Recession Watch

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By Cees Bruggemans

When reporting the FNB/BER consumer confidence results last week, it was noticeable how sensitive many people were about using the R-word (Recession).

Not everyone has apparently made the jump to such a drastic deterioration in economic outlook and it wasn’t as yet the way to think or generally speak of things.

Give them time and they will come around. We are on Recession Watch now, purely led by data, momentum and events. And policy choice. We are joining the ranks of the US, UK and New Zealand, which are also on recession watch.

To recap, a recession is said to occur when we have two or more consecutive quarters of GDP declining. Is that really so impossible under current circumstances?

One may feel intimidated after four years of robust prosperity growth, entering 2008 with 5%-5.5% growth momentum. It’s difficult to accept the speed of deteriorating events, having to contemplate an abrupt cutting of the economic engines, rapidly gliding to a standstill.

Yet we have been preparing the economy throughout 2007 for a change of pace for the worse and 2008 happens to bring together forces that can and do cut growth.

One obvious observation is that the motor trade on the passenger car side entered recession (falling volumes) as long ago as late 2006 (nearly two years ago).

Other consumer goods retailers and their manufacturing suppliers (furniture, household appliances) joined this parade at least a year ago.

Since then we have added to this growing list residential real estate (and home furnishing retailers) and residential building contractors (and building material merchants and some building material suppliers).

And the list continues to lengthen.

As to GDP in an overall sense, it still showed year-on-year growth of 4% in 1Q2008, but that was a statistical illusion. In a high growth phase like the last four years, whenever a quarter is compared with a year ago, one is ALWAYS working off a low base, yielding a high growth number when comparing with a year ago.

But to capture a definitive change of pace, one wants to know what happened in the course of that last quarter, and what that means for following quarters. Comparing it to a year ago has literally become academic.

To understand such quarterly speed, we take the change in activity level during the quarter and annualize it. Now we have the projected growth over the coming four quarters, if the momentum of this particular quarter were to continue unchanged for a year.

That very quickly starts to tell us whether the economy is approaching stalling speed. Here the omens are not good, people.

The 4Q2007 still had annualized GDP growth of 5.3%, a mighty roar, indeed a last hurrah. For 1Q2008 slackened off to 2.1% growth, and when excluding agriculture the remaining 98% of GDP was already down to a speed of 1.7%.

That’s like having your voice cut off in full oratory.

And that was only 1Q2008. More slowing lay ahead.

On this score it is perhaps useful to start paying attention to old trusted standbys such as leading indicators, but also to seek out redeeming features, just in case we forget about useful supports propping us up.

The SARB leading indicator is a compilation of indices which traditionally have tracked the business cycle closely, reliable identifying upper and lower turning points ahead of time.

After Easter 2007, the SARB leading indicator moved sideways for six months. From November 2007 it started to drop steadily and at an accelerating pace.

Historically, twelve months of declines in the leading indicator heralds the onset of recession. In other words, GDP growth has becalmed and the level of real GDP now starts to decline. Put differently, we are starting to see annualized decline in GDP.

At least two consecutive quarters of such conditions in a generalized sense, with real income, output and formal employment dropping, would qualify as a recession.

That line of reasoning would make 4Q2008, 1Q2009 and possibly 2Q2009 suspect, given current developments.

True, 1Q2008 was marked by special supply interruption, particularly Eskom electricity cutbacks and the way this hit especially mining output, but also parts of manufacturing and retailing.

Since then, load shedding has become minimal, or so it feels in everyday life, with electricity cutbacks to the mines at least partially restored and other heavy users adjusting their production schedules.

It isn’t as if the problem has gone away, but we have probably adjusted by doing things more efficiently, using electricity more sparingly without losing so much output, and also simply not saving as much electricity as claimed.

That line of reasoning could even see an output bounce in 2Q2008. But I wouldn’t bet the ranch on that outcome, as other features have come to the fore, overwhelming in their turn in their impact.

The RMB/BER business confidence index, the FNB/BER consumer confidence index and the much newer Investec Purchasing Managers Index are all qualitative opinion surveys trying to get a sense of changing conditions in the economy.

The first two surveys have long 30-40 year histories of also tracking the broader business cycle, with one or two quarter leads at upper and lower turning points. The PMI does the same more narrowly at manufacturing level, but ultimately as a gauge of what is taking place in the broader economy.

All three these indicators have turned decidedly negative over the past twelve months, by late 2007 heralding not only an end to the eight-year economic upswing underway since 1999 and signaling the start of an downswing, but also by the very abruptness of their changes signaling a much bigger change still ahead which could easily end in a recessionary becalming and decline.

The RMB/BER business confidence index peaked at 88 in 4Q2004 and was still at an elevated 80 reading in 2Q2007. It has since fallen to 45 in 2Q2008. In other words, while 80% of managers and businessmen still expressed confidence in 2Q2007, a year later only half did, with sentiment deteriorating with every passing quarter.

Indeed, when examining the record of the past thirty years, in which our business cycle has known massive swings, alternating bouts of high growth with prolonged periods of economic underperformance, the recent steep decline in the business climate signals another major economic slowing to be underway.

The same applies to the FNB/BER consumer confidence index. It was still at record high levels of +22 in 4Q2007, a level of confidence it has seldom achieved these past forty years, indicating an unprecedented satisfaction with affairs by a large majority of urban South African adults, as one would expect after four years of high prosperity.

Then abruptly in 1H2008 we find this index falling 28 points to -6, now indicating that a majority of consumers have lost confidence. Especially the 18 point drop in 2Q2008 is the biggest such decline in any quarter in 24 years (in other words since interest rates first breached 25% back in 1984 and grievously wounded indebted households and businesses).

Is there reason for such abrupt and deep change in sentiment? Yes, there is.

For some consumers it may have been the social and political events of recent months that were the main triggers, in some instances giving rise to emigration decisions. But not all South African consumers would have responded in the same manner to such divisive events.

Yet the deterioration in consumer confidence has been nearly uniform across population groups, language groups and income groups. These responses are measured in terms of three questions, all of them forward-looking:

Are you confident about the economy these next twelve months (yes/no)?
Are you confident about your own personal finances these next twelve months (yes/no)?
Is now a good time to buy durable goods (yes/no)?

When responses to these questions turn ugly in record time it can only be because of a major deterioration in economic circumstances. And that there has undoubtedly been, the main causes being higher inflation and interest rates and a decline in asset prices (houses) and probably real incomes and possibly already employment.

CPIX inflation had fallen to 3.5% in 2006, ensuring high real income and purchasing power. A year later CPIX had increased to 6%, already severely eroding real purchasing power. And then jumped within another year to 11% recently, with 13% looming shortly, now completely overtaking income gains, implying severe loss of real purchasing power.

Most visible was the cost of petrol and diesel doubling within two years, and food prices rising by nearly 20% this past year.

Keeping pace with this deterioration were increases in interest rates, from prime 10.5% in mid-2006 to prime 15.5% now. Also, households had increased their debt relative to disposable income by half in recent years.

Thus the debt servicing burden relative to disposable income doubled these past two years, from a comfortable 6% to a most uncomfortable 12% of income lately.

Until late 2007, the economy had been adding new formal employment at some 200 000 to 300 000 (3%-4% annually), in addition to creating many more informal income-earning opportunities in the economy.

But since late 2007, BER business opinion surveys show a uniform intention across nearly all goods producing and distributing sectors in the economy of reducing staff levels. Together with the electricity interruptions, and after allowing for further public sector employment growth, the economy in 1H2008 probably has already been experiencing a net loss of formal employment which is still gathering pace.

The strong spending momentum in the economy started to change in the course of last year, especially in response to rising interest rates. Household consumption growth halved from an annualized 9% early in 2007 to below 4% by yearend, slowing further to 3.3% in 1Q2008.

Anecdotal evidence suggests further slowing in such spending momentum in 2Q2008.

Fixed investment still grew by 15% in 2007, led by strong gains in infrastructure spending but also in private fixed investment.

However, there were already tentative signs of slowing in residential building activity at the plan stage under the influence of affordability concerns and implementation of the new National Credit Act.

Also, non-residential building activity started experiencing interference from electricity supply from as early as 4Q2007. These two building sectors contribute 20% of total fixed investment.

These two tendencies greatly intensified in 1H2008, with residential building activity hitting a proverbial wall and non-residential building activity discovering it couldn’t get electricity connection for many new projects on an indefinite view.

The uncertainties injected by these developments and the slowing economy generally started to undermine private fixed investments intentions more broadly, as shown by BER business opinion surveys.

In a way this was counterintuitive, seeing the very high levels of capacity utilization achieved over the high prosperity period, traditionally the great mainstay for strong fixed investment commitment.

It says something for the quality of events in 1H2008 that there has apparently been such an abrupt change of private fixed investment sentiment as businesses turned more cautious.

This obviously did not apply to the large government-backed infrastructure projects, or indeed some of the large private sector initiatives underway, although mining for instance was certainly shaken by the medium-term nature of the electricity issue.

A further aspect coming to the fore in BER business surveys, SARB data and anecdotal company evidence is that the spending slowdown has created involuntary inventory accumulation, in the trade sectors but also at manufacturing level.

These overstocked levels will need to be paired down, as well as adjusting order levels to the lower projected growth environment. This probably implies more output adjustments over the next six to twelve months in large parts of industry.

Bottom line in all this is that household spending growth prospects have fallen from 7% in 2007 to 2.7% in 2008, with durable goods this year declining by at least 5% (and possibly more).

Fixed investment spending growth prospects have similarly halved from 15% last year to 7.5% this year, with residential building this year and next year negative to the tune of 6%, and non-residential building activity expected to be declining next year by 8%.

The overstocked inventory condition will probably need to be paired down.

The redeeming features are windfall growth conditions this year in agriculture (maize harvest 60% above normal) and high commodity prices supporting mining (though output suffering due to electricity shortfalls).

Infrastructure-led construction is government dependent, parts of heavy industry benefiting accordingly. Public sector is recession proof, expanding merrily at 3.5%.

Together, these sectors represent 25%-30% of GDP. But in the remaining 70%-75% of the economy certain sectors have already for some considerable time been in deep recession (as mentioned). This weakness is spreading steadily wider as households lose purchasing power (on account of accelerating inflation) and real income (job losses, bonus shrinkage).

Households are gradually borrowing less, are increasingly delaying replacement of big ticket items (cars, furniture) and are starting to cut into other types of expenditure (travel, entertainment, leisure for the middle class and food, drink, clothing and commuting for the poorer segments).

Households as much as private business appear to be in transition, from a high growth period ending in the course of 2007 progressively throttling back spending speed ever since, but especially so since Easter 2008.

In March 2008 consumers still gave the impression that the economic outlook had deteriorated, but not their personal financial outlook. Whatever was going wrong was happening to other South Africans.

By June 2008 consumers not only doubled their perceived quarterly deterioration in the economic outlook, but now also deteriorated their view about personal finances by a like distance. Suddenly it wasn’t any longer only happening to the neighbours.

Yet with this very severe change in perception and loss of momentum already behind us, South Africa still faces yet higher inflation in coming months, with CPIX projected to reach at least 13% in 3Q2008.

What’s more, with crude oil above $145 there is as yet no certainty how high these prices could still go, with what feed through to yet higher inflation. And going by popular comment, media views and market signals, the SARB may not have finished raising rates, with the April and June 0.5% rate tightening in any case still to fully impact on the economy.

With electricity supply uncertainty continuing, changes in political leadership and possibly policy looming, and global inflation forces potentially still intensifying their pressure on us, South Africans are responding by downscaling their confidence and spending intentions.

Are we on Recession Watch? You bet.

Source: Cees Bruggemans, FNB, July 7, 2008.


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