Inside Insights 8 June 2009

Investment Intelligence|Inside Insights

A weekly, in-depth yet concise report on the most important recent market movements and economic developments.

Added on 08 June 2009 @ 12:00 AM

Things could be worse

An event that received little notice locally amidst the gloom over the -6.4% first quarter GDP number was the failure of Latvia, a member of the EU no less, to sell bonds at a $100m treasury auction. This is significant for three reasons. One, fears over excess government borrowing has been rising worldwide, and is one of the reasons behind the dollar's recent slide. Two, Latvia in particular has a sizable current account deficit (-6.7% of GDP) and also has sizeable foreign debt, as households borrowed extensively in euros to fuel a property boom as the currency (the lat) is pegged to the euro. Capital flight is making it difficult to maintain the currency peg and makes high interest rates a necessity. To protect the peg, government spending has also been cut at a time when it has been increasing in other countries. Thirdly, West European banks have some €1.3 trillion of exposure to ex-communist Eastern European countries. Swedish banks alone have $75bn of exposure to the Baltic states. If Latvia devalues its currency these banks face terrific losses, hardly desirable when stability at last seems to have returned to the global banking system. A devaluation would plunge many Latvian households into bankruptcy, and is therefore not politically viable. First quarter year-on-year growth in Latvian GDP predictably plunged -18%.

South Africa is also an emerging market with a large current account deficit. However, we're not nearly in the same boat. The rand remains one of the best performing currencies this year. Interest rates have been slashed and government spending increased to combat the slowdown. As the graph shows, yields on local government bonds have increased over the last few months, but hardly dramatically, indicating that markets have confidence in our domestic finances. This was confirmed at the successful $1.5bn eurobond issue a few weeks ago. Also, the JSE has experienced R23bn net flows so far this year. Lastly, President Zuma's maiden State of the Nation speech was also positive for local markets as he provided reassurance that the prudent monetary and fiscal policies that have allowed us to weather the storm better than others will remain largely in place.

Green shoots, or grabbing at straws?

According to the local purchasing managers' survey (now called the Kagiso PMI), the contraction in the manufacturing sector is slowing. The index level for May was 37.5, up from April's 35.6 and March's 36. However, the index remains far below the neutral value of 50, below which the sector is contracting and above which it is expanding. The PMI is forward looking; we will get the actual production data from the manufacturing sector (mining too) from StatsSA next week. It will hopefully point to stabilisation in the economy after the horrendous first quarter. The other key local data release last week was May new vehicle sales from industry body Naamsa (motor manufacturing is of course a key manufacturing sub-sector). Here too there is a slowing in the pace of contraction. But -34.7% year-on-year, down from -43% in April, is still a dismal figure. Both passenger (-27.2%) and commercial (-42.8%) vehicle sales remain extremely weak, meaning that demand from both households and business has dried up.

Even amidst signs of recovery in the world's economies, to which markets have reacted very positively, warnings were issued last week that growth over the medium term would be muted. Fed Chairman Ben Bernanke testified before Congress that, while he was more confident that the US recession would end this year, he expected the US economy to grow below its potential for ‘an extended period.' Meanwhile, the European Central Bank expects a sharp contraction in the Euro-zone in 2009 (at least -4%), and ‘near-zero' growth in 2010. With these two giant economies likely to grow very sluggishly for the foreseeable future due to high unemployment and low consumer spending, we shouldn't expect things to get too exciting on world markets any time soon.

Fairbairn Capital | Old Mutual

Investment Intelligence|Inside Insights