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Investment Strategy
Tuesday, February 1, 2005
Relative benefits

There is still room for lower interest rates in South Africa, if you consider the real rate: indeed a further fall of three percentage points in prime to 8% per annum, based on long-term analysis is justified. According to research by Old Mutual Asset Managers (OMAM) the real prime rate in this country has averaged about 4% since 1950 (see graph). With our inflation rate down to about 4% for calendar 2004, and prime still at 11%, gives a real rate of 7%, which is historically high.
“But,” says Charles de Kock, Head of Asset Allocation and Strategy at OMAM, “the economy is a little over-heated at present so I don’t see interest rates being allowed to fall further in the very near future.” Factors counter to a further easing of rates, in the short term at least, include rising household debt, a widening trade deficit, and strong rand.
Nevertheless, there is undoubtedly a structural trend downwards for interest rates, so investors had better get used to it. Of course, if inflation falls further on a sustainable basis, even a prime rate of 8% will be too high.
Comments Alwyn van der Merwe, Senior Portfolio Manager at OMAM, “The return that can be expected from cash is linked to the monetary policy measures implemented by the Reserve Bank.
“Since the late 1980s short-term interest rates have been high in real terms as monetary policy authorities set out to bring inflation in line with South Africa’s most important trading partners. While authorities have been successful in bringing inflation down to the current low levels, we expect continued discipline from them. Nevertheless, compared to an average real prime rate of 4% in the 1960s, the current real prime rate of approximately 7% arguably allows for lower rates in future.”
He says investors can expect a return on a cash investment of inflation plus 2,5% to 3,5% over time. This translates into nominal returns of between 6,5% and 7,5% on a cash investment over the longer term. Similar reasoning would suggest an expected nominal return of between 7,5% and 9,5% for bonds.
OMAM has the view that longer-term returns from equities are driven simply by the growth in profitability and dividends. Profitability is closely linked to nominal economic growth over the longer term.
“Applying our own growth forecasts, on this basis we expect companies to grow their profits by approximately 9% to 11%. Add to this the additional 3% expected dividend yield and we derive an expected longer-term nominal return from equities of between 12% and 14%.”
Mr Van der Merwe says these numbers do not compare favourably with the heady nominal returns recorded by the various asset classes during the high inflation environment of the 1980s. However, in real terms, these expected returns stack up well against those generated in an environment of higher inflation as we experienced previously.
“In the end it is the real returns that matter, as these determine the buying power available to investors.”
He says volatility remains a part and parcel of financial markets in general and of the local equity market in particular. And therefore it is not uncommon to see an exceptionally high return in a particular year.
For this reason investors should consider the longer-term expectations together with their specific risk profiles when investing.
“If risk and time is not an issue we prefer equities to bonds and bonds to cash.”
Meanwhile, the economy is booming on many fronts especially regarding increases in fixed investments and consumer spending, while general confidence is high.
Comments Mr de Kock, “It is our view that economic policy will be growth and jobs supportive. A weaker rand is a key ingredient in the policy mixture.
“Reducing interest rates further in order to help weaken the currency must therefore be an option.”
OMAM’s research shows that South Africa faces an economic environment far more like that of the 1960s than any other decade since. This period was typified by more muted economic cycles, higher average economic growth, lower inflation and lower real interest rates.

Copyright © Insurance Times and Investments® Vol:18.1 1st February, 2005
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