Economic commentary – Jac Laubscher, Group Economist: Sanlam Limited

1 October 2008

The global financial crisis – Part 1: Implications for the real economy and financial markets

Every week a new chapter is written in the unfolding drama that is the global financial crisis which has been gripping the world since August 2007. The possible future course of the crisis, the effect it could have on the real economy and the extent to which even countries that are not directly caught up in the turmoil (including South Africa) will suffer contagion, are regularly being overtaken by events.

The central point brought home strongly during the past week is that systemic problems require systemic and not piecemeal solutions. Hence the US proposal, which was not successful, to use taxpayer funds ($700 billion) to remove the impaired assets from the balance sheets of institutions, hopefully reducing counterparty risk, restoring trust in the system and freeing up the flow of funds.

Note that the $700 billion would not have been a donation to the institutions concerned, but an investment in financial assets at extremely low prices, with the potential for future positive returns. In fact, it is within the American government’s power to manipulate the prices of these assets. It is not for nothing that those involved in formulating the proposal consulted Warren Buffet! But apparently this is too difficult to grasp for many American members of Congress who believe it is more important for them to tune their violins while flames are threatening to engulf Rome.

According to some members of Congress the main problem is things such as the bonuses of financial institutions’ chief executives, the mark-to-market of assets, short selling of shares, etc. Do they not realise that one first has to extinguish the fire before installing new isolation material to prevent future fires? In any case, to date the authorities have largely succeeded in structuring the bail-outs in such a way as to protect the financial system rather than the shareholders of institutions.

The main problem is that the banking system has stopped functioning to a large degree, with banks preferring to hoard cash rather than lend it, especially not in the interbank market. The massive amount of liquidity already injected into money markets by central banks could not solve the problem. In spite of all the current negative connotations of credit extension, the normal flow of credit is the lifeblood of the economy without which it cannot function.

The first priority is therefore to normalise the money markets. However, this will not solve the problem as a whole. For normal lending to resume, many banks need to be recapitalised (the total capital requirement of banks globally is estimated to as high as $500 billion) and there is still uncertainty about whether that amount will be forthcoming from private investors or whether taxpayers will have to bear at least some of the burden.

But during this period the focus was perhaps too much on the financial system and too little on the collapse in the housing market in the US (and elsewhere), which is at the heart of the crisis. House prices continued to fall, with the median price of existing and new homes in August being 9,5% and 6,2% respectively lower than a year ago, and sales of new homes fell to the lowest level in 17 years. The Case-Shiller Composite House Price Index (see accompanying graph) has already fallen by 20% from its high.

The relentless slide in the housing market combined with the ongoing resetting of sub-prime mortgages continued to exacerbate the losses of financial institutions, more as a result of their exposure to structured financial products backed by mortgage debt than because of direct exposure to defaulting borrowers. Therefore the problems in the financial system cannot be resolved before the housing market has stabilised.

However, it is clear that house prices are not going to rebound anytime soon, with the inventory of unsold homes equal to 10,4 months’ sales for existing homes and 10,9 months for new homes – double the normal figure. The view that direct intervention in the housing market might offer a better solution for the crisis than intervention in the financial system is therefore not without merit.

The total assets taken onto the balance sheet of the US government in recent months exceeds the current total federal government debt of $5 400 billion by a wide margin. The actual cost to the taxpayer will depend on the price at which the government will eventually be able to sell these assets, or on their value should it hold them to maturity, and it will be substantially less than the exposed amount – it might even render a profit. In the savings and loan crisis of the early nineties, government recouped two-thirds of its initial exposure, and the final cost amounted to 2% of GDP. Kenneth Rogoff, a former chief economist of the IMF, estimates that this time it could be a more onerous 6% to 7% of GDP.

The bottom line is that it is manageable. The USA’s total government debt amounted to 36% of GDP in 2007 (of which 32% of GDP was in private hands), which is lower than for most developed countries. Its budget deficit came to -1,2% of GDP in 2007, although it is expected to rise to -3% of GDP in 2008/2009, with interest payments amounting to 8,3% of current revenue. The US can therefore afford a moderate increase in public debt, although it would have negative implications for the budget deficit in the short term. And again, note that the acquisition of assets by the state makes no difference to its net debt.

The fall-out for the real economy is bound to be significant, although it could be argued that a lot of bad news has already been discounted in forecasts. It is likely that countries in the developed world will go into recession with few exceptions.

Ireland is already in recession, the UK, Germany, Italy, Spain, Switzerland and Japan are at the brink, and it is difficult to see how the US can avoid recession. Global trade will suffer, and economic activity in the emerging world will also slow down considerably, even if outright contraction is avoided. Policy-makers will have to put inflation fears aside and try to protect the real economy by relaxing monetary and fiscal policy.

Growth forecasts are likely to be lowered further, especially for 2009, with global growth falling to below 3% for some time. This could be regarded as a “growth recession” and will cause uncertainty about the extent to which commodity prices could still decline. Although the global economy could gradually start improving in the second half of 2009, the adjustment to a new financial architecture that will take shape in the coming years will be a lengthy process which could put a dampener on economic activity for a long time.

Although the dollar’s recent appreciating trend, especially against the euro, has been interrupted by fears with regard to the fiscal implications of the bail-out, it may still benefit from the fact that the US is ahead of other countries as far as dealing with the fall-out of the financial crisis. The complacency seen in European policy-makers until recently is fast disappearing.

What are the implications for global financial markets?

Growth in company earnings, especially in the financial sector, is set to decline owing to lower economic growth and profit margins. Although valuations in equity markets are generally undemanding, the poor earnings outlook will constrain the performance of equities for some time to come. Markets will need assurance that economic conditions will improve fundamentally before they can attempt anything more than a relief rally.

The restructuring of the financial sector is creating exceptional opportunities for the strong to absorb the weak but, like shotgun weddings, opportunistic mergers and acquisitions transacted now may yet come back to haunt their perpetrators. Banks will have to review their business models against a backdrop of tighter regulation, and it remains to be seen what influence this will have on their future profitability. There is a general consensus that the financial sector has become bloated relative to the real economy and needs to shrink.

As in any bear market there will be investment opportunities from which to profit, although they will require more effort to identify – just keep an eye on Warren Buffet!

Bond yields will maintain their recent low levels for some time because of bonds’ safe-haven status in times of financial turmoil and economic contraction, but investors need to keep a wary eye on inflation – bear in mind that debtors have a proven interest in higher inflation. Once the economy turns around, bond yields could rise swiftly, resulting in capital losses. In spite of the increased issuance of government bonds by the US treasury, they are unlikely to lose their status as the global risk-free benchmark soon.

Emerging markets will not be immune. Investors’ need for capital protection will result in a greater bias for investment in local markets, with less capital flowing to more risky asset classes such as emerging markets. Emerging equities will remain under pressure, and the increase of more than 200 basis points in the emerging-market bond spread since mid-2007 does not bode well for the refinancing of maturing emerging-market debt, which allegedly will amount to $111 billion in the next 12 months.

However, the current turmoil in financial markets could also result in the reassessment of investment risks in emerging markets relative to developed markets, and once calm returns to the markets they could yet turn out to be big winners in view of their superior growth prospects.

What about South Africa?

The South African economy is already in a consumer-led downturn that is yet to bottom. Economic growth may have declined to below 2% in the third quarter compared with 4,9% in the second quarter of 2008. The global financial crisis has opened up various channels through which the downturn could be aggravated.

Export volumes and values could be further suppressed, with a negative impact on the current account, South Africa’s terms of trade could decline (the price of platinum has in fact fallen much more than that of oil), and capital inflows could come under more pressure – net foreign sales of SA equities and bonds have amounted to more than R20 billion since September 2007. South Africa is nevertheless fortunate to have such a low level of foreign debt at this point in time. A weaker rand could keep inflation elevated for longer in spite of lower oil prices, delaying the expected decline in interest rates. Declining asset prices, together with high debt levels, could force households to reign in spending even more.

Weaker demand will cause businesses to delay capacity expansion, suppressing capital spending. However, continued infrastructure spend will help to underpin the economy even though it cannot compensate for all the other negative influences, and the disciplined fiscal policy of recent years puts South Africa in a position to act contra-cyclically now by announcing a expansionary budget on 21 October.

Like their global counterparts, South African companies will also face pressure on their earnings. In spite of reasonable to even cheap valuations, local equities will struggle to perform in a global bear market. Bond yields are being held up by still high inflation, although they are discounting the probability that monetary policy tightening has reached its end.

In addition to the global financial turmoil, South African investors are faced with political uncertainty. Regardless of the machinations taking place around individual members of government, the crucial question is policy continuity. The final word on this question will unfortunately not be spoken until the new administration that is to take over in 2009 is well entrenched so that it can be judged on its actions rather than on its words.

It is therefore best to assume that an uncertain and volatile period still lies ahead. Caution remains the watchword.

 About Jac Laubscher       
 
 Jac Laubscher, Sanlam Group economist, discusses topical issues in the South African economy. 

As Sanlam’s Group Economist Jac Laubscher provides strategic economic input to the various companies in the group in support of their business strategies. He completed his economics studies at Stellenbosch University and he was the first South African economist to qualify as a Chartered Financial Analyst with the CFA Institute in the USA.

Jac still maintains strong links with leading academic institutions, and is well known as an independent and leading analyst of events and emerging trends in the South African economy and financial markets. His analyses are based on fundamental research.