Time for the US to fix its mess

Earlier this week we attended an ACI breakfast seminar at which Paul Hansen, Director of Group Retail Investing, STANLIB shared some of his views on local and international market conditions. He started his presentation with the global market buzzword of

The strain placed on global liquidity by questionable sub-prime lending practices is the tip of the iceberg. The US economy has also had to weather a series of interest rate hikes and is faced with the frightening prospect of declining employment numbers. Employment numbers are a good indicator of overall health in the US economy, and falling employment numbers remain a good early warning for US recession.

Hansen believes the US can deal with its crises if it takes concise action. His message to the US Federal Reserve was clear: cut interest rates and do whatever it takes to sort out the sub-prime mess.

A big cut by international standards

It appears US Federal Reserve chairman, Ben Bernanke, was paying close attention. A mere day after Hansen's presentation he slashed US rates by an impressive 50 basis points. To appreciate the significance, consider that major Western economies like the US and Europe prefer soft market interventions. The usual policy is to make small 25 basis point adjustments and wait for the impact to filter down through the economy. This decisive action confirms US concerns with the potential market fallout from the sub-prime crisis.

But will this move be enough? Does anyone really believe that an interest rate intervention will halt the sub-prime juggernaut? We share the view of many analysts that a 50 basis point reduction in the lending rate is unlikely to prevent a financial crisis that has been more than five years in the making.

We believe that the investors who helped the US markets to their biggest one day gain in years in response to the rate cut have acted prematurely. They will soon realise that the problems which inspired the rate cut remain. There are thousands of US homeowners who are unable to service their mortgage payments. And with US house prices showing steady declines, their assets no longer adequately cover their bond exposure. The recipe for disaster remains intact and the rate cut simply means it will take slightly longer to reach fruition.

Discount America at your peril

Another view expressed by Hansen was that the US is not as dominant a global player as it has been in the past. In support of this, he showed a slide summarising US imports. Although small by historical comparison, you would be a fool to ignore that the US accounts for 16% of Asias exports and 15% of Europe's exports respectively.

We agree there were times in history when the US had a much larger global footprint. However, to suggest the US's current size makes it less of a threat to global economic wellbeing is short-sighted. It will be virtually impossible for the global economy to power ahead in the event of a sustained American recession.

Luckily for South African investors, our economy is probably more insulated from the US economy than most. While we will be affected by a slowdown in the US our trade with European and Asian markets continues to improve, and should take up some of the slack.

Domestic economy has its own problems

This said South Africa has its own share of problems on the domestic front. While our GDP growth lags the emerging market average by some margin, South Africa is still growing in excess of 4% per annum. This growth is placing tremendous strain on both corporate and government infrastructure.

Of greater concern, says Hansen, is that South Africa's manufacturing capacity utilisation is nearing the 90% mark. Utilisation, which has been below 80% since 1998, soared through the 80% line in mid 2003 and shows little sign of slowing. There is simply not enough manufacturing capacity to meet demand and growth is hampered when essential supplies such as concrete, cement, steel, fuel, electricity and other production inputs are in short supply. The knock-on effect of the supply crisis is that prices of production and construction inputs rocket, putting additional pressure on prices and inflation.

This scenario emphasises an interesting aspect of South Africa's ongoing interest rate debate. Many analysts are worried that the Reserve Bank has gone too far in raising rates and that another hike will lead to a domestic growth slowdown. In reality, it appears South Africa is not well positioned to maintain its current growth rate and that the economy might need to stabilise (or even slow) for a few years to allow industry to catch up. Another rate hike might be the right medicine for what ails the economy at present.

The narrow focus on consumer credit has resulted in more serious economic problems being ignored. Continued GDP growth of more than 4% per annum is not sustainable on an infrastructure and capacity utilisation view. If growth continues unchecked we are bound to run into severe problems down the line. Rather allow a slowdown in growth now and allow the economy to catch its breath before pushing forward, than run the risk of a massive fall in growth later.

Editor's thoughts:
Hansen remains upbeat about prospects in the domestic economy. He also believes that the US sub-prime concerns will dissipate with time and not result in a major economic meltdown. We are more concerned with problems of domestic manufacturing capacity. Can South African maintain 4% per annum GDP growth in light of current manufacturing capacity constraints? Send your comments to gareth@fanews.co.za