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Fixing for a fight
Participating in the 1Q2009 FNB Fixed Investment Round Table were: .
Cees Bruggemans, Chief Economist FNB
Charles Martin, Senior Economist BER
Christelle Grobler, Economist BER
Erwin Rode, property economist, Rode & Associates
Johan Snyman, building economist, MFA
Bruggemans: How have things changed since our last Round Table discussion in November 2008?
Rode: Global trends foreseen late last year have accelerated and have become reinforced by deep recession and stagnation in our export sector.
Martin: Agreed, but we should emphasize that domestic trends have been more pronounced than expected, linked to high interest rates. The predominant feeling at the time was we would be largely shielded from the global crisis (decoupling), but this hasn?t worked out. There has been much more of a decline in economic activity than expected, and a negative impact on private fixed investment.
Snyman: Late last year
the SARB data for 2Q2008 and 3Q2008 fixed investment in residential buildings was sharply revised downwards, it was revised up for non-residential buildings and sharply higher for civil construction. This confirmed our long running expectations, with SARB data coming into line with unfolding reality, and now more correctly also reflecting other indicators, such as business mood of building contractors. This was a welcome correction as positive residential data did not yell with reality on the ground.
Grobler: The global picture has deteriorated at an immense pace since last October, impacting on many emerging markets and also South Africa, but this only started becoming clear from early 2009.
Especially manufacturing registered broad based pain, with 60 percent of our manufacturing sectors declining at a rapid pace in 4Q2008. The deterioration observable in the official data has been significant, with every passing day bringing new revelations as to what has
actually happened and is still taking place.
Bruggemans: Where next? Where are we heading?
Rode: The locomotive of the world economy, consumers, have been living beyond their means for the past decade or longer. This has created heavy imbalances, which need to be corrected. Dropping interest rates may not solve this. The correction may take many years, up to a decade.
Bruggemans: What is the nature of the correction?
Rode: The rich Western countries need to save more. There will therefore be less growth stimulus forthcoming from the world?s locomotive (consumption).
Bruggemans: Agreed, we have for the moment lost our traditional consumer of last resort, primarily American in nature. If the world is to resume growing, someone needs to take up the spending baton once again.
In the short-term governments can be expected to provide a lot of extra spending stimulus. In the long-term, emerging market consumers will take on a much
more dominant role in providing spending leadership.
For the medium-term, however, I do expect a partial resurrection of Western consumer spending in order to prevent too long a period of global underperformance and extreme resource slack. As things stand, US unemployment is in any case heading for 10 percent next year.
Rode: With US consumers in their present mindset, it will take a long time getting them back into the line.
Bruggemans: I know, but I don?t see other alternatives and it is pretty much the unstated aim of global policy to get consumers to give up their new found abstinence at their earliest convenience, primarily by becoming less anxious and postponing fewer big replacement decisions.
But for the interim governments are going to be consumers of last resort, pretty well nearly everywhere, though with differing intensities (Europe, Japan, South Africa less than global average, US and UK much more so).
Martin: If you
accept Erwin?s view, world growth will be very subdued for quite a while.
Bruggemans: What would be the implications? Relative underperformance, no inflation, low interest rates, high unemployment?
Rode: Governments everywhere won?t accept this. They will be proactive, but with what consequences?
Bruggemans: That?s the question: what?s the shape of things this year and next?
Rode: One South African expectation for me is a government budget deficit nearer six percent of GDP.
Snyman: A growing national debt, projected to increase from 22 percent of GDP last year to 28 percent of GDP this year.
Martin: Infrastructure fixed investment will remain well supported, as will social welfare payments. These will be important supports for the economy.
Grobler: Manufacturing capacity utilization fell heavily last year, from 86 percent to 82 percent by yearend, back to 2004 levels. Traditionally, one finds high and rising
capacity utilization providing the main incentive for increased private fixed investment. With capacity utilization likely to continue to fall for a while, and businesses trying to survive current conditions, fixed investment is probably the last thing on their minds today. Survival mode seems to have kicked in from mid-4Q2008. Private fixed investment spending will be falling this year.
Rode: Anecdotally, it is amazing how many property developers are still gung-ho, positioning for another major boom to come. Both residential and non-residential developers continue to commit themselves.
Bruggemans: Where is this leading? Huge oversupplies?
Martin: Bear in mind what happens in practice: the intentions are and remain bullish, but the focus is on cash flow, management, preservation, sweating of existing assets.
Bruggemans: Such a mood doesn?t translate into continuing commitment?
Martin: Cash flow has become the major issue in the
building trades, with government payments reportedly being comparatively slow. With more variation orders (wanting to change specifications) increasing costs and lack of skills in government lengthening administrative processes, payments are getting to be late even in the infrastructure game.
Rode: This is true in construction, whereas my views concern residential and non-residential developers. Both views apply.
Martin: Vacancy rates are going up. How are developers reacting?
Rode: Shopping centre supply is still steaming ahead as if nothing has happened.
Bruggemans: That doesn?t surprise so much, given the apparent firmness of especially non-durable retail conditions, going by company reports and economic data.
Rode: Shopping centre success is determined by the line shops, the mom and pop shops, small shops that need to be successful if the shopping centre in its totality is to achieve success. Yet these line shops are taking the
brunt of this retail downturn. Discretionary shopping is DOWN. Distinguish between the successful major non-durable anchor tenants and the discretionary line shops. There is a big difference in their realities at present.
Bruggemans: There is a change in conditions?
Rode: Oh yes, dramatically so. The feet count is down dramatically, with nominal sales stagnant among line shops.
Martin: There are big shifts taking place within the retail sector. The value-added product is starting to do poorly, with basic product sales improving as people trade down, in some instances heavily so. This still benefits the large retail chains, but the pinch is felt by the value-added producers and retailers. In other words, the line shops.
Grobler: You can see this clearly in the furniture sector. Production of the more specialist ?other? product lines in this category is heavily down.
Martin: Industrial space is not performing well, being linked to
manufacturing. Industrial space completions are -5 percent in 2008, compared to office space completed +63 percent and shopping space +32 percent.
Bruggemans: Non-residential building plans passed have been declining year-on-year since September 2008.
Snyman: Building plans for retail space has been moving sideways, industrial is down -5 percent, offices up +6 percent.
Bruggemans: Will demand for space be there, given the supply of space currently shaping?
Rode: Office vacancies are rising slightly at present, but so far nothing serious really. But demand is slowing down sharply with supply still rising. When taking a two-year view, it is inevitable that vacancies will rise and rental growth will slow, probably to single-digit.
Bruggemans: So despite the rather dire global outlook as discussed and uncertain local cyclical playout, why is there not a more severe property dislocation shaping?
Rode: Non-residential building
activity is in the upturn leg of a long upswing phase. That gives it a lot of protection.
Bruggemans: Is the residential market a similar story?
Rode: Residential is fundamentally different. Its long-term cycle has peaked and it is in the down leg of a downswing phase that may take seven years playing out.
Snyman: Residential buildings completed peaked in mid-2007, with a likely cyclical bottom around 2015.
Rode: US house prices in real terms moved horizontally in a narrow band ever since the 1950s. From the late 1990s, US real prices shot sharply higher out of this band, reaching a zenith in early 2006, thereafter starting a deep slide lasting to today and in real terms still having a lot of falling to do.
South African house prices experienced something similar. It tells us that prices moved too fast relative to incomes. This has to correct itself. The cycle corrects itself over a period of years (say seven) through rising nominal
incomes and stagnating nominal house prices, before the long-term equilibrium is re-established. The market over shot and is now steadily correcting.
Bruggemans: So where does that put us in 2009-2010?
Rode: In a worst case, house prices will have dropped nominally by up to -10% by later this year from their cyclical peak in 2007.
Bruggemans: Interesting. So if nominal income gains over a seven year period is some 70-80 percent, and allowing for a nominal house price drop of -10 percent since 2007 and thereafter stagnation, house price/income ratio by 2015 will have fallen to nearly half the peak value of 2007.
Martin: Supply of completed dwellings bigger than 80m2 is down by -6 percent this past year. Townhouses are down by -10 percent. Supply is contracting.
Rode: Bear in mind this is happening from a high level. Also allow that consumer potential for doubling up (and reducing their demand for new living space) is huge. Youngsters
can move back to their parents (or parents can move in with their youngsters). One can share with friends. It all reduces demand for new space.
Supply responds to this by correcting as developers put fewer housing units on the market, with profit margins currently dropping dramatically. Many developers are offering incentives/discounts/teasers to offload unwanted housing stock.
Martin: Housing demand in the gap market (household incomes between R200 000 and R300 000 per year) has dropped sharply in view of rising interest rates and stringent credit criteria applied by providers of mortgage finance.
Snyman: Rising interest rates had a major impact during 2006-2008 in eroding residential building plans passed and buildings completed.
Martin: The interest rate cycle has turned, and by implication the housing cycle should now also turn, based on historic behaviour. But we face a secondary shock by way of falling exports, employment, global
credit-linked (banking) anxieties, with the cherry on top being the National Credit Act, inducing banks to be more stringent.
Bruggemans: Yes, and the question is: do we come back? Will consumers respond in traditional fashion to falling interest rates? In the short, medium, long term?
Rode: The National Credit Act has changed the ball game or at least the rules of the game. It has put us 30 years back. House buyers today are again being asked to put 20 percent deposits down. In the short term, this breaks the behavioural link.
Martin: In the past, declining interest rates were accompanied by more lenient, rising loan-to-value ratios at banks. Not now, as banks prefer lower loan-to-value ratios, reinforced by the National Credit Act. Part of this also reflects what has been learned globally, to be more careful.
Snyman: The National Credit Act came in just as residential building plans passed went negative year-on-year. They have yet to
Grobler: The National Credit Act has broken the behavioural link, now belatedly reinforced by the global impact of credit crisis, export and employment losses. Business as usual won?t continue. There has been a break but its nature, magnitude and longevity is unknown at this stage.
Snyman: There is a technical factor at work as well, the simple base effect. The movements we are describing are cyclical ups and downs. As you go very low in the cycle, you are increasingly comparing ?nothing with nothing?. The cycle hasn?t necessarily broken, and an upswing may be seen to commence. But given what we are talking about here, it may imply a very long cyclical recovery rather than the traditional snappy one.
Bruggemans: In other words, it may feel like a cyclical break ? a lack of responsiveness where you would think falling interest rates wouldn?t have such a result. But it may simply take time for old relationships to come back, for the cycle to
re-establish itself, especially under current remarkable circumstances with so many contributing features. But eventually it will.
Rode: And in the interim lots of blood in the streets as developers suffer.
Bruggemans: Are we inclined to overstate the likely strength of the coming cyclical upswing by simply expecting old behaviour to reassert itself ere long, favourably reacting to falling interest rates? In other words, do we underrate the risk of a cyclical breakdown, even if it is temporary?
Rode: It is a legitimate question. Households wanting to buy a house now have to save first to get the 20 percent deposit together. This affects at least 30 percent of the property market (first-time buyers) and not a few old-timers discovering much less equity in their old property than they imagined, especially those who bought since 2005. This creates a cyclical break.
Snyman: Perhaps we should focus more closely on the amplitude and duration of the
Bruggemans: Historically we have had enormous cyclical falloffs (Rubicon 1985, Soweto 1976, Sharpeville 1960). But sometimes also excessive downside duration (with the 1989-1993 recession driven by political uncertainty).
It may be that we don?t so much see a cyclical breakdown as a transformation of the relationship (between interest rates and housing demand/prices).
Snyman: It has happened before. In 1992-1993 interest rates were declining, but political factors (Boipatong) incited a loss of confidence, depressing house prices.
Bruggemans: Considering what we have discussed so far, where is the cyclical bottom, what does recovery look like and what does it mean for fixed investment?
Snyman: For residential property the current episode is a very bad recession. These past 50 years we have had five episodes (1961, 1976, 1985, 1990, 1998) in which residential buildings completed declined by as much as 15-20 percent
year-on-year in some quarters.
The 3Q2008 was -5 percent, and I expect 2009 to see quarters of the order of -15 to -20 percent.
Bruggemans: What about non-residential (retail, office and industrial buildings)?
Snyman: Non-residential building activity is still in a long upswing. The 3Q2008 was +15 percent year-on-year fixed investment growth. The next two years are more likely to see -7 percent (2009) and -5 percent (2010).
An important support will be public fixed investment (police stations, clinics, courts, administrative buildings). Construction should record positive real growth, given the strength of infrastructure demand, but lower than in 2003-2007 (given the enormous base we are annually comparing with).
Bruggemans: What kind of fixed investment growth is that going to give us in 2009-2010? Will it be slower than previously expected?
Snyman: Residential could be -7 percent in 2008, even -12 percent in 2009 and +1
percent in 2010. Non-residential may be +12 percent in 2008, -7 percent (2009) and -5 percent (2010). And after still very strong growth in 2008 construction could be +8 percent (2009) and +3 percent (2010). Together these three sub-sectors represent 40 percent of total fixed investment.
Bruggemans: And the remainder?
Martin: Transport equipment contributes about 15 percent of the total. It splits between private (mainly commercial vehicles, ships, aircraft) and public (railway rolling stock, aircraft). Private will be negative in 2009 and may weakly recover in 2010. Public could be up in 2009-2010 (gautrain, Transnet locomotives).
Grobler: Machinery and equipment contributes over 40% of total fixed investment. The public side (infrastructure) will be up, increasingly so, but the private sector may surprise us how deep it could fall off. We may overall experience -10 percent (2009) and -5 percent (2010).
Bruggemans: That could overall translate
into zero to -5 percent decline in fixed investment in 2009 (probably -3.5 percent), and a possible further decline in 1H2010 but possible moderate recovery towards late 2010, quite different from the expected +10 percemt gain still recorded in 2008.
Bruggemans: On what did we really agree regarding 2009 and 2010? Real government spending will be 4-5 percent in both years, with household consumption being 0.5-1 percent (2009) and 2-3 percent (2010).
Differences seem to focus on fixed investment, where some of us expect a smaller negative growth in 2009 compared to others.
As to exports, all of us fear deep disappointment. But by how much will imports go down as well, deciding the impact over the current account, but also for GDP growth?
Our GDP estimate ranges from +0.5 percent to -1 percent (2009).
Bruggemans: Will we be in cyclical recovery (rising GDP) in 2010?
Snyman: technically, yes, but very
Martin: yes, gradually.
Grobler: mild recovery.
Bruggemans: for myself, yes, but a disappointing underperformance, slow and hesitant at first.
Bruggemans: What will be the likely dynamic of the cyclical turn?
Snyman: the tipping point will be falling interest rates, as always working with a lag.
Martin: interest rates.
Grobler: Change in perception, probably later rather than earlier, from 2H2010.
Bruggemans: For me it will be interplay between various forces:
inventory cycle (drawdown ending 2H2009)
household durable replacement cycle (shortening again from late 2009 under influence of falling interest rates)
credit cycle (gradually accelerating in 2010)
trade cycle (tepid turn in 2010, as the world turns)
private fixed investment (late turn 2010-2012)
Bruggemans: But we all seem to think lower interest rates may have a
lesser effect initially in turning things around, and much will depend on the global credit crisis and recession being successfully addressed.
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