Round Table: Cyclical Downturn Seeks Bottom and Rebound
By Cees Bruggemans
Attending the FNB Fixed Investment Round Table for 3Q 2008 with its usual heavy slant to property, building activity and manufacturing were:
Cees Bruggemans – Chief Economist, FNB
Bruggemans: Where are we in the fixed investment cycle, when we exclude government-supported infrastructure and focus especially on more market-sensitive areas?
Laubscher: Without doubt we are in a strong global economic downswing. In 2001 we had a brief global downswing, now it appears to be a deeper and more prolonged one. How do we respond to this global outlook? In 2001 we rolled through it, mainly because the rand depreciated heavily and supported our producers, keeping economic activity up. Not this time. At least not as yet.
Bruggemans: There is now no shock-absorber-of-last-resort (a weaker rand). So far the economy is absorbing the full shock of slowing activity.
Laubscher: If there is no switch into exports, domestic weakness will drive the manufacturing outlook as well. We may not survive this global slowdown in the same shape as we did in 2001.
Rode: The world has been living beyond its means and needs to work off the financial excesses. This means a prolonged period of economic weakness, especially for consumers. South Africa is in the same situation, though not as bad as the US. Recovery will take longer than expected. The downswing this time will be more prolonged.
Bruggemans: How old is this downswing? And how long will it still run?
Snyman: Since WW2 our downswings have averaged 14 months. I date the start from late 1Q 2008 (March). That takes me at least to 2Q 2009 in a mechanistic way.
Bruggemans: By all means, except I think the real damage already started in January 2008. That suggests on average a bottom in February-March 2009, going by history. But I don’t think this is quite an average downswing. So I would project a longer downswing, deeper into 2009, indeed stretching to 3Q 2009 or even 4Q 2009, also if the rand doesn’t come to the rescue by weakening (it usually has done this before), and assuming the SARB is quite late in starting its next rate-cutting sequence.
Laubscher: The abruptness of the current cyclical weakness intruding is rather unprecedented, not so? Or at least it was unexpected?
Bruggemans: Many people have told me it is the surprising suddenness of the onset of weakness and the extent of the declines since then that strike them as rather unusual. Many have not experienced something this virulent before.
Snyman: The 1982 downturn was similar. That was also abrupt, but turned out to be a very short recession.
Rode: But then we had artificial policy stimulation, even as fundamentals didn’t allow it, eventually making things worse (fully showing up in 1984-1986). Apparently our policymakers aren’t going to do that this time, not with fiscal or monetary relaxation, given the more responsible macro-management we see today. This suggests the cyclical downturn is unlikely to be short.
Martin: There are complicating factors. Political uncertainty, inviting wait and see, holding back, caution, as much among macro-policymakers as ordinary business managers.
Bruggemans: Most forecasters seem very locally focused, projecting the start of a cyclical upswing sometime next year, even while the global downswing may be prolonged.
Laubscher: Even a weaker rand, if it were to materialise, would still be happening into a weaker global picture. This wouldn’t help much. We need adjustment in favour of exports (as is strongly happening in the US), but our manufacturers have in many instances abandoned their export markets. These can’t be rebuilt quickly.
Rode: It suggests prolonged cyclical weakness.
Bruggemans: What consensus is there about the cyclical downswing? How long will it run before hitting bottom?
Snyman: We are looking at an 18-month downswing. This suggests a turning point only in late 2009. And that is without new global shocks doing yet more damage (or a belated major rand weakening terminating the downswing).
Laubscher: It is perhaps better to just emphasise the risks. Global factors (especially housing, credit and banking crises in the US and Europe) suggest a prolonged downswing. We would be impacted by that.
Bruggemans: The 1H 2008 change in expectations was very abrupt. What will the follow-through look like in 2H 2008 and 1H 2009? Will expectations deteriorate further? Will real growth activity fall off more?
Laubscher: Sentiment can deteriorate further, at least in certain sectors (retail, wholesale, even manufacturing, also consumers), but the falls could be smaller than in 1H 2008.
Martin: We are talking leading indicators here. The follow-through on real activity could still be more pronounced than seen so far.
Rode: Expectations are also reflecting the interest rate cycle, where I would say we have peaked.
Bruggemans: Peaking interest rates aren’t good enough to end the downswing in real growth activity. We need interest rates to be declining in order to see the turnaround in real economic activity.
Bruggemans: Can pronounced weakness in the motor trade and private housing industry be expected to spill over wider in the economy, as in most previous cycles? Or is it different this time?
Rode: It is different, with the residential and non-residential building sectors out of sync.
Snyman: Civil engineering construction continues to grow rapidly, driven by public spending.
Bruggemans: We certainly have growth anchors. This is the same as in the US, except there exports have so far been the growth anchor that is still holding. They are experiencing extreme weakness in some areas (housing, banking, motor vehicles, airlines), but overall are limping on. Until perhaps finally caught out by a bad play-out in their financial sector?
Snyman: Our non-residential building activity is being tempered, especially by electricity and municipal services constraints.
Bruggemans: How do you expect the various parts of the building industry to be playing out in this downcycle?
Rode: That requires an interest rate view.
Bruggemans: Well, consensus out there looks for a late start to rate cutting some time into 2009. What are the fixed investment implications, especially for the building trades?
Rode: Consensus is not clear about interest rate timing, magnitude of cuts and rapidity of cuts.
Bruggemans: Say onset 2Q 2009, with either an April or June start, in 0.5% moves per MPC meeting post elections. That seems to be the consensus.
Snyman: I see private residential investment in 2008 down by -7%, a further 5% down in 2009 and a hesitant +3% upturn in 2010.
Laubscher: BER sees -4% in 2008 (the 1H 2008 still being relatively strong) and -9% in 2009 (now off a high base), for the same net effect.
Martin: Residential building weakness will still be with us for some time, carrying on in 2009, with a deeper decline rather than in 2008. And 2010 could also still see a decline.
Rode: Given the high correlation between real house prices and building activity, I would caution against an early turn in building activity in 2009. I see a late turn-up, not before 2010.
Bruggemans: Is there housing oversupply, as in the US?
Rode: There is oversupply, but this could be taken up quickly if interest rates tumble. But I don’t expect an interest rate tumble. Also, there are still a lot of new houses in the building pipeline. I am amazed how much planned housing development there still is, as if developers haven’t adjusted their worldview yet. Fortunately banks are going to prevent overreaching.
Bruggemans: So this picture is still unfolding, with much longer to play out?
Martin: Manufacturing suppliers don’t always want to believe this. They think the first rate cut means it is back to the races for them. But it will take longer to play out.
Rode: It is rare to see such a confluence of major events as we are witnessing today: world downturn, South African downturn, a secular debt overexposure and secular peak in house prices. This is not a short, sharp cyclical dip. This could get to be a much longer play-out.
Martin: So do we still expect an 18-month downswing?
Laubscher: There is confluence of very big negatives. It will take time to work these things off, also locally. But I remain confident about our policy environment (fiscal cushion if need be). Also, Asian growth, though slowing, will support us. Our infrastructure story is strong. With monetary and fiscal policy responding, I am not too pessimistic as to how the broad economy can recover, even if there is more weakness in some parts (households) than in others (windfall sectors).
Bruggemans: This feels very much like a US replay. There is substantial weakness in parts, but overall no train smash. The economy remains coupled to policy instruments. But there is a prolonged weak play-out in the household sector, especially in housing, which should weigh on the broader economy and its eventual revival.
Laubscher: How does all this play in non-residential building activity?
Rode: Except for shopping centres, the fundamentals for fixed investment are strong in principle because of extremely low vacancies. Hence any growth in the economy will feed through to additional demand for space.
Shopping centres, however, are problematic in that there is no sign whatsoever of deceleration in building activity or intentions.
Bruggemans: A matter of retail competition? Creative destruction, seeking better market coverage at the expense of old shopping centre concepts?
Rode: It mostly reflects the lagged building effect of shopping centres that were planned in the heyday of the great consumer boom. The boom is gone, but the planned physical expansion continues to come on stream.
Martin: The year-on-year shopping centre growth in 1H 2008 in building square metres completed was +30%. Building plans passed (representing the future pipeline) were +50%.
Rode: There is still a massive wave coming in shopping-space building activity.
Martin: If the recovery in the overall economy and the revival in private consumer spending are as late and weak as expected, this shopping-space expansion could not generate its “expected returns”.
Bruggemans: How do things look elsewhere in non-residential building activity?
Martin: Industrial space (factories and warehousing, also related to imports) in 1H 2008 saw the volume of buildings completed decline by -20% year on year. In contrast, building plans passed declined by -5%. These types of buildings are erected quickly, allowing quick adjustments in activity.
Rode: It is quite possible that electricity certificates played a negative role in cutting things off so quickly.
Bruggemans: What is the office space reality?
Martin: Buildings completed +35%. Building plans passed only +3%. The robust expansion is still there in actual activity levels, but tailing off rapidly as the planned pipeline shrinks steadily.
Rode: With office rentals growing by +20%, but building plans passed doing only +3%, it tells you something is terribly wrong in this market segment.
Bruggemans: What is wrong?
Rode: Electricity plus lack of confidence. Also, political uncertainty in combination with high interest rates.
Martin: If the economy were to remain relatively strong outside the affected sectors, space demand will remain high. But building plans passed only increasing by +3% suggests limited supply expansion to come. Given already limited supply of office space existing today, even more upward pressure can be expected on office rentals.
Rode: Market values of existing buildings should increase yet further.
Bruggemans: Bottom line is that the +3% will change?
Martin: There is unlikely to be a sudden surge in building plans passed, given the broad outlook.
Rode: Well, given demand strength (low vacancies), supply intentions could change overnight linked to the political and interest rate outlook. There is some reason for hope.
Martin: But it takes time to draw up plans, get them approved. There are long lags, especially today.
Snyman: The cyclical fluctuations are very severe in non-residential building investment. When non-residential activity turns down, it can be three years down in a row.
Bruggemans: The fundamentals today are not a typical downcycle. This isn’t 1984. Now there are low vacancies in a still growing, if slowing, economy. Vacancies are unlikely to increase much, unlike 1984-1987.
Martin: Take a close look at additions and alterations in non-residential buildings. There is a major shift under way here. There is very strong growth here, as completions registered +40% growth in 1H 2008, but plans passed are also a strong +40%. The key here is electricity, with existing buildings being refurbished and being able to do so within their existing electricity capacity. It encourages a shift from greenfield to brownfield building developments.
Rode: In previous decades, the big financial institutions were major drivers of non-residential building activity. They would take a view on the expected cyclical turn, and take the plunge, banking on a subsequent recovery in space demand.
Bruggemans: Today the drivers are different?
Rode: Listed property funds are today’s drivers. They are sensitive about their JSE rating. It is difficult to motivate them to take an early decisive cyclical view. They need interest rates to come down before being prompted into new building activity. This addresses the riddle why non-residential building activity is not responding to the ultra-low vacancies and high rental growth. The key drivers are above all highly interest rate sensitive.
Bruggemans: How is the manufacturing fixed investment outlook shaping?
Laubscher: Manufacturing investment intensions declined sharply in 2Q 2008 according BER investment surveys. It was the first negative quarter in a long time. Investment will be under pressure as long as the growth downturn in manufacturing lasts.
Bruggemans: Not all manufacturing sectors are responding this way?
Laubscher: Some manufacturing sectors benefit from their agricultural links (especially chemicals) or civil engineering infrastructure activity (material suppliers). Motor manufacturers enjoy important export compensation today, still registering +70% increases in vehicle exports. But there are layoffs in the motor industry. Hopefully export growth will stimulate fixed investment, but it may only serve to compensate for weak domestic demand.
Rode: Car export momentum is also being lost, hence the motor industry layoffs.
Bruggemans: How do you see private fixed investment in machinery and equipment in 2008-2009?
Laubscher: Past growth was relatively high in line with high capacity utilisation, but this is likely to be easing in coming quarters. I expect slower investment as a result.
Bruggemans: In summary, how do we see the fixed investment cycle playing out?
Rode: The main conclusion is the probability of a longer deceleration than expected by the consensus. Business people, and expectancy generally, are probably still in denial about what is shaping. Talking generally, the cycle could be out by a year (a year beyond early 2009).
Laubscher: We are seeing a very abrupt downturn, to a large extent unexpected. I consider the ability of macro-policymakers to respond cyclically unimpaired. As a consequence I don’t want to be too pessimistic about the play-out. I see the cyclical bottom in 1H 2009.
Bruggemans: Any new shocks could delay things further. So the consensus is really priced for perfection, regarding the things we know and believe today.
Snyman: My experience when confidence turns down is that things continue to deteriorate at least for 12-18 months. Currently all my graphs (in the building industry) are pessimistic. Leading BER indicators should reverse come 1H 2009. But because these are leading indicators, in troughs leading by as much as three months, real economic activity may only hit bottom in 2H 2009 and only thereafter start improving.
Bruggemans: That could mean still nine, twelve or even more hard months to go till the turn. As to timing such recovery, much appears to depend on the onset of SARB interest rate cutting and what will influence the SARB in turn.
Source: Cees Bruggemans, FNB, August 28, 2008.
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