South Africa
Tepid Growth in a Global Recession
January 15, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

The outlook for the South African economy has deteriorated further. Whereas we initially expected a weaker currency to generate some export growth, it now appears that the world’s capacity to absorb South African exports will impose a much larger constraint on its external trade balance (and, as a corollary, GDP growth) in 2009. Weaker external trade volumes, in the face of declining commodity prices, are also likely to generate a negative feedback loop into private consumption and capital formation. However, counter-cyclical fiscal spending should help to keep GDP growth in positive territory over the year ahead, in our view.

Background

This week, our global economics team downgraded US growth further by 0.5pp to -2.4%Y in 2009, and was at pains to highlight that the risks are still skewed to the downside (see US Economics: Global Recession Aggravates the US Downturn, January 12, 2009). Earlier, our European economists also trimmed their 2009 growth estimate by some 60bp to -1.6%Y, thanks largely to weaker German export growth and general consumer deleveraging in the wake of an intensifying global recession (see Germany Economics: Export-Champion Relegated by Global Recession? January 7, 2009). Generally, incoming data for the global economy have become profoundly weak, with production and trade flows sinking in both industrialized and emerging economies. For example, in Asia (excluding Japan but including China), recent anecdotal evidence points to profoundly weak continental growth, with production activity plunging by the 6-12% rates that were last seen during the Asian Financial Crisis. We believe that China’s ability to take up the global slack is waning, particularly as the credit crunch continues to hobble trade finance operations globally. It is also clear to us that the global recession will have significant implications for South Africa.

Global Downturn to Hurt Exports

About 32% of South Africa’s exports are destined for Europe, while a further 29% and 13% are routed to Asia and the US, respectively. With GDP growth in these target markets slowing markedly, their ability to absorb South African exports will no doubt be significantly constrained this year – even if such exports are competitively priced on the back of the weaker rand. As a result, we now expect South Africa’s export growth to swing from an average 6%Y print since 2005 to -3.5%Y in 2009. This will be the first negative annual print since 1991 and represents a sharp revision from our earlier estimate of 4.7%Y.

Investment Spend to Decelerate, Not Decline

A contraction in export revenues will no doubt affect corporate profitability, as exports account for 28% of South Africa’s GDP. Also, considerably weaker global demand prospects will likely combine with the deterioration in local consumer and business confidence to dim prospects for domestic capital formation and inventory accumulation in 2009. As a result, we expect investment growth of no more than 4.5%Y. However, public sector investment spending should remain strong, as the government demonstrates its commitment to counter-cyclical fiscal policy. A relatively more accommodative monetary policy stance should also help to avert a contraction in fixed investment spend.

Flattish Private Consumption Growth

However, as corporates pare back investment spend,  employment growth is likely to contract too, leading to an overall decline in gross disposable incomes, with adverse implications for private consumption spend – particularly in an environment of tighter local credit regulation. With most South African household balance sheets already in desperate need of repair, it is not surprising that private consumption has remained weak and, in fact, turned negative in 3Q08. We look for consumption growth to remain negative for most of 1H09, followed by a mild recovery in 2H09 as the world pulls through and as monetary stimuli take hold. For the year as a whole, however, private consumption growth is likely to remain flat, despite 300bp of interest rate cuts.

Commodity Volume Terms of Trade Is Crucial

So far, the decoupling of oil prices from movements in gold and platinum is positive for South Africa (oil prices are down some 71% from their peak, while platinum and gold prices have fallen by only 59% and 18%, respectively). With commodities accounting for roughly a fifth of South Africa’s imports (mainly crude oil and petroleum products) and some two-thirds of exports (gold, platinum, coal, steel, etc.), it is important to note that commodity import prices need to fall by three times as much as commodity export prices for South Africa’s external trade balance to benefit from a downturn in the commodity cycle.  Hence, while movements in the commodity price terms of trade are important, the underlying trends in the volume terms of trade must not be ignored either. For 2009, we expect export volumes to fall as the globe slows, while import volumes remain rather sticky, thanks largely to relatively inelastic near-term demand for capital imports associated with the government infrastructure program ahead of the 2010 FIFA World Cup.

Current Account Gap Should Remain Wide …

We estimate that were oil prices to average some US$50/bbl as suggested by the oil futures curve, while gold and platinum prices average some US$850/oz and US$900/oz, respectively, South Africa’s visible trade balance could deteriorate from ZAR46 billion in 2008 to roughly ZAR70 billion in 2009. However, net invisible payments on the current account are likely to fall in 2009. For example, net service payments should be capped by lower freight costs as oil prices remain low, and by lower travel expenses as global trade flows ebb. Net income payments, on their part, should also fall as the global downturn hurts corporate profitability, resulting in lower net dividend outflows. However, relatively strong intra-regional trade will ensure that net transfer payments to the Southern African Customs Union (SACU) are in excess of ZAR20 billion this year. On the whole, therefore, we expect the current account deficit to remain at a high 6.8% of GDP in 2009, before widening further to 7.4% of GDP in 2010. With the global environment deteriorating by the day and financing flows becoming increasingly difficult to source, we believe that the risk to our year-end USDZAR target of 10.80 is skewed to the upside, particularly as we enter the February-April election period. 

… as Should the Fiscal Deficit

The ANC’s election manifesto released over the weekend points to significant fiscal disbursements to address the country’s socio-economic inequalities. Among other things, the ANC hopes to prioritize job creation, intensify agrarian land reform, promote food security, provide free and compulsory education for all children, introduce a national health insurance system and establish a new modernised criminal justice system. While some of these laudable objectives have already been provided for in the October budget, we believe that the residual funding gap could turn out to be in excess of 2% of GDP, lifting the public sector borrowing requirement (PSBR) north of 6% of GDP. The ruling party’s manifesto also proposes that fiscal and monetary policy mandates, including management of interest rates and exchange rates, take cognizance of economic growth, employment and other developmental objectives. While the manifesto fell short of calling for an abolition of inflation targeting, it nevertheless points to a likely broadening of the SARB’s mandate beyond the achievement of a numerical inflation target. This could have significant implications for the fiscus.

Offshore Funding Environment Remains Challenging  

Thankfully, outside of a US$0.6 billion, 9.125% May-09 Yankee bond, South Africa does not have significant external debt roll-over risk in 2009. However, in the current environment where traditional risk-free sovereigns in the industrialized world are hoping to fund significant amounts of government paper from a finite pool of global investible funds, we believe that it is reasonable to expect developed market issuers to crowd out second-tier credits like South Africa. We estimate that, on a net basis, the National Treasury is unlikely to raise more than US$2 billion (some 1% of GDP) of foreign debt in 2009, without paying punitive yields. This is a relatively small amount, considering an estimated current account deficit of some 7% of GDP, and supports our weaker ZAR call.

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United States
Global Recession Aggravates the US Downturn
January 15, 2009

By Richard Berner & David Greenlaw | New York

Despite early signs of healing in funding and credit markets, and significantly greater fiscal stimulus, we think the US economy will be weaker and inflation will be lower than we did a month ago.  Validating the direction of risks for the US and global economies we saw in December, we now expect a 2.4% contraction in real output and a 1.3% decline in headline consumer prices this year, compared with 1.9% and 0.3%, respectively, a month ago.  A key reason is that the drag on US growth from a sinking global economy has intensified, likely aggravating the downturn in output and corporate profits.  We expect that additional fiscal and monetary stimulus would promote a recovery in 2010 of about 2% (3% on a 4Q/4Q basis), but we now think that the headwinds facing the economy are even stronger than we reckoned in December.  Indeed, were we to assume the same level of fiscal stimulus as a month ago, the 2009 contraction in GDP might be 2.7% instead of 2.4%, followed by an anemic 1% recovery in 2010.

(Year-over-year % change)	2008E	2009E	2010E
Real GDP	1.1%	-2.4%	2.1%
Inflation (CPI)	3.8	-1.3	2.8
Unit Labor Costs	0.6	2.1	1.1
After-Tax ‘Economic’ Profits	-4.4	-29.4	8.8
After-Tax ‘Book’ Profits	-11.5	-22.0	10.4

Source: Morgan Stanley Research    E = Morgan Stanley Research Estimates

Moreover, sequencing and lags matter for assessing the economic outlook over time.  The improvement in money and credit markets is a constructive sign that the credit crunch at the root of the downturn will eventually end.  But that process will take both time and aggressive steps to clean up balance sheets and mitigate mortgage foreclosures.  Likewise, prospectively massive fiscal stimulus will boost aggregate demand, but it will also require time to enact, implement and get traction.  For financial markets, sequencing means that funding and credit markets must heal first to revive the economy and the prospects for corporate margins and earnings; only then can investors anticipate a better backdrop for risky assets like equities.

Recent signs in funding and credit markets signal that the Fed’s quantitative easing strategy is beginning to work, promising relief from the credit crunch.  Flooding the banking system with nearly US$800 billion in excess reserves and the ongoing benefits of the Fed’s liquidity and financing facilities have narrowed unsecured interbank lending and other money market spreads.  For example, 3-month Libor/OIS spreads – the best real-time gauge of stresses on bank balance sheets – plunged to 107bp last week, or less than one-third of the October 10 peak of 364bp.  Forward spreads evince much more improvement, with December at just 53bp; and a pick-up in term interbank transactions out to nine months is especially encouraging.  Likewise, the first wave of direct Fed purchases of mortgage-backed securities brought their yields well below 4%.  Eventually these actions may drag conventional 30-year mortgage rates to 4.5% or below, sending housing affordability measures soaring well above previous record-highs.  The credit markets are also thawing, but more slowly.  Following the credit rationing of 2008, in which investment grade net issuance plunged to a mere US$20 billion (a 10-year low), it appears that transactions are picking up briskly but spreads have only begun to narrow. 

But adverse feedback loops still have the upper hand.  The lagged effects of the credit crunch on the economy are still swamping the coming benefit from improved financial conditions.  Three adverse feedback loops will continue to weigh on the US economy for the next few quarters. 

First, the imbalance between housing supply and demand will continue to pressure home prices, impairing consumer wealth, reinforcing caution among consumers and their lenders, and thus restraining the demand for and availability of housing credit.  The plunge in new existing and pending home sales through November and home prices through October speaks to previous restraint.  While lower mortgage rates will clearly help housing, and there are glimmers of improvement in recent mortgage applications for purchase, the effects will take time to work. 

Second, capital spending will contract as a result of the credit crunch, the ‘accelerator’ effects of a sliding economy, the end of 2008 tax incentives for investment, sinking profits, and plummeting operating rates.  The evidence at year-end 2008 was mixed, with a 3.9% bounce in November ‘core’ capex orders bucking the slide of the prior three months, and commercial construction perking up in the fall.  Don’t let those data mislead: They are volatile and often lag behind the deterioration in fundamentals, and capital spending is now likely to contract more sharply in 2009 than we previously thought. 

Third, the slide in jobs and hours is now accelerating, menacing already-reeling consumer spending.  Measured by hours worked, private labor inputs in 4Q08 tumbled at an estimated 8.6% annual rate, the sharpest since the deep recession of 1974.  Private layoffs are surging in the early days of this year, and the pressure on state and local budgets is triggering government layoffs.  With slack in labor markets rising, wage growth will come under pressure, and nominal compensation is likely to contract in the year ended in 3Q09 for the first time since the recession of 1958.  To be sure, the plunge in gasoline and energy prices since July has given a US$170 billion (annual rate) boost to real incomes and promoted a bounce in November real consumer spending.  We think that this bounce is transitory, because falling energy quotes are only a lull in the ‘perfect storm’ for consumers: The impact of falling wealth, jobs, incomes, reduced access to credit and rising foreclosures is promoting consumer caution and paying down of debt.  Such a return to thrift will be helpful for consumers in the long run, but it risks intensifying the downturn as the ‘paradox of thrift’ restrains aggregate spending.

Adding to these domestic headwinds, the global recession is now in full swing and threatens to be a drag on US growth.  For two years, strong global growth buffered the US economy from a housing-induced credit crunch.  Indeed, over the two years ended in 3Q08, real net exports accounted for nearly three-quarters of the 1.7% annualized increase in US real GDP.  Now, that tailwind has turned into a headwind.  Incoming data for the global economy are profoundly weak, with production and trade flows sinking in both emerging markets and industrial economies.  In Asia excluding Japan but including China, production declines range from 6-12% for the year through late 2008, rivaling the collapse during the Asian Financial Crisis of a decade ago.  Both imports and exports are falling sharply, reflecting weak domestic and external demand and Asia’s pivotal role in global supply chains.  The credit crunch has hobbled trade finance, limiting the ability of importers and exporters to carry receivables and goods in transit.  In the non-US industrial economies, production declines through late 2008 range from 4-13%Y.  The pattern in trade is more varied, but declines in exports are beginning to gather steam.

This sharp downturn is more than a short-term inventory adjustment.  Instead, it reflects the spillover from weak US demand and the effect of the credit crunch on global trade finance and capital spending.  We believe that our European economics team’s sharp downgrade of Eurozone growth to -1.6% from -1.0% a month ago is consistent with that view.  And we think that the recessions our global team expects in Japan, the UK and Latin America reinforce the downside risk scenario for the global economy we outlined last month.  For the US, this is grim news indeed.  A weaker global economy will pull down exports faster than imports, depressing manufacturing output, jobs and income. 

Massive fiscal stimulus will help offset these headwinds, but it will take time to have an impact and the credit crunch will limit fiscal traction.  We assume that Congress and the Administration will agree on a multi-year stimulus package amounting to about US$800 billion, of which roughly half will be spent in F2009.  That’s more than double the fiscal boost in F2009 that we assumed a month ago – US$400 billion versus US$150 billion previously.  The plan will likely include income and/or payroll tax cuts, grants to state and local governments for Medicaid relief and infrastructure, stepped-up infrastructure outlays, and increased unemployment insurance and food stamp benefits.  As a result, the F2009 ‘cash flow’ deficit will jump fourfold to nearly US$2 trillion. 

But two factors likely will limit thrust.  First, with wealth falling and the credit crunch still in play, we think that consumers are likely to save a significant fraction of any tax cuts to pay down debt.  We estimate that in the spring when the tax cuts kick in, the personal saving rate will jump to nearly 6%, and that it will hover at around 5% over the forecast horizon.  Second, infrastructure spending rates will ramp up slowly.  We expect that at most 20% of the appropriations for infrastructure spending will occur in 2009, and that the outlays necessarily will extend over several years. 

The global downturn has intensified US deflation risks.  The story goes well beyond the plunge in commodity prices, although we now see headline CPI down by 2.7% by 3Q09.  Rising economic slack at home and abroad will also play a major role.  Weakness from abroad is likely to further increase the prospective US output gap to more than 7%, near the 1982 post-war high.  Slack overseas will put downward pressure on import prices, and the dollar has stopped declining.  US monetary policy is positioned to fight those risks, although policy abroad – especially in Europe and Latin America – is still playing catch-up. 

Sequencing is important for both the economy and investors.  The hopeful signs in financing and credit markets have important implications for investors: Monetary ease and central bank liquidity facilities have improved funding markets.  The Fed’s use of its balance sheet to support specific financial markets has lowered mortgage and other rates and promoted a stretch for yield.  Corporate credit markets have begun to heal.  With these trends likely to continue, we continue to like cash corporate bonds and overseas over US sovereign debt, and expect only modest dollar appreciation.

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India
Deeper Industrial Slowdown Ahead
January 15, 2009

By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai

Summary

The global deleveraging trend continues to unravel at a rapid pace. Over the last few weeks, economic data around the world have continued to indicate a major contraction in foreign trade and industrial activity. Our US and Europe economics teams have again reduced their growth estimates for 2009. Recent growth data in Asia also surprised on the downside. In this environment, we believe that India is likely to see further downward pressure from the external environment. We believe that external support from capital inflows, as well as export demand, will be weaker than expected. We are cutting our GDP estimates for 2009 by a full percentage point to 4.3%. 

Global Growth Environment Continues to Deteriorate

Global growth has continued to surprise to the downside. The first round of credit defaults has caused risk-aversion in the financial system and further growth slowdown in many of the Anglo-Saxon countries. Foreign trade data, one of the key indicators of this trend, have been much weaker than expected. Exports from Germany contracted by 11.8%Y in November (versus +1.3% in October). Similarly, exports from Japan contracted by 26.7%Y in November (versus -7.8% in the previous month) and exports from the US decelerated by 4.7% in October (versus +8.8% in September). Our US economics team has further reduced its 2009 GDP growth forecasts to -2.4%, from -1.9%. For Europe, our team now estimates -1.6% growth in 2009 compared with -1.0% previously. 

Capital Inflows to Remain Weak for Longer

Over the last few years, India’s GDP growth accelerated much higher than the potential growth due to large capital inflows. India’s GDP growth accelerated to an average of 9.3% during the three years ended March 2008 compared with an average of 6.6% and 6.0% in the preceding three and five years, respectively. Capital inflows have risen significantly over the last five years. India received an average of US$10 billion per annum during F2001-03, and that number increased to US$107.2 billion in F2008. Higher capital flows have been the anchor of a self-fulfilling virtuous cycle of an appreciating exchange rate, lower interest rates and strong domestic demand growth.

Indeed, India has had one of the strongest credit cycles within the Asia ex-Japan region, driven by low real interest rates and strong capital inflows. Credit growth has been persistently higher than nominal GDP growth by a large margin. The outstanding bank credit stock increased from just US$186 billion as of March 2003 (the starting point for the current credit cycle) to US$638 billion by end-F2008 (Y/E March).

In F2H09, we estimate capital outflows of US$10-15 billion. Unfortunately, capital inflows into India have less to do with India’s long-term fundamentals. The trend for capital inflows into India and other EMs has been dependent on the global risk appetite, which, in turn, has been driven by liquidity and the growth environment in the developed world. To the extent that capital inflows have suddenly witnessed a sharp fall, India is now continuing to face a growth shock.

Payback from India’s Own Credit Cycle Excesses

Over the last four years, the banking system has witnessed average credit growth of 28.3% compared with nominal GDP growth of 14.8%. To the extent that banks were aggressive in disbursing credit at unusually low rates to the marginal borrowers at cycle-peak GDP growth, they are now facing a potential rise in NPLs. We believe that from 2H05 and in 2006, the banking and non-banking financial sector were liberal in pricing credit. However, the first round of growth shock is now causing an increase in NPLs in the non-banking as well as banking system. NPLs are already rising in the real estate sector, unsecured personal loans and SME loans. With industrial production having reached close to a 15-year low of -0.3% as of October 2008 and the cost of capital still high, NPLs will likely rise further. This would make banks risk-averse to lending to the corporate sector, resulting in a vicious slowdown. We expect credit growth to slow to 10%Y over the next 6-8 months.

External Demand Shock to Add to the Downside

India’s export growth averaged 24.1% over the last three years ending September 2008, driven by strong global growth. However, over the last three months, export growth has decelerated sharply. While until recently the strong demand from emerging markets including Latin America, Emerging Europe, Middle East and Africa ensured that export growth remained healthy, over the last four months disruptions in the macro environment of these economies have been evident. Apart from the weakening demand, exports have also been affected by the lack of availability of foreign trade credit and inventory liquidation. India’s exports declined by 9.9%Y in November compared with -12.1% in October and +10.4% in September. While we expect some improvement in 2H09, exports are likely to be unusually weak over the next six months. We now expect exports to decline by 11%Y in 2009 compared with 16% in 2008 (estimated) and 23.6% in 2007.

Industrial Production to Contract in the Coming Months

While deceleration in growth, as reflected in GDP growth, may not appear as severe, industrial production – which matters for the listed corporate sector – is likely to witness a deeper slowdown. Industrial production decelerated to an average of 2.5% for the three months ending November 2008 from a peak of 13.6% in the quarter ended January 2007. Further weakness in domestic demand, owing to the rise in the cost of capital and sharp deterioration in external demand, will likely result in industrial production declining for a few months between December 2008 and June 2009, in our view. Recovery is likely to be tepid from 4Q09. This would be the worst industrial sector performance since the 1991-93 crisis.

Cutting 2009 GDP Growth Estimates

We expect the fixed investment cycle to reverse sharply. Particularly private corporate capex is likely to witness significant contraction. In addition, weaker global growth will also be apparent in the form of a slowdown in external demand. While lower oil prices should help to reduce the current account deficit, we believe that lower exports and remittances from non-residents should offset a large part of this gain. Moreover, as we have argued, for the balance of payment outlook, capital inflows are more important than the current account balance.

Moreover, tight lending standards are likely to restrict consumer loan growth and private consumption spending. Job losses in the urban economy are already rising. Employees in many sectors are witnessing declines in wages. Indeed, anecdotal evidence suggests that this is the first time that the slowdown in the economy appears to be influencing wage growth for so many sectors across the economy. Some of the traditionally defensive services sectors are also resorting to job cuts.

Building in weaker domestic as well as external demand, we are cutting our GDP growth estimate for 2009 again to 4.3% from 5.3% estimated earlier. We are also cutting our F2010 (year-end March) estimate for GDP growth in India to 4.4% from 5.3%. Indeed, our estimate for GDP growth excluding agriculture at 4.6% in F2010 would be the lowest growth India has seen since F1992. We expect GDP growth to recover in 2010, in line with our global forecasts. US and European GDP growth are expected to rise to +2.1% and +1.1%, respectively, in 2010 from -2.4% and -1.6% in 2009. We believe that the improvement in domestic demand in 2010 will be restrained by the fact that the banking sector will likely remain impaired because of large increases in NPLs in 2009. We forecast 2010 GDP growth to be at 6.1% (6.2% for F2011, year-end March).

Aggressive Monetary Easing but Limited Fiscal Stimulus

We expect monetary policy easing to continue through to 1H09. We are now expecting the repo rate (the key policy rate) to be reduced to 4.5% by June 2009. We also expect the central bank to supplement the rate cuts with additional liquidity support measures such as the cash reserve ratio cut. In an environment where global inflows are slowing and other non-banking financial sources have been hit, the importance of funding through the banking sector has increased. However, as discussed earlier, despite the measures taken by the RBI, banks’ risk-aversion should remain high when NPLs are rising. Moreover, we believe that, in an environment of risk-aversion and poor business sentiment, the private sector is unlikely to respond effectively to the monetary easing and so a counter-cyclical fiscal policy assumes an important role.

However, the Indian government has been running pro-cyclical fiscal policies over the last few years. In F2009, we estimate that the fiscal deficit including off-budget liabilities will be 11.3% of GDP, one of the highest among the large economies in the world. While the government’s subsidy burden on oil and fertilizers will fall to negligible levels in F2010, the government will also suffer a decline in tax collections, keeping the deficit at high levels. Public debt to GDP, after including off-budget liabilities, is estimated to increase by 96.7% as of March 2009. Hence, the government has been restrained in its fiscal policy response so far. The government has already announced a set of measures. The three key important fiscal policy measures taken so far include: a) additional government expenditure of Rs200 billion (about US$4.1 billion); b) allowing India Infrastructure Finance Company Limited (IIFCL) to raise tax-free bonds of Rs400 billion (US$8.2 billion) for refinance of infrastructure investments over the next 18 months; and c) allowing state governments to borrow Rs300 billion (US$6.1 billion) more before March 2009 to fund capital expenditure.

We believe that the measures announced so far are not large enough. Moreover, the effectiveness of these measures is also uncertain. The most useful fiscal measure in the current environment will be to implement large infrastructure projects where financial risks are with the government, as the private sector may continue to shy away.

In this context, we are not sure of the effectiveness of the role of IIFC in promoting infrastructure investments. Similarly, we are skeptical about swift execution by state governments to increase capital expenditure by March 2009. Hence, we believe that the government measures will help, but are not enough to prevent the downside in growth.

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