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• • • First Quarter in Review o Global o Local Outlook Asset Class Return

Global equities staged a promising revival after the Federal Reserve led Bear Stearns bail out in March 2008. Global financial markets breathed a significant sigh of relief, believing that the Fed’s interventions to revive the economy would be far reaching and effective enough to avert recession. As such, equities rallied at the expense of global bonds that lost some steam as market participants believed that the worst of the credit crisis had passed. The perfect storm soon erupted as oil prices surged dramatically ahead, closing at a record high $141 for the quarter. Equities consequently sold off as lingering credit woes, slowing growth and now racing oil prices had decidedly broken the camel’s back. 2008 has largely been touted as recessionary for the United States but this economy has surprised by showing its flexibility and resilience in the face of significant challenges. The Bureau of Economic Analysis (BEA) recently revealed that the US economy grew at an annual rate of 1.0% in the first quarter compared with 0.6% in the fourth quarter of 2007. They stated that the continuing slow growth of the economy reflected continuing weakness in residential housing, downturns in consumer spending on durable and nondurable goods, and slower growth in business investment. Going into the second quarter, growth is expected to continue to hold up due to a sustained weaker US dollar and the US government’s consumer stimulus via tax rebates.

Source: Bureau for Economic Analysis, 27 June 2008.

Above is a graphic sourced from the BEA that highlights the impact of this stimulus on real disposable personal income and real consumer spending. Real consumer spending (personal consumption expenditures) revealed that spending on household energy service was strong. The BEA states that personal income rose 1.9% in May, after increasing 0.3% in April 2008. This increase is attributed to the Economic Stimulus Act of 2008, which raised government social benefits. It is also stated that wages and salaries, the largest component of personal income, increased 0.3%, after decreasing 0.1% in April 2008. Despite this benign growth outcome, US consumers are still pessimistic. The Conference Board’s Consumer Confidence Index reached further lows as consumers battle with inflation and deteriorating employment prospects. Spiraling food and energy prices are eroding buying power while employment concerns remain.

Housing starts continue to show that this sector remains under severe pressure. House prices are also rolling over decidedly. The S&P Case-Shiller national house price index showed that steep declines in home prices continued in April 2008. The index showed that declines in the prices of existing single family homes across the United States declined in excess of 15%. Housing as well as credit woes are set to remain in place for some time as evidenced by the US Senior Loan Officers’ Survey released in May 2008. This survey revealed that despite Fed intervention via the Fed Funds rate, bank lending practices had tightened further. The majority surveyed stated that they had tightened lending standards for commercial and industrial loans largely due to reductions in risk tolerance. Similarly home equity lines of credit have been reduced due to declines in appraisal values. Respondents also stated that with regard to residential mortgages, increases in defaults on obligations due to significant changes in borrowers’ financial circumstances had reduced bank’s risk tolerance. The resulting impact has been to increase credit qualifying criteria and also to offer credit at ever wider spreads to banks’ costs of funds. This then numbs the desired aggressive Fed impact via the Fed funds rate. Once again we wish to highlight the importance of secure employment. We have seen despite souring consumer sentiment and tightened lending practices; the US economy has managed to grow. The key underpin is that corporates entered this cycle with little debt on their books and have thus been able to maintain payrolls despite economic weakness.


US Jobs as shown in the graphic above do highlight the economy’s vulnerability but when compared to 2001, we see that the economy is in better shape. The unemployment rate is edging upwards but is still some way from the highs experienced in the early 2000s. But should the perfect storm entrench itself, the picture is likely to turn dramatically. The notion of a perfect storm is the manifestation of every worst case scenario! The US economy is not only suffering from the credit crunch but also a weakening economy. The Fed has done well to offer monetary stimulus pushing down bond yields and providing much needed relief to the economy. Now, with oil prices reaching stratospheric levels, the Fed bias is forced to move away from growth concerns to inflationary concerns and hence market expectations of higher US interest rates. That combination of rising bond yields at a time of economic weakness is the perfect storm. In some respects the US economy is better off than many of its counterparts as interest rates are currently at low levels. For economies like the United Kingdom and Euro Zone where interest rates have been elevated; ever higher rates will have a serious negative impact on output. Numerous reasons are postulated for record high oil prices which are bringing global financial markets down to their knees. There is indeed the issue of supply and demand. Refining capacity remains under pressure and bringing in additional supply remains challenging. As such lean inventories are adding pressure to prices. Geopolitical concerns in the Middle East and Nigeria continue to add pressure. Speculative trading is also touted as a paramount contributor to the state of affairs. Furthermore oil rich countries are also blamed for applying domestic subsidies that artificially deflate prices for locals who then use oil indiscriminately. The Chinese have recent raised fuel prices by 17% to cut energy demand, after a long period of offering subsidised lower fuel prices to their consumers. Lastly, US dollar weakness has been heralded as chief contributor to these record breaking oil prices and below we see how well these two variables co-vary. The 12% rally in oil prices in June 2008 alone has significantly eroded equity gains. Specifically, the MSCI global equity index was down 8.1% for the month with emerging markets worse off, down 10.2% in June 2008 alone. Over the quarter, Brent Crude prices have gained 35% to close at $141. For 2008 to June, oil prices have rallied close to 50% while over this period, global equities are down about 12% and the US dollar has only depreciated 8% relative to the Euro.


Inflation rates across the globe have raced ahead, threatening growth outcomes via increased interest rates. The Chinese continue to increase reserve requirements while in the UK and Euro zone, expectations are rife that rates will be increasing in the third quarter despite expectations of economic weakness. May Euro zone inflation of 4% is the highest on record for the fifteen nation bloc of countries.

Indeed the perfect storm has erupted and recessionary fears have moved beyond the borders of the US as probabilities of global recession are making waves. Oil and food prices have taken centre stage as key drivers of global financial markets.


The domestic economy kicked off 2008 with sobering news from Eskom and the impact of this has been felt most acutely on the first quarter’s gross domestic product (GDP) outcome. In the fourth quarter of 2007, GDP came out at 5.3% and in the following quarter, this more than halved to 2.1%. Key detractors were the mining and manufacturing sectors; the former detracting 1.1% while the later shaving off 0.2% from the final 2.1% outcome.

Source: Reserve Bank Quarterly Bulletin, June 2008

The latest Reserve Bank’s Quarterly Bulletin highlighted that platinum, gold and diamond mining experienced sizable declines in production and that these lower production volumes were directly related to Eskom’s sporadic power shedding in the opening months of 2008 and the subsequent restricted supply of electricity to the mining sector. Issues of flooding and temporary shaft closures in the wake of accidents were also noted as contributing factors to the mining sectors 22% decline in output from the previous quarter. As for the manufacturing sector, the SARB states that power shedding,, weaker global demand, slower domestic real income growth, relatively high interest rates and high input costs all weighed on this sector. Positive growth came from the agricultural sector, where farmers were likely taking advantage of better agricultural prices. When considering the expenditure side, consumers continue to buckle under the pressure of rising interest rates, petrol and food prices. Final household consumption expenditure has hit 3.3% for the first quarter of 2008, down from an average 7% for 2007. Durable goods being the component that has been hardest hit. Growth in real disposable income has also decidedly rolled over, now hovering below 3% in the first quarter of 2008. As growth continues to suffer, employment is well likely to follow suit, further undermining real disposable income. 5

The economy’s balance of payments worsened significantly with the current account deficit for the first quarter reaching 9% of GDP. Net dividend outflows played a major role in accelerating this from 7.3% of GDP in 2007 as a whole. The deficit continues to put the Rand under pressure but the widening carry trade has benefited the balance of payments. Specifically, other investment inflows into SA increased from R5bn to R34bn due to increases in non resident deposits with SA banks – this to take advantage of prevailing interest rate differentials in favour of SA.

The Monetary Policy Committee has continued to hike interest rates despite the slowing economy. In the June meeting, the MPC stated that they expected inflation to peak in double digit territory in the third quarter of 2008 and only to return to target in the third quarter of 2010. The deterioration in the forecast was attributed to higher-than-expected inflation outcomes, a more depreciated rand as well as further upward revisions in international oil price projections. This statement was made prior to the National Electricity Regulator of South Africa (NERSA) decision regarding Eskom’s proposed tariff hike. The long awaited NERSA determination approved an additional 13.3% for Eskom, bringing the total year-onyear tariff increase to 27.5%. NERSA further stated that if the current economic climate continued and Eskom’s capital expenditure plans remained, then tariff increases of between 20-25% per annum were projected over the next three years. Clearly, electricity prices will continue to put pressure to the inflation outlook. CPIX in May came out at 10.9% with food inflation up 17% (driven by grain products) and running costs for transport up a whopping 27% over the year. Over the quarter, petrol prices have shot up by an additional R2 per litre; with pump prices now in excess of R10 per litre. Even if one excludes food and energy prices, core CPIX is now running in excess of 6%, which would argue for further interest rate hikes. May PPI figures surprised on the upside, recording 16.4% for the month, year-on-year. The shock outcome was largely blamed on steel and basic iron prices. Despite this, the inflation outlook remains bleak particularly as fertilizer and pesticide prices continue to rise thereby adding further pressure to agricultural inputs. It seems that the light at the end of the tunnel may be getting farther and farther away. It has come as little surprise that domestic financial markets have struggled in such a harsh environment. Interest rate sensitive sectors like bonds and listed property have sold off over 6

the quarter, down 5% and 20% respectively. Financials and Industrials have lost 14% and 1.1% over the quarter respectively. Foreigners have largely lost their appetite for South African counters as evidenced in the graphic below:

South Africa’s Fitch credit rating was cut in June from positive to stable. Moody’s subsequently also raised concern about the future sustainability of South Africa’s current rating outlook; stating that recent events appeared incongruous with a positive outlook. This comes at a time when National Treasury is likely to issue bonds to support Eskom’s infrastructure needs and also at a time when the days of revenue overruns have come to an end. The political landscape also presents its own unique set of challenges. Domestically, the quarter saw the eruption of large scale xenophobic attacks sweep the country’s poorest townships. These violent attacks sent shock waves internationally and led to the displacement of thousands of foreigners. Lack of political leadership, lack of effective service delivery and criminal intentions were all touted as reasons behind this terrible scourge of violence. On June 16, the recently elected ANC Youth League President stated that they would be prepared to kill for Jacob Zuma’s national Presidency. This controversial statement left many uneasy. The instability in Zimbabwe also continues to plague the SADC region. The political economy remains a key driver of foreign sentiment.


During the first half of 2008, we have positioned our portfolios conservatively, paring back risky assets in favour of domestic cash. Going into the second half of this year, we cautiously begin to nibble at riskier domestic asset classes. The key reason for this change is that we now believe that the domestic interest rate cycle has peaked and that we can look to interest rate cuts in the middle of 2009. Despite this, we acknowledge upside inflation risks that may limit the Monetary Policy Committee’s fire power. Furthermore global growth is set to slow into the second half of 2008 and this is likely to heighten risk aversion and thus undermine flows into emerging markets. The US economy has thus far shown its resilience and weathered the global perfect storm. First quarter GDP has come in at 1%, higher than the fourth quarter 2007 value of 0.6%. In May, consumers also received a sizable boost via the Economic Stimulus Act of 2008, and this is likely to push second quarter GDP well beyond 2%. Despite this, the economy is not out of the woods just yet. Employment growth within construction, finance & insurance, manufacturing and wholesale trade remains in negative territory and house prices continue their downward spiral. Profit margins remain under pressure due to soggy consumer demand in the face of ever rising input prices. Furthermore the Federal Reserve has articulated its concerns about inflation implying that the Federal Funds rate had bottomed out. The Chairman has recently relayed his Semiannual Monetary Policy Report to the Congress, stating that; “the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policy makers is to prevent that process from taking hold1” Furthermore weakness in the mortgage and banking sector has yet to come to an end. The US Treasury has recently made efforts to bail out Fannie Mae and Freddie Mac. These two government-sponsored entities own $1.5 trillion in mortgage assets and guarantee another $3.7 trillion2. These two large entities have come under severe pressure due to the ailing mortgage market. The support from the US Treasury will allow them access to adequate capital to cover their housing losses. The outlook for developed economies in general is bleak as they continue to struggle with raging inflation and with central bank hawkishness. The latter implies that relief for these economies is not in sight. This is particularly the case for the 15 bloc Euro Zone where the European Central Bank has recently hiked interest rates despite market expectations of growth slowdown. Expectations surveys are depressed as the economies in the bloc face tight monetary conditions whiled juggling rising input costs and deteriorating export income. The United Kingdom experience; the Bank of England is seemingly prioritizing the inflation outlook, which means higher interest rates for longer. We therefore believe that earnings growth will, in line with global growth, remain below trend and with limited monetary stimulus, the outlook for global equities is not compelling. We believe that the catalyst for equity market performance is a sustained correction in oil prices. With oil prices coming off, inflation pressures would subside and central bank rhetoric turn in favour of growth concerns.

1 2 15 July 2008 BCA Research, 2008


In the local space, we continue to believe that the domestic growth picture remains under pressure but a recession is not in sight. For 2008 and 2009, South African growth is likely to approach 3% due to the impact of higher interest rates and capacity constraints. Business and Consumer confidence surveys have decisively rolled over with business struggling with decreasing profit margins and embattled consumers forced to spend more on energy and servicing debt. With declining output, earnings have come under pressure. Despite this, the markets have recently been cheered by the anticipated rebasing and reweighting of inflation from January 2009. The new basket of goods takes greater account of services and lowers the weighting of food by around 7%. The weights for both electricity and petrol are also reduced. This is equity-positive but given the shaky international equity market outlook, we are hesitant to aggressively begin buying local equities. Statistics South Africa unveiled the new CPIX inflation weights in July and both bond and property markets have rallied on the back of expectations of lower inflation and consequently interest rates. We originally expected CPIX to average 8.9% in 2009 but given the new information, this is likely to approach 7%. The net impact of that is twofold; we no longer expect an interest rate hike in August 2008 and we are penciling in interest rate cuts in June 2009. This is our base case view and we do acknowledge that movements in the oil price and second round inflationary effects are the key upside risks. The recent rally in the Rand has also boosted bond performance but we do believe that fair value for the Rand is closer to R8.10 and we expect this weakness to come through as the prospects of monetary easing take hold. Our twelve month bond return expectations move up to 16.5% and we thus trim our under weight exposure. We may move to neutral after the August Monetary Policy Committee meeting sheds more light on the interest rate trajectory. Property yields touched the 10% level at the end of June but have since rallied considerably, with yields now around 8.6%. With our expectation of interest rates on hold, this asset class now becomes much more attractive. With growth in income in the order of 10%, we expect solid double digit returns from this asset class over the next twelve months. We continue to advocate a neutral exposure to alternative assets as these play a key role in reducing risk via the diversification opportunities that they provide for portfolios. Although cash has been very good to us in recent market conditions, it is now beginning to lose some of its appeal. While we remain over weight this asset class, we have pared the exposure down somewhat, favouring riskier asset classes.


3 Months Headlines Indices Africa All Share Africa Top 40 Africa Mid Cap Africa Small Cap Africa Fledgling Africa Resource 20 Africa Industrial 25 Africa Financial 15 Africa Financial and Industrial 30 Africa Capped All Share Africa Shareholder Weighted All Share Economic Group Indices Africa Oil & Gas Index Africa Basic Materials Index Africa Industrials Index Africa Consumer Goods Index Africa Health Care Index Africa Consumer Services Index Africa Telecommunications Index Africa Financials Index Africa Technology Index All Share Sector Indices Africa Chemicals Africa Electronic & Electrical Equipment Index Africa Industrial Engineering Index Africa Automobiles & Parts Index Africa Beverages Index Africa Food Producers Index Africa Health Care Equipment & Services Index Africa Pharmaceuticals & Biotechnology Index Africa General Retailers Index Africa Travel & Leisure Index Africa Media Index Africa Support Services Index Africa Industrial Transportation Index Africa Food & Drug Retailers Index Africa Fixed Line Telecommunications Index Africa Banks Index Africa Non-life Insurance Index Africa Life Insurance Index -0.9% -7.3% -2.0% -1.0% 0.6% -1.2% -10.7% -3.4% -14.5% -18.8% 14.6% -12.9% -7.0% 3.2% 12.8% -14.8% -6.5% -13.7% -15.7% -22.2% -16.1% -17.4% -6.3% -15.4% -30.1% -19.1% -26.7% -35.1% -0.4% -20.6% -25.1% -13.2% 7.3% -23.9% -22.2% -30.6% -18.6% -28.4% -5.5% -16.1% 2.6% -15.7% -41.3% -15.2% -38.3% -33.1% -9.6% -31.7% -39.8% 6.6% -11.6% -25.3% -12.1% -31.4% 19.8% 12.1% -9.9% -2.7% -8.0% -1.6% 3.4% -14.5% -8.0% 37.3% 32.1% -17.1% -8.2% -26.1% -16.1% -0.9% -25.5% -17.4% 78.3% 34.5% -15.1% -0.9% -33.0% -21.4% 21.3% -27.2% -20.1% 3.4% 5.3% -9.8% -14.0% -8.0% 13.4% -1.1% -14.0% -5.1% 1.8% -0.2% 6.4% 10.7% -19.6% -22.7% -23.3% 33.3% -6.3% -24.9% -11.9% 3.5% -0.5% 10.1% 15.1% -19.3% -20.5% -21.4% 39.9% 0.0% -27.4% -9.1% 7.5% 3.4% 6 Months 12 Months


Africa Equity Investment Instruments Index Africa Real Estate Index Africa General Financial Index Africa Software & Computer Services Index Africa Gold Mining Africa Platinum & Precious Metals Africa Property Unit Trusts - (PUT) Africa SA Listed Property - (SAPY) Bonds, Cash & Inflation All Bond Index Stefi Composite CPI (Pevious Month) CPIX (Previous Month) Currencies Rand Dollar Exchange Rate Rand Pound Exchange Rate Rand Euro Exchange Rate Dollar Euro Exchange Rate Dollar Yen Exchange Rate Commodity Prices Brent Oil (USD/Barrel) Gold (USD/oz) Platinum (USD/oz) Copper ($/Ton) CRB Index Global Bonds & Equity Global Bonds (R) MSCI Global Equity (R) Global Bonds S&P 500 Nasdaq MSCI Global Equity MSCI Emerging Mkt FTSE DAX Global Hedge Funds HFRI Composite FoF (R) (Previous Month) HFRI Equity Hedge Index (R) (Previous Month)

-16.8% -12.6% -9.0% -8.0% -4.5% 1.9% -19.8% -19.6%

-20.8% -28.0% -14.1% -17.4% 4.1% 31.5% -30.4% -28.4%

-19.5% -37.9% -17.5% -20.1% -2.1% 32.9% -25.1% -22.0%

-4.9% 2.7% 4.6% 4.3%

-6.7% 5.4% 7.0% 6.8%

-2.7% 10.6% 11.7% 10.9%

-3.2% -2.6% -3.6% 0.0% -5.8%

14.9% 14.5% 23.7% 8.0% 5.2%

11.2% 10.6% 29.4% 16.4% 16.1%

34.8% 1.0% 3.7% 3.0% 19.6%

47.7% 11.0% 35.6% 31.4% 29.0%

96.9% 42.4% 62.6% 14.7% 46.6%

-7.3% -5.6% -4.2% -3.2% 0.6% -2.5% -1.6% -2.4% -1.2%

20.6% 1.4% 4.9% -12.8% -13.5% -11.7% -12.7% -13.1% -19.0%

30.0% -2.7% 16.9% -14.9% -11.9% -12.5% 2.6% -16.1% -19.6%

-1.8% 0.3%

11.0% 11.8%

8.4% 9.3%


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