The coming storm – a scenario
By Cees Bruggemans
The FNB Fixed Investment Round Table for 4Q2008 was attended by:
• Cees Bruggemans, Chief Economist FNB
• Pieter Laubscher, Chief Economist BER
• Charles Martin, Senior Economist BER
• Erwin Rode, CEO Rode & Associates
• Johan Snyman, Medium-term Forecasting Associates
Bruggemans: For over a year now, the world economy has been buffeted by two major storms (commodity inflation shock and financial crisis), but will we continue to experience stormy conditions next year, even though the nature of what we are facing is changing?
Laubscher: The global commodity inflation shock may have been abruptly reversed since midyear and the global financial storm of the past year may be in the process of finishing, but we remain so to speak in the eye of the global storm.
The real global economy is only now being hit hard by what has happened in credit.
This will take time to play out. Still, we expect central banks and governments to do the necessary, whatever may be required to stabilize the global situation.
Rode: Many of the rich Western industrialized countries, especially the English-speaking ones, overstretched themselves for too long. This will take time to correct, much longer than anything experienced recently.
Symptomatic of this phenomenon is real house prices, which had been moving in a predictable band for decades. But then from 1999 these real house prices took off like a rocket, especially in the US, brought about by ultra-low interest rates.
People were using their houses as ATMs, with builders following. In some instances, as in the US, this led to a huge oversupply of new housing stock. This will need to be worked off before normality can resume.
Laubscher: All major economies will be contracting in 2009, in other words experience recession, according to the latest version of the revised IMF forecasts released only last week. This global recession is worse than 2001 or 1990. According to some, it will be worse than 1980 or 1974. Indeed, it could be the worst since WW2.
Bruggemans: We are apparently no longer talking a V-shape or a U-shape. Some people, including our Minister of Finance, are talking about an L-shape cyclical condition? Especially 4Q2008 and 1H2009 prospects in the US and UK now look dire, with the European and Japanese outlooks also further deteriorating by the day.
Laubscher: I prefer a wok-shape to the global recession, elongated and deep, showing a steady descent, a broad deep bottom and only a gradual eventual recovery. The loss of global output will be substantial, in addition to the financial losses being written off. Both of these will be in the trillions of Dollars eventually.
Bruggemans: Spillover into the real global economy is now fully underway, with output falling off surprisingly steeply, especially of late?
Snyman: Real sector demand is falling off sharply in many countries. Housing starts, cars, steel, energy demand, you name it.
Bruggemans: How is this impacting on emerging markets?
Rode: Emerging markets are dependent on exports. The falloff here is deep.
Bruggemans: There has been gradual erosion of export growth in many emerging countries during most of this year. Then we saw the abrupt falloff in commodity prices since mid-2008, followed by extreme financial stress in the more exposed emerging markets during September-October, requiring major central bank and IMF support to stabilize these situations.
Laubscher: We expect substantial export slowing in emerging countries. But we can also in many of them expect attempts to boost domestic demand via higher consumption and greater infrastructure efforts. Growth may slow down, but not everyone will end up in recession.
Martin: Especially commodity producers will be in trouble, with commodity prices falling heavily, and export volumes suffering. Their declining terms of trade imply loss of national income.
Bruggemans: True, but many of these countries have built up huge external surpluses and they will be drawing some of this down. It is a big shock absorber for the world economy.
Rode: It is a fairytale to think emerging countries can depend on their consumers to overcome this global weakness.
Laubscher: Countries such as China may see their export growth falling off, but their import costs will be substantially lower as well. Their terms of trade will be improving, boosting national income.
Bruggemans: China has been lowering interest rates, has stopped appreciating its currency, is encouraging its banks to make more credit available for housing and other types of investment and is apparently contemplating a huge fiscal boost. A fiscal package of $580bn has been announced for 2008-2010. That could be the equivalent of the likely US fiscal effort over the coming year, but in a much smaller economy.
India has seen its currency weaken and has aggressively started to cut its interest rates. With a large budget deficit it has less scope to take fiscal action. These stories are repeated in many countries at present.
Bruggemans: How are these changing conditions affecting South Africa?
Laubscher: There doesn’t as yet seem to be a full realization among our population and business sector of the real economic impact of what is coming our way.
Bruggemans: We remained well insulated from the financial crisis globally because of close bank supervision and the isolation imposed by exchange control. But we didn’t escape the financial market sell-off earlier this year, and the Rand weakened by 10% in 1H2008.
Martin: The 3Q2008 was far more dramatic in the way our export prices fell off, and then in October we also experienced these huge equity market sell-offs, with foreigners this year selling over R50bn of their portfolios and the Rand losing another 30%.
Bruggemans: It certainly has been turbulent, though oil and the Rand were important shock absorbers. When one annualizes our oil import costs, and allow for 5%-10% volume effects through mid-2009, our oil import bill doubled between mid-2007 and mid-2008 to nearly $30bn, but by last week had shrunk to $12bn.
Unfortunately, many of our export prices also collapsed this year, with platinum peaking at $2300 and now at $800 and gold topping $1000 and now nearer $700, with other commodity export prices similarly down.
Martin: The 40% Rand depreciation this year has certainly helped to shield mining companies and many manufacturers, also encouraging import replacement, though many platinum producers are apparently in trouble.
Laubscher: South Africa is certainly exposed on the export side. Half our exports go to industrialized countries, where GDP growth is seen going from 3% growth last year to -1% GDP decline next year. That implies export volume losses for us, even if the Rand is a shock absorber. There is considerable concern about our manufactured exports.
In contrast, many of our commodity exports are weighted to Asia, where we expect growth to continue. But in the case of platinum, global car demand weakening steeply is a major concern.
Rode: Our terms of trade are falling, our export volumes are weakening and our national income will be declining.
Bruggemans: With this global picture an unpromising backdrop for 4Q2008 and most of 2009, how is our fixed investment shaping?
Martin: Residential fixed investment is affected by banks tightening their credit standards yet further. Besides affordability issues (high interest rates) and municipal services being problematic, the supply of credit is being increasingly constrained.
Bruggemans: How do you see things the next 12 months?
Martin: Conditions shouldn’t change much. Interest rates will come down, but banks will remain tight for some time, and people will be cautious, not spending as freely as usual. Increased asset repossessions impact negatively on sentiment, holding people back on new commitments.
Rode: Real house prices will be heading south for a long time. There is a very close correlation with real residential investment. Don’t expect a miraculous turnaround in building activity soon. Residential fixed investment growth data from the SARB is set to worsen further. Nominal house prices are still seen declining by 10% peak-to-bottom through next year as a worst case.
In contrast, the mid-1980s saw only a minimal nominal decline of 2%-3% in house prices. This current experience may be worse. Unfortunately we don’t have a good statistical understanding of supply and especially oversupply of housing to assist the analysis.
Developers seem to have spare housing stock, which they try to rent out. Some developers are in trouble, selling existing stock at reduced terms. But some of this is distorting prices. They can keep their prices high and get them so registered at the deed office, creating one impression, while through the backdoor guaranteeing rental income for one or two years to buyers, so-called teaser terms, lowering the effective price of the stock. This practice is perhaps not widespread, but it still distorts our sense about how house prices are evolving.
Martin/Rode: Developers continue to build, apparently thinking demand will be there, not least because interest rates are going to decline. The Development Imperative is in full swing. Developers have assembled whole teams, which are partially, if not fully, committed to projects, at least psychologically. Having on tap assembled teams of effective staff that have made millions for them in recent years, many developers are inclined to push on through this cyclical dip.
Bruggemans: These seem to be echoes of the mid-1970s when so many developers ultimately went out of business after overreaching themselves?
Martin: There apparently remains enormous denial about what has hit us, and can still hit us in the coming year, as is being discussed here. Not all developers seem to have taken this fully on board yet.
Rode: Developers acquired an enormous optimism over many good years and tend to extrapolate this into the future. One can generalize here at the national level. Many developers continue to win town planning approval for their schemes or are in the process of gaining approval. Many of them are pushing on with their schemes.
Martin: The interest rate outlook is only one factor that will shape conditions going forward. Real effects, such as the global condition and its impact on employment and national income, are going to be just as important.
Snyman: There will be niches and nodes doing well, such as low cost housing remaining strong, but that remains only 10% of the overall residential building market.
Bruggemans: Residential building activity is 10% of total fixed investment. Non-residential activity is another 10%. How are things shaping there?
Rode: Suddenly there is no more development finance, which seems to have dried up. Banks apparently are a lot more cautious.
Martin: Eskom connectivity is being substantially reduced, as recently reported.
Rode: Lack of new building activity is getting worse. The trend is down. Retail space is hit hardest, being the most overbuilt, but otherwise it is across the board. Vacancies are starting to appear, anecdotally. Small mom and pop convenient stores are worst hit.
Martin: Bigger ones, too.
Rode: Still, non-residential fundamentals (except retail space) remain very strong, with few vacancies as yet.
Laubscher: The retail boom came to a rather abrupt end. It came from a high level. Takes time for space needs to adjust. How much downward momentum is building?
Rode: Retail landlords can hide for long by adjusting rentals. Vacancies take time materializing. Even so, retail supply is overcommitted and pain is coming.
Bruggemans: The economy is really being confronted by a massive two-step adjustment, isn’t it?
First there was the domestic adjustment to the commodity price shock and the non-sustainable nature of our recent boom years. And when we had kind of made that adjustment by early this year, we encountered this second set of massive external shocks in terms of the global financial crisis, the resulting collapse of the commodity boom and now global recession looming, forcing further substantial employment and income adjustments on us as well. We may have the benefit of major shock absorbers limiting the shock impact, but there will be sector pain.
Snyman: Tendering competition among building contractors has intensified greatly, especially non-residential. This implies lower profit margins and also reflects less new work coming out on tender. BER opinion surveys show that 11% of building contractors mentioning increased tendering competition in 4Q2007, rising to 66% in 3Q2008. This number will still rise further into next year.
Laubscher: Commercial vehicle sales are down?
Martin: Heavily in all ranges, including light and medium-sized, but also heavies. There is pain out there, also in mining, especially shaft sinking and platinum juniors.
Laubscher: Mining is under pressure, with electricity constraint an ongoing issue, but also export volumes declining. Mining output this year through August is over 7% down on last year. Most unpromising.
Bruggemans: How is manufacturing shaping?
Laubscher: The Investec PMI at a reading of 46 has now been six months below 50. This suggests a drop in demand, lower employment and a mild contraction of -2% in output, not as bad as 2003, but this can change shortly.
Indeed, the manufacturing fixed investment outlook could change for the worse. Coming months will tell.
If residential and non-residential building activity and commercial vehicle sales are leading indicators, we are rather worried as to what could still happen to manufacturing fixed investment.
There still lingers a projection of prosperity of many years duration, but this can now change.
In contrast, infrastructure investments (roads, power stations, Gautrain, airports, pipelines) remain strong, still anchoring the growth outlook.
Snyman: Even so, mention of increased civil construction tendering competition has gone from a reading of 19 to 49 in FNB/BER opinion surveys between 4Q2007 and 3Q2008, suggesting small construction companies feel the heat of less contracting activity and more tendering competition.
Laubscher: We don’t feel too pessimistic about manufacturing prospects. The 40% Rand depreciation this year encourages a lot of import replacement. There has been a sharp change for the worse in manufacturing outlook in consumer sectors, but with a move away from domestic sales into exports. This should provide some compensation for the increased domestic pressures.
Still, the key questions ahead focus on how much fixed investment may be cut back and how much employment will face retrenchment.
Bruggemans: The growing roll call is rather intimidating, to say the least. These are mere estimates:
• motor trade, 30% fewer dealers
In addition, I suspect commission, bonuses and overtime income will shrink in coming months in many sectors.
Rode: Confidence has weakened and fixed investment can only deteriorate next year.
Martin: Correlation between confidence and fixed investment is traditionally very strong. Confidence is already very much off, with fixed investment still to show its full colours. We expect private non-residential fixed investment, like residential fixed investment, to decline substantially at annualized rates in 2H2008.
Bruggemans: In summary, none of this promises much good news in coming quarters as GDP growth, confidence and fixed investment are expected to deteriorate further, not least due to the impact of global forces only now starting to be felt in earnest as global financial crisis gives way to global recession.
Source: Cees Bruggemans, FNB, November 10, 2008.
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