General investment outlook for 2010

Posted On Tuesday, 15 December 2009 02:00 Published by
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With the year 2009 fast drawing to a close, attention has turned to the outlook for 2010. Dr Prieur du Plessis, Plexus group chairman, sheds some light on his investment team’s thinking regarding prospects for the global economy and financial markets

The year of 2009 will be remembered as a year of contrasts. The year started with a devastated world economy. Liquidity had dried up as financial institutions turned their backs on each other and on clients owing to the uncertainty about their ability to survive the crisis. Financial markets were sold down to ridiculously low levels, leaving investors with huge capital losses. Central banks issued rescue packages to large financial institutions, cut interest rates to almost zero and reverted to quantitative easing and other troubled asset relief programmes to reduce the systematic risk in worldwide financial systems.

The year ends with strong indications that central banks’ emergency measures have been successful. Most financial institutions survived; there are strong indications that the global economy is emerging from the recession and equity markets, especially emerging markets, have delivered exceptional returns for investors who were willing to take some risks.

However, investments are not based on the results of the past year, but on future opportunities.

The outlook for global economic growth, inflation and interest rates
Economists and market analysts are divided on the sustainability of the global economic recovery and the prospects for global economic growth in 2010. As long as uncertainty prevails, inflation remains subdued and central banks keep interest rates low while maintaining most of the emergency measures, liquidity will remain high. We believe the current level of liquidity is too high and the greatest risk to the financial system lies in these excessively high levels of liquidity that could ignite and fuel inflation to very high levels. At the same time we also believe the high levels of liquidity and inflation may offer the best investment opportunities in 2010.

The situation could change late in 2010 if the global economy returns to higher growth rates, or when worldwide inflation increases. This would leave central banks with no other choice but to withdraw the existing emergency measures and increase interest rates to reduce liquidity.

Exchange rates
The current weakness in the US dollar and the GBP is undoubtedly the result of the low interest rates and high levels of liquidity in the US and UK financial systems. This dollar and GBP weakness should continue as long as interest rates remain low and liquidity high. Investors should therefore limit their offshore exposure to the US dollar and the GBP in favour of currencies such as the euro, yen and emerging-market currencies. Investors can expect the US dollar and the GBP to strengthen later in 2010 if the US and the UK start to increase interest rates. The offshore exposure should then be realigned to a more balanced exposure.

Commodity prices
Commodities are priced in US dollars and prices should strengthen as the dollar continues to weaken. Industrial commodities should also benefit from stronger economic growth as the demand for commodities increases. Gold, however, would benefit from higher inflation and from the efforts of mainly emerging countries’ central banks to diversify their foreign exchange reserves away from the overwhelming exposure to the US dollar.

Stronger economic growth should soften the negative effect of a possibly stronger dollar on industrial commodities later in 2010, and the higher level of inflation should cushion the negative effect on gold. Although prices would remain strong, further upside potential should be limited.

Equity prices
The easy money on equity investments has been made with the rerating of PE valuations from extreme lows to the currently above-average valuations. Any further sustainable gains in equity prices should be underpinned by solid growth in company earnings.

The mining and basic materials sector should benefit from the current higher commodity prices, but industrial companies would need a more definite recovery in industrial production and consumer spending. Financial institutions should benefit from the improved quality of current loans and further growth in credit extension. The year 2010 should thus be a stock pickers' market where good returns will depend on the fund managers’ ability to identify value in mostly small and mid-cap companies.

Property offers the potential of capital growth (as the value of the underlying property holdings increases) as well as the potential for the income stream to grow as the rental escalates yearly. The investment potential of listed property should improve as property prices recover and economic growth improves. Vacancy rates in commercial property would decline, resulting in an improvement in rental income. A moderate exposure to listed property would therefore be a good alternative to low-yielding interest-bearing instruments in an income-generating investment.

Interest-bearing instruments
When central banks were forced to lower short-term rates to close to zero, yield curves normalised (short-term rates lower than long-term rates) by default. Even long-term rates were pushed lower when these banks bought huge amounts of bonds back as part of their quantitative easing programmes.

The after-tax return on cash and money-market instruments is currently very unattractive. A portfolio of perpetuate preference shares offers a much more attractive proposition. The yields of most preference shares are after all linked to short rates and the yield of preference shares will increase when short rates increase.

The very low bond yields are unattractive from an income perspective, but stronger economic growth and higher inflation could push long-term rates higher to more attractive levels. However, any increase in long-term rates means an immediate drop in the capital value of investments in bonds. This is also true when long-term yields increase at the end of the quantitative easing programmes. Inflation-linked bonds would be a more attractive alternative as the principal investment will grow in line with inflation.

No one can say for certain what 2010 will hold for investors. However, we are aware of the destructive effect of shocks in financial markets and we realise there are as many risks that investors should bear in mind as there are opportunities offered by financial markets. Identifying and managing these risks are just as important as identifying and seizing the investment opportunities.

Publisher: eProp
Source: Plexus

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