5) Prospects for the US stock market - how unhealthy is the US economy? June 2001

Prospects for the US stock market - how unhealthy is the US economy?

This week I write from the US where a fierce debate is raging on the state of the US economy. All pundits agree on one thing - Greenspan the Fed Chairman will cut interest rates by between 0.25% and 0.50% on Wednesday. This will be the sixth interest rate cut in as many months, bringing the Fed funds rate down to below 4%, from 6.5% in January 2001.

The US economy has slowed dramatically since reaching its peak GDP growth rate of 8.3% at the end of 1999. For the past few quarters the US GDP numbers have hovered around 1%-2%. Clearly this is a dramatic deceleration, but not a recession.

Big investment powerhouses Goldman Sachs and Morgan Stanley diverge on their views regarding the severity of the US economy and its impact on the stock market's performance. Goldman sees the broad US index, the S&P 500 rising from current levels of 1200 to 1550 (a 30% rise) over the next year, with the Dow moving to 12 500 (approximately a 20% rise from current levels of 10 600). Lehman Brothers expects a year-end S&P 500 of 1400, with 1600 being reached by December 2002.

Morgan Stanley by comparison, expects more bad news with more US blue chip firms reporting weaker than expected earnings and issuing renewed profit warnings over the next two quarters. Morgan along with many commentators have little faith in the Federal Reserve's ability to cure what ails the US economy - in the short term. This camp expects not only lower corporate profits, but a spike in layoffs and a cutback in consumer spending over the next 6 months.

The key question at present is as follows: Can current US monetary and fiscal policy overcome two recent bubbles which have suddenly burst: These bubbles are:

1) the dramatic surge in capital spending in technology and telecommunications; and
2) the wealth effect driven partly by a rampant Nasdaq and strong US dollar.

Most analysts expect that Greenspan's interest rate cuts will only begin to have a decisive impact towards the end of the year. President Bush's $1.3 trillion tax cut will arguably not have any real impact on the economy as it has not been designed to provide consumer's immediate incentives to spend. The tax cuts are not front-end loaded, but rather the major cuts only kick in five to six years from now. Lower marginal tax rates will however still help consumer spending.

It is also worth noting that since interest rates remain friendly, housing and the overall US property market remain robust and healthy. In addition, new car sales have also held up to many economists surprise. This indicates that the US consumer is better off than many expected.

Why the rebound is under way:
Productivity measurements in the US during the first quarter 2001, increased 3% over the same period last year. The key variables that have been the underpinnings of the New Paradigm business cycle remain intact:

· The inflation rate for capital goods such as equipment and machinery remains far lower than the inflation rate for labour.
· The rapid obsolescence of IT products continues to encourage ever faster replacements.

The recent growing spread between the capital goods inflation rate (-1%)and the labour inflation rate (4%), points to a recovery in IT spending, as has always been the case in the past. IT spending accounts for some two thirds of all capital expenditure in the private sector. Lehman Brothers are now forecasting a recovery in capital spending growth of 5% in 2001, and a 9% growth in IT spending.

The US's indisputable ability to produce goods and services more efficiently lies at the heart of the New Paradigm theory. The bears miss an essential point: a continuing array of innovative technologies has led to continued deflation in capital goods and technology prices, as old items soon become obsolete.

It therefore makes sense for US businesses to invest more in goods than in people, thus substituting capital for labour. A case in point is when a person is traveling, companies prefer to equip that worker with a laptop, cell phone and a hand held device, rather than maintaining redundant help at the office.

Steadily falling interest rates almost always generate a cyclical rebound in capital spending, resulting in a return to the robust capital spending of recent years and more productivity gains. With the Fed's frequent rate cuts, capital expenditure will shortly rebound.

Historically, the S&P 500 has bottomed an average of 3 months after the Fed started lowering interest rates. The market hit its trough on April 4th, right on schedule at 3 months and one day after the Fed began its rate cuts on January 3rd. One has to go back to the Great Depression to find a time when Fed rate cuts failed to ignite a recovery in the S&P 500.

Clearly, the US stock market is set for a rebound over the next year.

Anthony Ginsberg is the Managing Director of GinsGlobal Index Funds and the author of the book "South Africa's Future". He previously served as Barclays Bank's Director for Southern Africa. His e-mail is ag@offshorepro.com

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Why South Africa's constitution needs to be changed

Last month, I attended an interesting conference at Stanford University titled "Democracy in Africa". The conference brought together African experts and scholars from around the world.

Sadly, the current word on Africa is arguably at its most negative in at least a decade. US State Department attendees expressed considerable disappointment with South Africa's AIDs policy, economic growth rate, our government's refusal to come out strongly against undemocratic forces in Zimbabwe and how one of our Cabinet Minister recently unleashed the police and intelligence services - on "perceived enemies".

An interesting aspect of the conference dealt with the constitutional trap South Africa has unwittingly fallen into. According to attendees our constitution has permitted the creation of an all-powerful Presidency and an extremely weak Parliament.

They argued that the current constitution limits dissent and debate. SA requires an amended constitution, which makes it easier for new political parties to be created. The required amendments should allow for MP's with personalities to cross the floor for certain votes, while permitting groups of MP's to split from their party. This is in line with many parliaments the world over.

Under the current system of proportional representation dissent has been effectively squashed and MP's are rendered powerless. Attendees tended to agree that being an MP in SA, at present, is akin to being a rubber stamp for the views of your party's leader. Attendees surmised that since MP's largely owe their seats to currying favour with the party leadership (there is little grassroots input), there is no incentive for them to speak out.

Attendees argued that Parliamentarians in SA have been rendered increasingly irrelevant. They pointed out how Parliamentary committees, which on the face of it are permitted to investigate government expenditures and veto Cabinet bills - have been weakened by threats from above to not rock the boat. Andrew Feinstein the ANC chair of one such committee was recently relieved of his duties, since he insisted on investigating the R50bn arms deal.

Attendees also pointed out how SA currently lacks a viable political opposition movement with a realistic chance of unseating the ruling African National Congress. This coupled with a constitution embracing a hybrid form of proportional representation, UK Westminster government and the US federal system - has created an increasingly apathetic voter populace and has led to the development of the stereotypical African single strongman framework and unaccountable members of parliament.

Many attendees agreed that despite SA's constitution being designed to prevent the development of an African one party state or single strongman, the current framework has produced unintended consequences. The newly beefed up Office of the Presidency with 350 employees and its own Minister, effectively coordinates all Government policy thus creating an all powerful presidency, with little accountability according to attendees.

South Africa has in essence copied the US system of electing state legislatures and Governors (or Premiers), however such elected office bearers are unable to make any major policy without reverting to the federal authorities.

Unlike the US Federal and state systems, the South Africa's provincial legislatures have very little fiscal autonomy, judicial or educational authority. Provincial Premiers and Mayors are hand-picked by the top leadership from the respective political parties. Seven of the nine provinces are currently overwhelmingly ANC and the provincial legislatures have little if any say over such federal matters as police, education, crime and fiscal policy.

Attendees debated the fact that proportional representation in South Africa has resulted in the following weaknesses:

It is clear that there is an increasing need to revisit the weaknesses inherent in our constitution. SA is at an economic crossroads. SA needs to mobilize its best and most talented individuals in policy making. This will not occur as long as SA selects its Cabinet Ministers from purely parliamentary frontbenchers, while the majority of MPs remain weak and unknown.

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Why the Rand will shortly hit R10 to the US Dollar

Since 1981, the Rand has only twice appreciated against the US dollar during any calendar year. The Rand lost more than 20% of its value against the US dollar during both 1996 and 1998. More recently over the past 18 months the Rand has again depreciated by over 20%.

Given the lack of meaningful large-scale privatization and continued delays, it is hard to envisage a scenario whereby the Rand can buck its trend of annually depreciating by an average of 10%. This means we all need to buckle our belts for a R10 to the dollar exchange rate by 2003.

The existence of few if any globally competitive financial or tax incentives to encourage long-term foreign investment into SA, coupled with the growing number of SA blue chips seeking offshore listings - points to continued weak foreign direct investment and reduced foreign passive inflows into our stock market.

Global investment houses which in the past often purchased Rands in order to buy our local blue chips, no longer need to access our currency. They now go direct to the London bourse or other global stock exchanges, to purchase shares in our best companies.

The delisting of De Beers has shrunk our local stock exchange by an additional 8%, reducing the size of our market's capitalization in relation to the rest of the world. Large international index tracker funds, will therefore reduce their exposure to the SA market in line with our shrinking size.

Political events in Zimbabwe certainly do not help attract foreign capital to our shores. The recent World Competitiveness Report again indicates that SA moved sideways in the international economic rankings. In 1996 we were ranked 43rd. In 2000 we had moved up only one place to 42nd position.

The above picture unfortunately is not pretty. The reality is that the Rand will continue to depreciate by an average of 10% per year. Unless immediate steps are taken to make SA a far more attractive destination for international capital and investment - we are headed for an exchange rate of at least R10 to the Dollar within two years.

The US dollar remains the world's only true long-term safe haven currency. Not only is it the dominant currency in world trade and foreign exchange, but the dollar belongs to the world's only remaining superpower - both economically and militarily.

Although many South Africans take solace in the weak Euro currency and the British Pound, we need to face realities. The Euro has both a very short and dubious track record, while the British Pound continues its decade long slippery downhill slide against the dollar.

Our country's net worth needs to be measured against the most dominant and stable international currency. In reality SA as a nation is losing at least 10% of its net worth annually.

Any household or business losing 10% of its value a year would do something about it. It is high time that SA's policy makers began to open their eyes to the numerous economic success stories, the world over. Sadly, without large doses of foreign investment it is hard to imagine the Rand breaking out of its 20 year depressing cycle.

Knock-on effects of a weak Rand:
A rapidly depreciating Rand not only leads to imported inflation, but also causes a number of economic policy constraints. Whereas Alan Greenspan of the US Federal Reserve has no qualms whatsoever about cutting US interest rates to stimulate the US economy, our Reserve Bank must always consider the impact on the Rand when they wish to cut rates.

In a fruitless exercise to protect the Rand from any further weakness, our Reserve Bank has often been guilty of being far too slow to cut interest rates. The lack of foreign inflows into SA, has ramifications for our entire economy. Until such time that SA experiences large scale privatization, we can expect our policy makers to attempt to protect the Rand and limit inflation, through higher than desired interest rates. Such historically high interest rates continue to cripple our economy.

The bottom line is that a weak currency leads to excessively high interest rates that harm our economy. Is it any surprise then that SA has experienced record liquidations and bankruptcies over the past few years?

We are headed towards R10 to the dollar within the next 24 months based on current trends. The only way to stem the Rand's depreciation is to encourage bucket loads of foreign investment. Without such investment, our interest rates will remain far too high to stimulate our economy and most citizens will continue to get poorer in relation to the rest of the world.

Sadly R10 to the dollar may prove to be an optimistic scenario for 2003. Some foreign analysts are banking on closer to R11 to the dollar in 24 months time.

Anthony Ginsberg is the Managing Director of GinsGlobal Index Funds and the author of the book "South Africa's Future". He previously served as Barclays Bank's Director for Southern Africa.

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Why indexing is a winning investment strategy

Celebrated stock picker Warren Buffet approves: “Most investors, both individual and institutional will find that the best way to own common stocks is through an index fund.”

Perhaps the world’s most famous active portfolio manager, Peter Lynch of Fidelity Investments recently stated: “The deterioration of performance by professionals is getting worse. The (general public) would be better off in an index fund.”

The respected US newspaper, The Wall Street Journal reinforced this sentiment in April 2001: “Sorry, mutual fund managers, it still pays to be an index investor.”

What is an index fund?
An index fund is a unit trust that mirrors as closely as possible the performance of a stock market index. For example, many mutual fund companies have since established S&P 500 index funds to mirror that index by purchasing all 500 stocks in the same percentages as the index.

More than $1.5 trillion is currently invested in index funds throughout the US. There currently exist 249 index funds in the US for individual investors. More than 80 unit trust firms in the US, now offer an S&P 500 index fund. In Europe, indexing’s growth has recently mirrored the US.

Currently 12% of the money invested in US unit trusts (mutual funds) resides in index funds. Among pension fund investors portfolios, indexing accounts for 30% of assets. In the US, large Fortune 500 and Government pension funds have at least half their assets indexed. The Colorado State fund is 66% indexed, while Kimberly Clark’s $2bn pension fund is now 90% indexed.

Indexing eliminates a number of risks associated with investing:

• Eliminates the risk of individual share and sector selection.
  
• Eliminates the risk of selecting the wrong investment style such as growth vs. value.
  
• Eliminates the risk of picking the wrong portfolio manager to implement whatever style you choose.
  
• Eliminates the risk of picking the wrong unit trust or portfolio manager.
  

Situation in SA
Although most local unit trust firms continue to underperform both the foreign and local indices, few if any are willing to admit defeat to index funds. Only 3 out of the 25 local general equity funds have beaten the JSE All Share Index performance over the past 3 years (to March 31, 2001). The average return over this period by a general equity unit trust was a dismal negative 2.2%.

By contrast the three best performing general equity funds over the past three years (end of June 2001), were all index funds. Interestingly, even Old Mutual an active fund manager has now decided to offer local index unit trusts.

Currently the most celebrated local index funds all track the ALSI 40 index which is dominated by SA’s largest companies. Given our unique resource based economy, it is true then that our most common index is overweight in resources. But this does not mean that indexing as a principle cannot be applied in SA. Take for example Brait’s Financial & Industrial Index fund (tracking the FINDI), which continues to outperform its sector competitors. Sector indices such as an industrial index fund, will not fall foul of being overweight resources.

Global indices vs. unique SA case

Globally foreign indices are generally far broader than our own ALSI 40. Most of the industrialised world’s leading indices contain anywhere from 100 shares (e.g. FTSE 100, Nikkei 225) to 5000 shares (Wilshire 5000). The shares are also spread over a well diversified range of sectors. In the case of the MSCI World Index 1300 shares comprise this most global of indices. Sector wise the index’s make-up is as follows: Technology 24.3%, Financials 17.8%, Telecommunication 8.5%, Consumer Discretionary 12.7%, Health Care 9.9%, Industrials 9.6%, Energy 5.4%, Consume Staples 5.4%, Utilities 3.6% and Materials 2.8%.

Index funds globally beat the majority of unit trusts with regularity. This is true both of the equity and bond markets. In any given year there are plenty of actively managed funds that outpace the market index. But most revert to mediocrity – witness technology and small cap funds in recent years.

Taking the broadest measure of the US equity market, the Wilshire 5000, it has outperformed 56% of all US general equity funds over the past 5 years, 60% over the past 10 years and 67% over the past 15 years. In truth you would have done even better than these numbers indicate. Poor performing actively managed funds tend to be closed or are merged out of existence. The worst performing funds typically go out of business and are not counted in long-term records.

The largest single unit trust worldwide the $94 billion Vanguard 500 Index Fund, which tracks the Standard & Poors 500-stock index, has also outpaced 65% of general equity US funds over the past 10 calendar years.

When it comes to the foreign indices, not one of the five foreign funds offered in SA, could beat the MSCI World Index over the past 5 years.

Winning for a reason
Given the high turnover (trading of stocks) found within actively (non index) managed unit trusts, it is estimated that index funds automatically enjoy a 1%-2% lead over active funds. The costs incurred in trading so frequently, allow index funds to build up a sizeable head start, before the annual performance races even begin. Index funds also do not use the pricey services of professional stock pickers either.

The key to the successful performance of index funds, is their ability to stay out of the bottom one third of all unit trusts performance. Between 1963 and 2000, the S&P 500 index funds only appeared in the bottom one third of unit trust performances, four times. This equates to one in ten years. Who would not be happy with a fund like this?

Indexing should not be thought of as a "hot" or short-term investment strategy. Indexing gains its advantage over the long-term. Indexing's main appeal, is therefore not to investors who expect to make a "killing." Instead, the strategy is designed for long-term investors who seek a very competitive long-term investment return through broadly diversified portfolios.

Star portfolio managers are really comets

It’s time to stop taking your chances with portfolio managers and experts identified as stars. All too often these are comets that are disguised as stars. Inevitably they burn out. It is far safer to diversify offshore by going straight to the center of the universe and own the sun (i.e. the entire stock market). This is what indexing is all about.

Beating the market is a loser’s game
Very few professional fund managers can beat the market. Since there is no reliable way to identify the fund managers who will outperform the market, investors are best served by buying a broad spectrum of stocks at lower cost.

As the owner of index funds you will own all the best largest companies in the world. This means whenever you get an earful from your colleagues about their latest hot stock pick, you can nod knowingly and say, “Yes, I own that one, too.”

For the typical South African investor seeking exposure in the international markets, indexing is by far the safest and most straight-forward method of investing.

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