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Investment Strategy
Friday, August 1, 2008
Inflation no longer the world’s villain

The risk of a spike in the global inflation rate on the back of spiralling oil prices has been much touted as the villain responsible for the general doom and gloom pervading the investment markets around the world.

But a closer look at the real relationship between the rising oil price and inflation shows that investors have been reacting to a perceived threat rather than a real threat.
Graham Mason, CEO of Prudential Portfolio Managers in South Africa, says for the first time in decades the global inflation rate has not kept pace with the oil price. “A comparison of how global inflation has typically reacted to periodic oil price shocks since the 1970s shows corresponding spikes for both. But in 2002 the correlation between the oil price and inflation fell away completely. The data shows no correlation between the global oil price and inflation.”
Mason says global headline inflation is now moving in the 3% to 5% band, while the oil price is running at around US$140 a barrel. In 2000 a barrel of oil came in at just under US$25 a barrel, while global inflation was also around 3% to 5%.”
Mason says, while the world has braced itself for an inflation rate that would follow the oil price, this did not materialise. As a result, stock markets have priced in the inflation shock that has not come, and are now looking incredibly attractive at a forward PE of 10.5. The South African equity market is even cheaper at a forward PE of 9.4; indeed, the cheapest it has been in a long time.
“There is no question that the inflation rate both globally and in South Africa has been under pressure, but the reality is that it is still low compared to historic levels. At the same time, however, the oil price has reached historical highs.”
So what has changed? Mason says the number one inflation damper is the fact that wages no longer trail the oil price.
“In the past rising oil prices would invariably lead to higher wages. But over the last two decades the fall of the Berlin wall and the access to cheaper labour in India and China has provided the world with an increased global labour pool of about 1-billion people. This has significantly lowered the cost of wages as well as production and service delivery.”
Mason says countries are increasingly focused on reducing labour and other production costs. Invariably, this helps curtail inflation. He believes that this key driver of earnings growth is here to stay, both globally and in South Africa.
Prudential predicts earnings growth of 35% over the next 12 months. How will this impact on the JSE All Share Index? Mason says resources remain the wild card.

Resources under the loop

Gary Quinn, mining analyst and equity fund manager at Prudential, says resources are in their tenth year of an incredible bull run. “In the past resources would experience short-lived upturns of between three to five years, with the down cycles often lasting several years. Typically, the up-cycles would be caused by an increase in demand, with a corresponding increase in supply then sparking the next down cycle.”
But, says Quinn, this time the demand has not been met with the required supply, causing commodity prices to rise relentlessly. According to him, a number of historic events are responsible for the supply problems that are spiking up the price of resources:
The decline in commodities prices in the 80s and 90s led to dramatic under-investments in infrastructure by mining houses. When the demand from China suddenly became significant from early 2000, supply could not keep pace.
In addition, India and other emerging markets representing some 2-billion people also experienced sizable growth in infrastructure, therefore demanding more resources. As a result the normal supply response to high prices did not happen. Thus the last three years have been more about supply shocks than demand surprises.
He says ironically the supply and infrastructure problems in the mining sector that have caused commodity prices to rocket are also behind rising mining costs. This is having a dampening effect on earnings growth and will be a concern in the future if commodity prices do not continue to rise.
Quinn’s view is that despite the incredible run that commodity stocks have experienced in recent months, this is probably not the time to put new money into commodities. “We don’t have a pessimistic view on commodities, but we are increasingly developing a muted view on earnings growth potential.”
He says that it is difficult to predict what exactly will eventually cause the commodity cycle to turn, but adds that it is Prudential’s view that the cause may be a reduction in demand, which may in turn lead to slowing world GDP growth. He says there are already early signs suggesting that this is true for oil, platinum and gold. “We are starting to see consumers opting for cars with smaller engines in response to rocketing world fuel prices, slowing the demand for oil. The demand for platinum was lower in 2007 than it was in 2006. And the demand for gold jewelry hit a 14-year low in the first quarter of this year.”
Prudential therefore believes the commodity cycle is close to its peak. “We are underweight resources, and we are definitely avoiding small cap mining stocks and start-up ventures.”
Time to panic? No, says John Kinsley, Chief Operating Officer of Prudential. “If you consider that over every 10 year period of return since 1900 in SA, only equities outperformed inflation in every one of those periods — quitting equities altogether is never a good idea.”
Kinsley points out that despite equities trumping inflation and cash by far over the longer-term, the average investor repeatedly loses out on the surges in the stock market.
He says while the three year performance figures to the end of June 2008 show that equity unit trust fund sectors delivered attractive performances of between 23.5% and 31.5% for this period, the bulk of the inflows went into money market and specialist cash sectors, which all delivered below 10%.
Kinsley says the opportunity cost for the majority of South African investors has therefore been big, although some investors did benefit through exposure to low equity and real return funds. But he also agrees that an client’s time horizon when investing is crucial in deciding on the appropriate investment vehicle.
“If you only have one year or so to go before you need your money, there is no doubt that you should be invested in a money market fund. However, if you have three or more years you should have a well diversified investment portfolio.”
Therefore, says Kinsley, if you have a long-term investment horizon and are currently in an investment portfolio that has been structured for the long-term with the help of a qualified financial adviser, you would be wise to stay where you are. If you did not, you should consider implementing a long-term investment strategy now.
“This does not mean, however, that you can’t park new money in a money market fund and benefit from the current high interest rates. This is assuming, of course, that you have no debts to repay.”

Copyright © Insurance Times and Investments® Vol:21.7 1st August, 2008
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