In a tough environment, where should investors be looking?

With inflation expected to rise and interest rates likely to follow suit, a consumer under pressure and an expected downward adjustment of many asset prices, where should an investor turn? Marriott Asset Management provides some perspective on these issues and gives investors some pointers.

During 2010, the South African investment environment was characterised by foreign demand for bonds and equities, a strong rand and consequent low inflation. This resulted in further interest rate cuts and an economy that favoured consumers while exports and the mining sector were impeded. The extraordinary success of the Soccer World Cup elevated South Africa in the eyes of the world and left a very positive feeling in so many minds

However, the outlook for inflation has deteriorated markedly. Inflows of foreign funds during 2010 contributed to an 11% appreciation of the annual R/US$ exchange rate, helping to contain inflation at historically low levels. We expect a decrease in the quantum of foreign inflows into South African capital markets. Further appreciation of the rand from current levels is therefore highly improbable and the buffer against the inflationary impact of excessive wage increases, hefty electricity tariff hikes and rapidly rising food and energy prices will be lost. Approximately 23% of the inflation basket is a measurement of food and fuel prices which are directly impacted by the currency.

We consider inflation to be the most important economic variable as it influences the income yield and income growth prospects of all asset classes. In addition to this it has a profound impact on the lifestyle of income-dependent investors as well as being the benchmark for real returns.

The South African equity market has shown strong performance under the favourable conditions. But local equities withforward yields in the region of 3.4% based on dividend growth consensus forecasts for 2011 (which may well prove to be overly optimistic) are below their historic averages. This, together with the expectation that earnings growth, and hence dividend growth, from local companies are likely to be subdued in the face of a struggling consumer, leads us to believe equity valuations are demanding. Given this, we are not convinced that the equity bullrun will endure.

2010 saw dividend growth of some 16% generated by South African companies. In part this reflects a resumption of certain dividends that were waived during the financial crisis, while consumer spending also served to boost company profits.  However, we are cautious about further growth in consumption. Although historically low interest rates have allowed consumption to revert back to near pre-recession levels, the South African consumer remains overly indebted and under-saved.  Consequently, any increase in interest rates is likely to constrain consumption significantly.  With the likelihood of rising inflation and higher interest rates in the years ahead, we anticipate that the consumer will have less spending power which will ultimately hamper dividend growth of many SA companies. 

With expensive local equity income streams, offshore opportunities look far more attractive. Dividend yields of first-world mega-cap stocks are unusually high especially when one considers local alternatives, thus equity valuations in these markets are presenting investors with a significant opportunity to generate inflation-beating returns over the next five years.In addition, higher South African inflation is expected to translate into a depreciating rand. Investing in offshore markets, would offer investors a hedge against a weaker currency while simultaneously affording the opportunity to diversify risk.

Investors who do not wish to invest offshore should look to the more defensive local sectors, such as pharmaceutical, food, and telecommunications. Such companies are able to protect their turnover and pass on rising costs to consumers, which will enable them to prevail in the current market conditions.

The South African bond market has benefited from increased foreign demand and the impact of a strong rand on inflation. These dynamics are unlikely to continue due to rising inflation and an anticipated decline in foreign demand. We therefore favour inflation-linked bonds due to their attractive real yields and inflation hedged income.

Property fundamentals remain weak and, given the longer-term inflation outlook in South Africa, we continue to consider property to be an expensive source of income. Property has strong bond-like characteristics, resulting in the yields of both asset classes being highly correlated.

This release has been issued on behalf of Marriott Asset Management

For more information contact:

Marriott Asset Management:
Bronwen Barclay, Head of Marketing & Distribution: 031 765 0736 or 083 797 9979
Duggan Matthews, Investment Professional: 031 765 0705 or 071 951 8449

Shirley Williams Communications
Shirley Williams: 031 564 7700 or 083 303 1663
Gillian Findlay: 082 330 1477

About Marriott Asset Management

Marriott is a differentiated asset management house that provides solutions for retirement using an income focused approach to investing. The tag-line “Income Focused Investing” evolved as a result of the investment philosophy underpinning Marriott Asset Management.

Marriott Asset Management began as Russell & Marriott in Durban in 1862, making it one of the oldest financial services businesses in the country. The company currently has over R8-billion in assets under management, and offers a number of investment products including local and international collective investment schemes. Marriott Asset Management was acquired by Old Mutual in 2005 and now forms part of the Old Mutual Investment Group SA as an independent boutique.