Cyclical recovery, structural constraints
By Cees Bruggemans, Chief Economist of FNB.
Attending the 1Q2011 FNB Fixed Investment Roundtable:
Cees Bruggemans: The economy is recovering steadily, with a strong consumer revival leading (car sales, retail trade), but manufacturing slow and fixed investment still badly lagging (especially in the building trades and construction).
There seems to be a quite normal cyclical recovery underway in parts, supported by low interest rates, while other parts seem to be held back, in places by severe structural constraints.
Globally, we face serious event risk (Arab Awakening, European debt, Chinese property), but growth seems to be well vested and inflation is coming back into view, commodity-led. Asset markets have been giving emerging countries a rest, liveliness rotating back to developed countries, especially in equities.
Along with concerted policy action (SARB foreign reserve buying), this has seen the Rand pull back some 10% from 6.60:$ to nearer 7.20:$. With our inflation expected to rise from a recent 3.2% to 5%-6% by yearend, markets have abruptly brought forward their view of our first increase in interest rates, now expected sometime in 2H2011, prime rising by 200-300 points by late 2012 from 9% today.
Though SARB is expected to start raising rates relatively ‘late’, the changing inflation prospect is likely to force it to act eventually, with the economy by then two years into recovery.
Cees Bruggemans: With this as background, what’s the outlook for fixed investment?
Hugo Pienaar: Late last year SARB made quite dramatic upward revisions to consumption growth and downward revisions to fixed investment performance.
Fixed investment for 2009 was at first described as +2.4% but later this turned out to be -2.2%. That’s an R10bn real switch. The 1H2010 was at first described as -2%, but the latest estimate is -6.5%.
Private fixed investment has been modestly recovering in 2Q+3Q2010 from cyclical lows, but public corporations have slowed dramatically to near zero growth.
Household consumption recovery has been relatively strong compared with previous upswings, whereas government infrastructure spending disappointed most. Private fixed investment was mostly shaped by the global recession of 2008/2009 and local structural constraints.
Pierre Blaauw: The fixed investment picture in the public sector is most surprising, with the money available (budgeted) but even Treasury apparently not quite understanding WHY budgets aren’t fully spent. There is clearly frustration at other government departments for not spending their budget allocations, but Treasury seems to have only limited control here.
Elsie Snyman: Manpower capacity at municipal level is most limited, explaining a large part of the under-spent.
Pierre Blaauw: Government is a collective of many parts, with many intricacies influencing things. Some parts want to and can deliver, others don’t deliver.
Hugo Pienaar: Traditionally, fixed investment spending lags coming out of recession after households are already growing nicely. In the beginning of any cyclical upturn, capacity utilization is still low (as today still the case in manufacturing at 81.6%).
Businesses want to see this rising, with sales recovery proven and well vested before fixed investment starts to respond. With consumption recovery already sustainable, capacity utilization will rise further in 2011-2012. That’s good news.
Elsie Snyman: We are again having a consumption-led recovery, but this time it is not very credit-assisted. Fixed investment is lagging, but this seems to be more than just cyclical – that’s the bad news.
Hugo Pienaar: Any part of manufacturing benefiting from the economic upturn should by rights see a recovery in private fixed investment. Motor manufacturing fixed investment is one example, with many company announcements made in recent months. Here exports are also important, as we are benefiting as a niche producer from the world motor industry recovery.
Pierre Blaauw: Given this consumption focus, is that fixed investment prospect robust or fragile?
Hugo Pienaar: Consumption recovery is now robust, but can it handle higher interest rates? Consumers today are more vulnerable than in earlier cycles because of still high debt loads.
Elsie Snyman: I am concerned about these noises of higher interest rates from later this year. We are only just coming out of recession, with consumers only starting to regain confidence. There are still many vulnerable people out there. Consumption would react quickly (negatively) to any rate increases.
Cees Bruggemans: The FNB/BER consumer confidence index has been at very high levels for over a year now, with even stronger readings about own financial prospects. There is a body of consumers out there that feels quite positive.
Hugo Pienaar: I am optimistic about consumers for now, but am not sure how they will react to the risk of higher interest rates, given still high debt levels.
Cees Bruggemans: We probably can expect some early caution when it starts happening. Consumers are unlikely to ignore rising rates.
Meanwhile, strong consumption gains now suggest strong private fixed investment responses in select consumer-related areas, but probably only from 2012.
Hugo Pienaar: Business confidence as per RMB/BER surveys is relatively low today compared to historic upswings since 1970. This probably is a consequence of the events of recent years, making people cautious.
Erwin Rode: Surely this implies private fixed investment will be cautious going forward.
Johan Snyman: American research has shown conclusively that after a financial crisis economic recoveries are usually weak.
Erwin Rode: Substantial overcapacity restrains investment.
Hugo Pienaar: There is high risk to any forecast. This is probably not a normal upturn. There are structural changes that are important.
Elsie Snyman: Potentially not a sustainable upturn.
Erwin Rode: Typical decisions today would be cautious about fixed investment.
Johan Snyman: In any growth cycle, if the economic upturn is accompanied by a building and construction revival you expect to see a strong overall expansion. However, if building/construction isn’t participating you can expect a weak cycle. I suggest you read up Johan Cloete (Cees’s predecessor as chief economist at Barclays National Bank – see the quote at the end of this analysis).
Erwin Rode: We saw that clearly in 1983. Government stimulated but it wasn’t sustainable.
Hugo Pienaar: That view ties in nicely with what we see today. Recovery is consumer driven but unbalanced.
Pierre Blaauw: Post-1994 we also didn’t see immediate reaction. Building/construction took time to believe what was happening. Only by the late 1990s was there buy in.
Erwin Rode: It takes time to mop up capacity slack.
Hugo Pienaar: Policy uncertainty can also be a factor. In the BER manufacturing survey we ask respondents to rate various constraints. When we plot political confidence against private fixed investment we get a nice fit.
Considering what we hear daily about policy coordination and politics as it affects business, is that reason enough to hold back (for now)?
Johan Snyman: Household debt levels are an important consideration in the entire outlook. Household debt as ratio of disposable income was 50% in 1999 (at the start of the previous economic upswing) and was still near 80% in 2009 (at the start of this upswing). This ratio needs to drop cyclically for there to be good sustainable support for this cyclical recovery. This will either happen because consumers incur new debt at a slower pace or income rises.
Cees Bruggemans: Both are happening. Debt is rising at about 6%-7%, while nominal income is growing at 8%-9%.
Pierre Blaauw: The bottom line is that for now the business mood may remain subdued and tentative about news flow, with few real signs of improvement. In building/construction there may be the odd tender, but nothing structurally lifting the market mood. Next two years look grim.
Cees Bruggemans: Let’s talk about structural constraints, if any, holding things back.
Johan Snyman: In the residential property market, and in the residential building industry, it is the combination of the National Credit Act and high debt levels that keep things restrained. Low interest rates are a positive.
Erwin Rode: Banks have to adhere to the National Credit Act. That obviously constrains them in how much they can lend. The implication is that there is an extended structural adjustment taking place in the residential building industry of a few years’ duration. So far one year down and another four to go.
Cees Bruggemans: Biblical proportions. Seven fat years followed by seven lean years.
Pierre Blaauw: Electricity remains a major constraint. Not enough is being done to build extra capacity. Things are being done to restrain electricity demand, but this can only be a limited solution.
The new electricity generating supply being added this decade can only ease the constraint in a limited way. The country is not getting back to a 15% supply buffer. In the 2020s we will face Eskom replacement needs.
Not enough will be happening this decade or the next decade to really ease the electricity constraint. It is a long term problem. It will cap private sector development in mining, heavy industry and property development.
In the building sector, property developers need electricity connection. Municipalities are granting connections, but are not guaranteeing electricity supply. This is forcing developers to think alternatively in terms of new technology, enforcing green practices. This is putting up capital costs (but giving long term benefits).
Elsie Snyman: There are no new (property) developments at present. The Eskom grid will be seriously pressured in 2011-2012. We are hopeful for new developments, but doubtful.
I don’t think the higher capital costs are a serious constraint on new property development. The problem is that demand and the approval process aren’t there.
Erwin Rode: Costs of new (property) developments are structurally shifting upwards in some municipalities. This is because some municipalities cannot provide bulk services like sewerage, water, electricity. This responsibility is being shifted to developers, raising capital costs tremendously. This means that in the medium term it will become more costly to produce more houses and structures generally.
Once through the present slack period (by 2014/2015), we can expect enormous increases in rentals and selling prices thereafter. It will have a generational effect, with old owners benefiting and young ones burdened.
Elsie Snyman: The only really viable housing segment currently growing is the affordable market. That is where the pent-up demand is concentrated. This market is targeted by the government, which wants the private sector to engage. Creative thinking processes are required here to get things going.
Pierre Blaauw: Government needs to make funding available for household groups with a combined monthly income of R3500 to R14000. The challenge is to get developers and the banks to commit. For now there is a standoff.
Elsie Snyman: The interest is there, but not enough response. Too many developers have burned their fingers.
Erwin Rode: It is the only market segment left, really. But there are practical problems. There is also an old problem. The developers get a too low return in this market segment – that’s why they left it alone during the boom years.
Cees Bruggemans: What about the traditional, conventional middle class housing market over R500 000?
Erwin Rode: House prices in this segment are still drifting lower. Price is the most important driver for fixed investment in housing. With prices stagnating or going lower there is no interest. Fixed investment in this housing segment will be problematic for some years. Real house prices should still decline for another three years. AND the interest rate cycle will be turning up.
The building statistics very much support this story, with building plans passed and buildings completed still falling.
Elsie Snyman: The only growth is in additions and alterations, but we are talking here the small, minimal stuff. The minor, non-structural market segment is stirring, as can be seen at the building merchants.
Cees Bruggemans: So what will the residential building market do this year?
Johan Snyman: Modest 3% growth in 2011 off a low base.
Hugo Pienaar: The BER also thinks so.
Erwin Rode: That’s too optimistic. There are two drivers, interest rates and house prices. Given what we have discussed on both these subjects, the chances are for more of a decline rather than a rise in residential building activity this year.
Elsie Snyman: There may possibly be a rise, but would it be sustainable? In the single-dwelling luxury-market building plans passed have cyclically turned up, but how sensitive is this to rising interest rates into 2012?
Erwin Rode: I suggest a word of caution. That uptick was in the wake of the uptick in house prices that ended in the middle of last year.
Elsie Snyman: The developer-driven stuff is not there, which questions how strong growth will be.
Erwin Rode: Some sections are doing well and are turning up, with building costs constrained and interest rates low. But this doesn’t apply to the larger housing market.
Cees Bruggemans: What about non-residential prospects?
Elsie Snyman: There has been a sharp fall in building activity across the board.
Erwin Rode: A function of overcapacity, especially offices.
Cees Bruggemans: How long before rentals start to move? Vacancy rates seem to have cyclically turned?
Erwin Rode: I give it 18-36 months.
Elsie Snyman: 36 months. Regarding new office space delivered the last 12 months, some 60% is still vacant.
Erwin Rode: Office vacancies suggest the corner has been turned (the top of this cycle was in line with the long-term average). The vacancy level is now 9%. This should keep dropping gradually these next three years. But it is only below 5% vacancies that you might see a hot boom developing with 10%-20% rental growth. I don’t expect us to get to 5% by then or for a boom to follow because of the infrastructure constraints as discussed.
Johan Snyman: In non-residential building activity the demand for bricks and mortar in my view is still declining in 2011, stabilizing in 2012, picking up moderately in 2013. When addressing contractors, you hear new foundations only happening in 2013.
The truth is: The last boom was exceptional. Going by cycles, the next recovery (this one) can be less strong.
Elsie Snyman: But was it really a boom or only catch up?
Johan Snyman: I sense builders views are more moderate today compared to being more upbeat last November.
Erwin Rode: People are coming over to my view ………….
Cees Bruggemans: The construction outlook is similarly constrained. Enormous pent-up demand for infrastructure maintenance, replacement and expansion, but apparently not enough manpower capacity to manage the contract flow.
In the private sector there is more chance of a cyclical recovery, but mining for instance remains hampered by electricity constraint, the mining rights issue and the political debate around nationalization.
In conclusion, the economic recovery appears quite unbalanced, with especially consumption in normal recovery, yet fixed investment still mired at low levels, with a number of sectors, especially building and construction, experiencing structural constraints that may in each instance still last a number of years.
This could temper overall economic recovery, keeping growth rates modest, at least through 2011-2013.
On this score I would like to quote my predecessor, Johan Cloete, for nearly 30 years chief economist of Barclays National Bank. In his 1990 book “The business cycle and the long wave with special reference to South Africa” (Institute of Bankers, Johannesburg) he indicated that business cycles and building cycles interact in such a way that they support or retard each other over the course of the cycle.
“In the South African economy, as in other economies, statistics show that business cycle upswings that coincide with an expansion in building activity tend to be relatively strong and prolonged, while those occurring during periods when building activity is declining tend to be relatively short and anaemic. Similarly, business cycle downswings occurring when building activity is contracting tend to be relatively severe and prolonged, while those coinciding with the expansion phases of the building cycle tend to be relatively short and mild”.
Source: Cees Bruggemans, FNB, February 22, 2011.
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