Issue: March/May 09

The ups and downs of equities

What can we expect from equities this year?

Pension funds invest in a number of asset classes to achieve the best possible return within acceptable risk limits. They include cash and bonds which contribute relatively stable returns on portfolios. More risky and volatile assets, such as equities and property, are then added in an effort to enhance returns.

Unfortunately, with  the possibility of higher returns comes increased risk, as the recent fall in global stock markets has shown. This begs the question...

Why do pension funds invest in equities?

As equities are riskier than bonds and cash, investors require a higher return (or risk premium) to invest in shares. What then is a risk premium? It is simply the extra return investors require over and above the cash return, to invest in equities.

This, in theory, rewards investors for taking on the higher risk. This extra reward can be seen when comparing equity returns to cash and bonds returns over longer time periods. For example, South African equities have returned 6.5% per annum more than cash over the last 10 years.

Whilst this extra return from equity is evident over longer periods, the drawback is that over shorter periods investors can incur significant losses, especially when economic growth and company earnings growth are disappointing. When a slowdown in especially severe and widespread, as it is now, poor returns could be experienced for many years.

Local legislation limits equity holding to a maximum of 75% of total pension assets. The balance of the fund has to be held in bonds and cash. This limits downside in the fund because, for instance, if the equity market fell 50%, the total value of the pension fund would not decline by as much. Pension funds also invest in a large number of different companies so that the funs is not as exposed to the misfortune of any one company or segment of the economy. The percentage held in equities can also be reduced when macro-economic and earnings forecast suggest that this is prudent.

What drives equity returns?

Equities generally perform well in a growing economy. Growing economies allow companies to sell more of their products and generate more revenue and profits for shareholders. It also enables companies to employ more people, who then have more money to spend, thus increasing economic activity. Major economic regions, including the US, UK, Japan and Europe, are now in recession, with the result that company profits are declining. This means that equities in those markets are now worth substantially less to shareholders.

What fuels the economy?

In an attempt to predict equity prospects, analysts need to forecast the likely health of the economy. Interest rates set by the Reserve Bank are followed very closely. As a general rule, higher interest rates are negative for equities, whereas lower interest rates are positive. Why is this? In an effort to manage the economic cycle and prevent inflation and the economy overheating, the Reserve Bank raises interest rates when growth exceeds the maximum possible growth that the country's resources are infrastructure can sustain. A country can only afford to spend so much, which, if not properly manages, can undermine the future health of the economy. Increased interest rates cause reduced borrowing by consumers and business. In other words, spending and the economic activity are curtailed. Companies sell less of their products, retrench employees and consequently make less profit.

When interest rates are lowered, consumers and businesses are able to borrow more money at cheaper rates. Consumers spend more and company revenues and profits increase. Companies have to hire more people to cope with increased turnover with the result that these positive factors combine to propel the economy and company profits.

South Africa's economy is also highly dependent on the global economy, as it exports large volumes of commodities to the major economies of the world. When the global economy is growing strongly, demand for commodities increases, which in turn drive their prices higher. This increases the revenues and profits of local commodity producers, driving their share prices up.

The current severe global slowdown and decline in commodity prices mean diminishing company profits, and shares that are worth less to investors. Low commodity prices result in many mines making losses and retrenching large numbers of employees. Falling income, or no income at all, leads to reduced spending and slower economic growth.

How will equities perform this year?

Falling interest rates should provide relief to consumers and businesses, supporting the economy. Unfortunately, at this stage the negative impact of the global economy recession is more than offsetting the positive influence of the lower interest rates, with the result that the local economy and company earnings are likely to be disappointing this year. On a positive note, increased government spending, particularly on big infrastructure projects, should underpin the economy.

It is also hoped that lower global interest rates and government rescue packages will restore global growth. A number of market indicators, such as declining equity prices and bond yields, suggest this could be some way off.  The question is then why not hold zero equities for now and buy when the situation improves? History has shown that markets are very difficult to time. When equities turn around from market lows, much of the gains are seen in a short period of time, as sentiment improves. If you have not invested, it is possible that you could lose out on much of the good returns.

For more information, please contact RMB Asset Management on