Lynch Investment Strategy, Haver With the economy contracting sharply as a result of the deleveraging, central banks had no other choice but to flood the system with large scale monetary stimulus. Quantitative easing programs, better known as QE1, 2 & 3, started. In fact, if central banks had not reflated asset prices like they did, we probably would have experienced another depression. To put things into context, the UK s current base rate (similar to our repo rate) of 0.5%, is the lowest in 300 years. UK Base Rate since 1705 Source: BOFA Merrill Lynch Global Investment Strategy, Global Financial Data, Bloomberg In their latest update, the Bank of England said that their bond buying program would be maintained until such time that economic indicators dictate otherwise. 2

3 In the US, the QE programs pushed bond yields down to post WW2 levels. It certainly puts the world s problems into perspective if interest rates had to be decreased to post WW2 levels. It is clear why market participants believe the 30 year bull market in bonds is over and done with. From 14% in the 80 s to a low of 1.6% in April of this year, it is hard to see how yields could go any lower. DJIA and US Treasury Bond Yields since 1900 Source: BOFA Merrill Lynch Investment Strategy HEADWINDS AHEAD.. Since US Treasury Bond Yields set the benchmark for interest rates globally, it is clear that bonds as an asset class would face severe headwinds in the future. Listed property which is highly correlated to these bonds yields, faces the same headwinds. As per the graph below it can be seen that the Federal Reserve, together with other global central banks, indeed succeeded in creating a wealth effect (inflating asset prices for a feel good effect). The correlation between the S&P 500 index and the FED s balance sheet is 90%. The Stock Market now follows the FED s Balance Sheet Source: Haver Analytics, Gluskon Sheff 3

4 With the FED s decision to start tapering (reducing the amount of bond buying), it begs the question how markets will react. Although the decision has been well communicated to the market, the amount of tapering is unknown. What is pretty evident is that it is happening sooner than previously expected. History has shown that negative interest rates, as we have witnessed in the US to date, create bubbles. This could have direct consequences for bond markets globally. No doubt, emerging markets (SA included) will be a loser as our twin deficit makes us stand out like a sore thumb. Higher inflation as a result of outflows from emerging markets has already prompted Brazil, Indonesia and Turkey to tighten monetary policy. Watch this space! The Fed s experiments in providing negative real rates... Source: Haver Analytics, Gluskin Sheff...have always led to excess Source: Haver Analytics, Gluskin Sheff 4

5 Markets and Your Portfolio Those classes of investments considered best change from period to period. The pathetic fallacy is what is thought to be the best are in truth only the most popular the most active, the most talked of, the most boosted, and consequently, the highest in price at that time. - Fred Schwed, Where are the Customer s Yachts? - With the All Share Index remaining at elevated levels of valuation, it certainly poses challenges to the investor. On the one hand investors in need of a high level of interest income are facing a bond and property market with potentially severe implications. On the other hand, investors looking for capital growth face high valuations. JSE All Share Index Long term PE Source: BFA McGregor All of a sudden diversification no longer offer any protection, as central bankers have distorted financial markets like never before in history through the QE programs. Given all that facts already mentioned and with markets looking forward, fund flows should favor Developed markets over Emerging markets as the graph below indicates. US Stocks relative to Emerging Market stocks since 1949 Source: BOFA Merrill Lynch Global Investment Strategy, Global Financial Data 5

6 So what would be a realistic expectation for our equity market over the next few years? Looking at the historic returns from different market PE s, an investor investing in the All Share Index today should only expect a 1% annualised return over the next 4 years. Unless we get the high level of earnings at a lower PE, it will be extremely difficult to generate high real returns over the next few years. Historic returns at various market PE s Source: I-Net & Allan Gray research, data updated to 31 August 2013 Clients would have noticed that we have increased our percentage cash in our portfolio by reducing our weightings in those companies that we believe to be at risk of a correction. At the same time new client fund are patiently invested into companies trading well below market valuations. As we have said on numerous occasions, the best way to reduce risk is to pay significantly less than the company s fair value. As far as global currencies are concerned, I believe that we are at the early stages of a return to parity on the US Dollar versus the Euro (a bold call indeed). I believe that a combination of normalisation of monetary policy, innovation, the return of manufacturing jobs and the large shale gas discoveries will re-engineer and strengthen the US economy substantially, bringing about opportunities that will naturally draw large scale of investment to the US. 6

7 The US Dollar since 1967 Source: BOFA Merrill Lynch Global Investment Strategy, Bloomberg To participate in this longer term trend, we have already identified and will continue to search for companies that will participate in this development. Should this outcome materialise, it goes hand in hand with the belief that the current commodity cycle peaked in This is bad news for South Africa as a commodity producer and foreshadows ongoing rand weakness. The Long-Run Bear Market In Real Commodity Prices Peaked in

8 As an example, the copper price is trading well in excess of its long run averages. The current global economic growth is far too weak to keep it at these elevated levels and thus we should expect much weaker prices going forward. Iron ore prices are looking similarly and therefore pure copper and iron ore companies are avoided as an investment. Rolling 10 Year annualised Copper price returns since 1920 Source: BOFA Merrill Lynch Global Investment Strategy, Ibbotson, Bloomberg Analysing the elevated levels of financial markets, we have no other choice but to become increasingly conservative in our judgment. I highlight this because our investment philosophy dictates our actions - and not the market. At the end of the day total return consists not only of the winners, but just as much from the losers that we have avoided. We therefore ask our clients to remain patient as we look for new opportunities. Let us not get drawn into the herd mentality. Conclusion Many years of deleveraging still lies ahead as consumers try and restore their own balance sheets. Investors should lower their expectations as future stock market returns are likely to be muted. There is no clear outcome to this global economy yet deflation or inflation. Only time will tell. As long as we religously stick to our investment philosophy, returns will look after themselves. Free State Greetings Hannes Barnard 8