For the optimists, 2006 was yet another triumphant year. Our optimistic prediction at the beginning of the year of a 25% return from South African equities proved still too conservative, as the market delivered yet another massive 40% plus return — despite what was not the most perfect of years: it saw a war in the Middle East, four rate hikes, more chaos in Iraq, more HIV/Aids, more crime, more corruption, rape trials, further deterioration in Zimbabwe and the first blows in the fight for presidential succession.
So what fuelled the 41% return enjoyed by equity investors last year?
Firstly, the Chinese/Indian scramble for resources in Africa continued, with the resources sector up 44%. Secondly, financials and industrials, which were relatively underpriced, finally received the attention they deserved, returning 36% and 42% respectively.
In line with global developments and fuelled by some very attractive valuations, the wave of private equity investors scouring our market has resulted in a substantial rerating of a number of our listed companies. While some have since delisted, having been bought out by both local and foreign investors, others have rallied strongly in anticipation of very attractive cash offers.
Thirdly, despite a brief mid-year collapse in confidence, global sentiment towards emerging markets remained positive.
The rand, predictably, continued its gradual decline, ending down roughly 9% against the dollar (although it was typically volatile, shedding roughly 22% at one stage), and oil returned to more benign levels.
What then can we expect from 2007? From an interest-rate perspective, we are either at the peak, or almost there. While another 50 basis points up is possible, it becomes less and less likely if oil stays at current levels — which it should. A variety of factors have contributed to the weakness in the oil price, including a milder-than-expected hurricane season, a warmer-than-expected winter in the northern hemisphere, less speculative activity, additional capacity and declining geopolitical tensions. A democratically run United States Congress should also ease further tensions.
Once again, expect a gradually declining currency — and given the weaker oil price, you should see inflation peaking in the second quarter.
WHAT ARE THE RISKS FOR 2007?
The two main risks for 2007 are:
US housing market: 2007 will see the US housing market under renewed pressure.
A soft landing will see house prices drift sideways to slightly off going forward, putting heavily over-geared US consumers under pressure but unlikely to make them stop spending completely or panic.
A hard or crash landing, however, would see prices correct fairly significantly and panic from consumers, and spending would dry up completely. The question then would be whether the Asian consumer can take over from the US consumer, in which case the world would slow but not stall.
We believe the softer landing to be the more likely outcome.
The extent to which the US (and hence the global economy) slows will dictate Chinese and Indian growth, which in turn will affect demand for our commodities — and our currency, our economic growth and the performance of the JSE.
Presidential succession will play itself out continuously throughout the year. There will be rumours, denials and lots or rhetoric. Some candidates will be market friendly and others not. Hopefully sanity prevails over emotions. Watch this space.
So what should investors be doing? Remain diversified — equities aren’t cheap and a correction at any stage is entirely possible. However, equities are not in dangerous territory, as is evidenced by the fact that there are equity funds on PEs of approximately 12x, with dividend yields of up to 4%.
This year should once again see equities outperforming bonds, although by a lot less than the past few years, which will make portfolio diversification more palatable. Barring any abnormal events, 2007 should see equity returns comfortably outpacing inflation, bonds returning roughly 8% and cash approximately 9%.
Jeremy Gardiner is a director of Investec Asset Management