How resilient will SA be to the global economic slowdown?
By Shaun le Roux
The results released by Barloworld yesterday tell a tale of two worlds: Orders for the equipment that they distribute in Europe and the US have fallen off a cliff, while business in Southern Africa is still buoyant, underpinned by a very healthy demand for Caterpillar products in mining and construction. This is representative of what we perceive to have been a commonly held view – that South Africa is going to prove to be quite resilient to the global economic slowdown.
But is this confidence well-founded?
There is nothing new in the under-performance of the advanced economies. Economic data has been pointing to a G7 recession for some time – RECESSION has recently been confirmed in both the Eurozone and Japan, while the US will ultimately show that their economy started contracting much earlier this year.
And yet for the Southern African region, two pillars of strength have remained: mining and infrastructural construction. But will these areas of support hold up in the context of the recent collapse in commodity prices and the dramatic global slowdown? Recent share price performance in the domestic construction sector would imply that the market is taking quite a dim view on the future prospects for profitability in both these areas.
Take a look at the graph of Murray and Roberts below.
The dramatic fall in commodity prices started with the slump in demand from the West, but owes much of its magnitude to worries over current and future demand out of China. Clearly, the break-neck growth rates in industrial production and demand for raw materials out of China have slowed materially. Currently, metal inventories are building fast as China’s export market starts to weaken in line with softer demand for their products from the US and Europe.
It is our belief that healthy demand for raw materials out of China will eventually re-assert itself, but that commodity producers will first have to contend with a very tough market for a year or two. Accordingly, we do expect wholesale cancellation of planned mining projects where capital expenditure is not too far down the track, particularly with the funding for new projects becoming so scarce. At current commodity price levels many green-fields projects will be frozen, along with new spend on exploration and drilling. Barring the large-scale higher margin projects, there is just no money to be made and where producers can afford to close more marginal mines and refineries whilst they await a return to balance in supply and demand, they will do so. Refer the recent announcements of production cuts by the likes of Xstrata, Lonmin, Rio and Vale.
Of course, the resulting tightening of supply will eventually be supportive of robust prices returning but, in the meantime, miners, suppliers of mining services and equipment and mining construction companies are in for a tough time.
Naturally, aggressive scaling back by mining companies will be very negative for employment levels in South Africa! Cosatu are going to be hosting quite a few marches against unemployment before this one blows over.
On the infrastructural spending side, the medium-term outlook is much healthier. The Southern African region needs to play catch-up for the decades of under-investment in infrastructure. Substantial new investment is required in fixed capital to provide a base for future economic expansion. In the short run, funding for projects has been somewhat curtailed by the credit crisis and the resultant shoring up of balance sheets by the private sector. This is likely to increase the occurrence of project delays, but is not expected to derail the long-term spend.
The evidence points to a much tougher environment for domestic construction companies in the near term, with order books from mining related projects likely to come under pressure and the environment for commercial and residential building looking particularly soft. Competition for tenders will intensify and margins will come under pressure. Until recently, construction shares were perceived to be a relative safe haven within domestic equities with phenomenal earnings growth rates, increasing margins and growing order books. The global economy has significantly dampened the short-term outlook for construction companies, but the medium-term prospects still look relatively attractive. Share prices have come back far enough to make these companies worth a look again, given their medium-term prospects, but the fact is there are plenty of cheap shares out there.
There is a belief that a recovery in domestic consumption may cushion the economy somewhat and there may be some merit in this. The South African consumer has been stretched for some time and some breathing space is in sight in the form of rate cuts and lower food and fuel prices. Unfortunately, the tough economic environment and looming job cuts are going to mean that the upswing in domestic consumption is likely to be muted. In addition, the South African consumer found himself over-indebted at the peak of the last cycle and will take some time to repair his balance sheet, particularly given our somewhat pessimistic outlook for the domestic property market in 2009.
Share prices in areas like Resources and Construction are telling us whether South Africa will emerge unscathed from the global economic malaise. Unfortunately, the answer is “Not on your life”.
Source: Shaun le Roux, Alphen Asset Management, November 18, 2008.
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