Hunting peaks as growth sacrifice deepens

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By Cees Bruggemans

As we approach midyear, the global and local scenes are still upping the ante daily.

Locally, we have just increased interest rates for the tenth time by 0.5% in two years, prime rising to 15.5%, with more increases likely. Perhaps not many more, but enough to turn yesterday’s outperformance to dust.

The economy is sending out clear signals, in consumption and private fixed investment spending, and in the building trades, manufacturing, transport, retailing and financial and business services, of heading for recession.

Saving graces such as windfalls in agriculture, non-gold mining and infrastructure construction (between them 12% of GDP), will probably not help us much. The implosions in other parts of our economy are just too severe for that.

If that is our local trajectory, we still have at least two nagging questions: Will Eskom once again surprise us with future blackouts, further knocking GDP growth? And will there be an early rather than a late switch in macro policy emphasis, such as raising inflation targets (or even abandoning them) and returning to deficit budgeting (as Turkey did only two weeks ago)?

Neither of these may happen. But we may as well worry about these things rather than suddenly being surprised by them.

The country has apparently not yet succeeded in sufficiently changing its electricity balance. Unless power is unintentionally saved by much slower growth, winter peak loads may yet cause unscheduled load shedding, further reducing GDP growth.

Easing the macro policy stance would in the short term ease the growth sacrifice in progress. But it could also weaken rand prospects and further increase inflation (and interest rate) prospects in the medium term. Not necessarily a happy prospect, reminding one of the evolution in the 1970s.

Although important in potentially influencing our future financial and economic trajectories, these local forces may not be our most decisive drivers. These are most probably still based offshore, shaping the global environment, whose influences are steadily shaping our existence, like weather depressions this time of the year accumulating over the Atlantic and heading for Cape Town.

On this score, the world plainly can’t quite believe what appears to be still heading its way.

After being sandbagged by fearful Anglo-Saxon housing, banking and credit adjustments, which in their own right are capable of turning off the global lights if left unattended, quick central bank responses saved the day.

With these emergencies still only half addressed, an even bigger adjustment threatened. Oil and food prices, having already risen for five years and therefore thought to be approaching a cyclical peak, accelerated into 2008 with undiminished vigour. This process may not yet be at an end, judging by oil and agricultural commodity prices.

This possibility continues to boggle global minds. Surely, with oil prices this high and global GDP growth distinctly slowing, the oil demand/supply balance will improve to the point of causing an oil price relapse?

Well, yes it will happen eventually, but not necessarily quickly, or at least not without some serious mayhem.

A quick analysis reveals two components to global oil demand (rich world/poor world), three components of supply (OPEC, Non-OPEC and substitutes), inventories and the buffer between actual demand and supply capability.

The unvarnished truth is that rich OECD oil demand has not grown at all in recent years, and fell by 0.3 million barrels daily last year. But poor emerging demand continued to surge by 1.4 million barrels daily.

The rich world practices conservation and substitution, and grows very slowly into the bargain. The US economy is most exposed to rising oil prices, and has the most potential for reducing demand.

But a US equivalent part of Asia subsidises its oil demand, encouraging wasteful oil demand growth on top of rapid GDP growth. Though cracks are appearing in these arrangements, many governments remain intimidated by their internal political trade-offs.

The long and the short of it is that global oil demand is slowing, but only gradually.

Instead of oil supply vigorously expanding new investment in response to steeply higher prices, resource nationalism in many OPEC countries inhibits this. Worse, non-OPEC countries experience physical setbacks (old oilfields running down), manmade disasters (civil war, government incompetence) and natural ones (hurricanes).

Thus we find that global supply barely keeps pace with oil demand gains, with the only real additions coming from biofuels, and other substitutes still technically disappointing.

As a consequence, global commercial inventories aren’t really rising much, the global supply buffer remains an uncomfortably low 2mbd and the biofuel response is destabilising global agriculture.

This, by the way, is the configuration that got us from $30 to $140 oil, with the imbalance actually deteriorating slightly over the intervening years.

So what drives the oil price higher?

Global consumers and financial players are not comfortable with a small 2mbd supply buffer. When a minor oil producer gets knocked out (something that happens quite easily, be it as a result of a hurricane, civil war or whatever), the world could suddenly go short of oil.

The global market-place is trying to rectify this situation by pre-emptively bidding up the oil price in search of adequate buffer insurance, commonly thought to be 5mbd.

But no matter how the oil price rises, global supply is unable or unwilling to oblige by raising output fast enough. Thus the accommodation has to come from the demand side. Here some slow change is under way in some regions owing to slower growth, conservation and substitutes, but other regions adjust their oil demand much more gradually.

The net result is a persistent process of global price discovery, steadily pushing oil prices higher in search of a resolution to the demand/supply balance that will provide long-term stability.

Does that sound familiar? Creating maximum short-term instability so that we may have long-term peace of mind? If that sounds like war, it is entirely unintended.

This is the structure of the evolving global economy and market adjustment mechanisms talking. It is realism at its worst reshaping our world.

How bad can it get?

Gazprom went live with a $250 view last week for 2009, topping Goldman Sach’s $200 view of last April. I met some farmers recently who are planning for another 50% increase in the next twelve months. That would top $200.

Even if partly softened by the existing fuel levy, another 40% gain in refined oil product prices to R14/litre would directly add 2% and indirectly probably a further 2% to the coming CPIX inflation peak of 12%, to which any Eskom tariff increases over and above 14% must still be added.

At a guess, $200 oil next year would imply an early 2009 CPIX inflation peak of over 15%, oil and Eskom driven.

But this is before including any further agricultural surprises. Unfortunately, the Northern planting season is already disappointing in parts (US Midwest, Iraq, Western Australia). Maize prices are setting new global highs of over $7 a bushel daily.

Our current agricultural windfall is partly shielding us, but will that still be the case next year? At worst, we could be seeing yet another 2%-3% added to the CPIX peak, or at least an extension of the peak deeper into next year.

Does that suggest 15%-17% CPIX peaking territory, but lingering with us for much longer in 2009?

This is as yet not a formal forecast. But do realise where $200 oil, super Eskom tariffs and agricultural nasties will lead.

This is compared to a current CPIX of 10.4% and a core CPIX (excluding energy and food) of 6.1%.

We then have yet to model the business pricing and wage round responses to such a play-out, with any acceleration therein further extending the CPIX peak.

Meanwhile, going by the June MPC decision, the SARB is already getting cold feet about raising interest rates further and incurring too much unwanted growth sacrifice.

If our CPIX inflation trajectory has as much as 50% and possibly 70% further to go, and is spread over a longer time frame than ever imagined, what are we supposed to pencil in for SARB interest rate decisions?

Will we willy-nilly incur a deep recession and asset market implosions just to keep on matching CPIX gains with interest rate increases? Or will prime 20%-22% be a few bridges too far?

I believe SARB capitulation along Turkish lines would be somewhere in prime 16%-18% territory, if only because still rising oil and agricultural commodity prices had acquired an evidently self-destructive streak.

In other words, a breaking point globally would eventually approach, in which growth would fall away sufficiently for oil price discovery to end and the long-awaited price implosion would get under way.

Hopefully at some point the SARB would envisage such an end-game, incorporate this in its two-year forecasts, act upon it by ceasing to raise rates, and indeed to start focusing on the return journey, with recession problems looming large.

The next 12-18 months may prove momentous. Hopefully oil prices will have receded enough by mid-2010 to make global visitors still willing to come and enjoy the World Cup with us in person rather than opting to remain behind their distant tellies.

That’s another risk we face. Not that the stadia aren’t ready (they will be), or that Eskom will switch off the lights (they won’t, at least not in cities hosting qualifying games) or that the tournament be cancelled (it won’t).

But too high an oil price could mean there would be more local tickets for resale after all.

An unpredictable few years still lie ahead.

Source: Cees Bruggemans, FNB, June 18, 2008.


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