Despite high valuations, global equities remain the asset class of choice

With South African equities trading at a hefty valuation of more than 18.5 times historical earnings, investors should continue to look offshore where prices are more attractive, and to improve diversification and take advantage of potential currency weakness.

Commenting on Novare Investments’ economic report for the final quarter of 2013, Francois van der Merwe, Head of Macro Research at Novare said: “In South Africa, earnings growth expectations leave little room for disappointment and we are worried about the margin of safety in the domestic equity market.”

On prospects for the domestic bonds, van der Merwe said higher global bond yields, upward inflationary pressures, South Africa’s twin deficits as well as currency weakness are risks to the bond market.

On a more positive note, he added that the mining and manufacturing sectors have the potential to drive domestic economic growth as they take advantage of the global recovery and the weaker rand.

“While we expect them to contribute to a faster pace of growth in 2014, these sectors will be constrained by reduced competitiveness stemming from labour unrest, wage negotiations and tight power supply. Government policy could suffer paralysis until after the general elections scheduled for April. In the run-up to the election there is the potential for unrest and events will be scrutinised by foreign investors.”

Van der Merwe said it seemed the global economy had reached an inflection point, with a greater probability of exceeding expectations over the coming year. The US economy’s acceleration is gathering momentum, the European economy is emerging from recession and aggressive Japanese reforms should support that region.

“Re-synchronised global growth seems to be on the cards for 2014, and many of the tail risks that investors were worried about in 2013 have faded. There are no obvious shocks threatening the global outlook.

“After a bumper year of equity market performance, scepticism is rife over the sustainability of the bull run. We believe that the conditions that were in place to support last year’s performance will persist over the coming year, although return expectations are more muted. Global equity markets should be supported by continued accommodative monetary policy, low inflation, solid corporate earnings and healthy company balance sheets.”

Van der Merwe said that current valuation levels will only be a concern if company profits contract over the coming year, which is unlikely as profits will be supported by accelerating economic growth.

The liquidity tailwind from zero interest rates will be the main equity market driver, but there is a risk that central banks have created an addiction to easy monetary policy that could be hard to break.

“We expect that global equities will easily outperform global bonds. Developed market sovereign bonds will be negatively impacted by unwinding accommodative monetary policy. However, should global GDP growth be stronger than expected, this would push inflation higher and accelerate policy normalisation.

“Political and geopolitical risks have migrated from developed markets to emerging markets. Many emerging markets are facing hotly contested political elections this year and twin deficit countries will be under the spotlight as they face the potential for foreign capital withdrawals,” van der Merwe said.