September 2011 – ZA Economist

MPC rates decision: Testing the waters but not jumping in

The MPC yesterday downplayed the risks to inflation correctly, while the risks to the domestic economy received full attention. Listening to the litany of economic problems facing the SA economy referred to by Governor Gill Marcus during her speech (quoted below*) I had a moment of near exhilaration that the MPC would in fact surprise the market by cutting rates. The economy is clearly screaming out for them as it has been doing for some time.

But then caution prevailed. We can blame global risk aversion and its impact on the rand for the predictable pusillanimity in Pretoria. But the case for an interest rate cut was debated and the Governor provided every indication that a cut next time round is now very much more likely (if the economy stays on its present sub-optimal course) and especially if the rand recovers some of its losses, which it will if the global risk appetite recovers to a degree. Brian Kantor

Extracts from the MPC statement that pointed to interest rate action, not inaction:

The depreciation of the rand poses a potential upside risk to the inflation outlook. However the degree of this risk will depend on the extent and persistence of the depreciation trend, which in turn will be influenced by the duration and intensity of global risk aversion. The rand tends to be more sensitive to changes in global risk perceptions than most of its emerging market peers. At this stage the MPC still considers the upside risk to the inflation outlook from this source to be relatively moderate, but rising.

Domestic economic growth remains disappointing, with the negative output gap widening to around 3 per cent in the second quarter of 2011 and gross domestic product growing by 1,3 per cent, following the 4,5 per cent increase recorded in the first quarter. Both the primary and secondary sectors contracted in the second quarter, while real value added by the tertiary sector increased only marginally. Wide-spread industrial action, which continued into the third quarter, contributed to this subdued outcome, and is expected to weigh negatively on third quarter prospects as well.

Recent high frequency indicators are also not very favourable. Mining production contracted at a year-on-year rate of 5,1 per cent in July, and by 4,3 per cent on a month-on-month basis. Manufacturing output declined at a month-on-month and year-on-year rate of 6,0 per cent in July, confirming the sharp decline to 44,2 index points observed in the Kagiso/BER Purchasing Managers Index (PMI) in July. Despite a modest recovery in August to 46,7 index points, the PMI remained below the neutral 50 level, pointing to a further possible contraction in the sector. The construction sector also remains subdued with both the FNB Building Confidence Index and the FNB Civil Construction Index remaining at very low levels, while there was a further decline in the number of building plans passed in the third quarter.

Overall business confidence, as reflected in the RMB/BER Business Confidence Index, has declined for two consecutive quarters, and at 39 index points is well below the neutral level of 50. The Bank has lowered its forecast for average growth in 2011 to 3,2 per cent, down from 3,7 per cent, while the forecast for 2012 has been reduced from 3,9 per cent to 3,6 per cent. The forecast for 2013 remains unchanged at 4,4 per cent. The lower forecast is a result of the lower-than-expected outcome in the second quarter, as well as a downward adjustment to the global growth assumption. The risks to this outlook are seen to be on the downside.

The lower growth trajectory does not bode well for employment creation, which has been relatively muted. According to Statistics South Africa, employment in the formal non-agricultural business sector increased by 0,1 per cent or 5,701 people in this second quarter of 2011. The outcome was, however, negatively affected by the decline in public sector employment associated with the termination of contracts of temporary employees hired for the municipal elections.

Consistent with the moderation in domestic production, growth in real gross domestic expenditure also declined, from an annualised growth rate of 7,9 per cent in the first quarter of 2011, to 1,3 per cent in the second quarter. A positive development was the further acceleration in the growth of real gross fixed capital formation, albeit off a low base, from an annualised rate of 2,7 per cent in the first quarter to 4,0 per cent in the second quarter. Nevertheless the ratio of gross fixed capital formation to GDP, at 18,9 per cent, is still well below the peak of 24,6 per cent measured in the fourth quarter of 2008.

Consumption expenditure by households has to date been the main driver of growth. However, in the second quarter of 2011, growth in consumption expenditure moderated to an annualised rate of 3,8 per cent, compared with an increase of 5,2 per cent in the first quarter. Real retail trade sales increased at a year-on-year rate of 2,8 per cent in July, but declined by 0,7 per cent in the three months to July compared with the previous three months. Growth in motor vehicle sales, while still positive, has also declined. Consumption patterns may have been distorted somewhat by the high base effects arising from the 2010 World Cup, and a clearer picture should emerge in August. The RMB/BER Consumer Confidence Index has declined for two consecutive quarters, underlying the fragility of the outlook.

Consumption expenditure is expected to remain constrained to some extent by low rates of credit extension and continued debt deleveraging by households. The ratio of household debt to disposable income declined further to 75,9 per cent in the second quarter of 2011 from a peak of 82,0 per cent in the first two quarters of 2008. Twelve-month growth in total loans and advances extended by banks to the private sector has fluctuated around 6 per cent in the three months to July. Mortgage advances, which is the largest category of credit, grew at a year-on-year rate of 2,9 per cent, consistent with the slow pace of recovery in the domestic property market. The main driver of growth in credit extension was the category of other loans and advances, in particular general loans which reflect primarily corporate sector borrowing. This category grew by almost 15 per cent in the year to end of July.

Source: MPC statement, 22 September

The Eurozone crisis: Thanks for coming – but no thanks

The European central bankers and finance ministers invited Timothy Geithner, the Secretary of the US Treasury to their weekend meeting in Poland, but did not take that kindly to the sense of urgency he tried to convey. Jean Claude Trichet, head of the ECB, was ungracious enough to indicate that the outlook for European governments’ fiscal deficits at a 4.5% average was significantly better than that of the US. This average however conceals a wide standard deviation about the average which is the European problem and especially the problem of European banks. The Europeans in turn urged the US to adopt its tax on financial transactions proposals that seem like an invisible way to raise revenue – but only if all financial regimes cooperate (something the Americans and British seem unwilling to do).

The markets did not at all like the news flow from across the Vistula River. Increased risk aversion drove equity markets lower. Emerging market equities were especially vulnerable and took the rand predictably lower with them.

Daily moves in the S&P 500 and the Emerging market benchmark, September 2011

As we show below the benchmark MSCI EM Index lost 3% by the close and the rand/US dollar was a little more than 3% weaker as investors hedged their EM bets in the market for rands.

Daily moves in the Emerging market benchmark and the rand-US dollar, September 2011

Neither SA rand denominated bonds nor commodity markets escaped the downward draft. Rand denominated bonds are no longer acting as the safe haven they were earlier in the month. Commodity markets, despite yesterday’s declines, can still be regarded as holding up very well relative to the equity markets, helped presumably by superior growth still emanating from the emerging economies.

The RSA All Bond Index and the CRB Commodity Index

The shining light yesterday was predictably the higher rand price of gold and the still higher rand price of gold shares listed on the JSE. The gold shares even outperformed the gold price on the day.

The rand price of gold and the JSE Gold mining index, 31 August 2011=100

The European financial leadership does not appear to take the threats to European banks nearly as seriously as investors in them do. The European banks, represented by the Eurostoxx bank index, has lost over 50% of its value since March. This Index lost about 5% yesterday. The numbers bandied about in IMF and other circles indicate that the Euro banks are undercapitalised by about EUR220bn. European governments do not, as yet, seem willing to assist such an infusion of capital into their banks that would not at all be beyond their financial capacity. Unless Greece does manage to step back from the default brink, such a capital raising exercise will indeed be as urgent as Geithner has been arguing. The Greek drama is surely now very close to its final scenes (one way or the other), in the form of a recue or hopefully orderly bankruptcy proceedings.

What Geithner knows very well, but apparently failed to convince the Europeans accordingly, is that the solution to Europe’s financial crisis is very similar to that of the US crisis – that is pump cash into the banking system without limits to provide liquidity – and also to pump capital into the banks without delay so that they can resume business more or less as usual. The solution to Europe’s and the US’s long term fiscal imbalances will take longer and require much more fundamental reforms that politicians will have to wrestle with.

The rand and long term interest rates: Still plays on global risk aversion

The rand came under moderate pressure last week – it lost about 2.5% on a trade weighted basis. Compared to a year before, the rand is now about 9% weaker than a trade weighted basket of the currencies of its trading partners.

The trade weighted rand September 2010 to September 2011 (September 2010 = 100; higher numbers indicate a weaker rand)

The trade weighted rand, week ending 16 September 2011 (9 September 2011 = 100)

The rand/US dollar exchange rate has continued to follow very closely the direction given by emerging equity markets, represented by the MSCI EM equity Index. This we show below where the influence of the EM equity index on the rand can be seen very clearly. However, as may also be seen, the rand/US dollar has moved from being somewhat overvalued – relative to emerging equity markets – to marginally overvalued by this criteria. On Friday emerging equity markets moved higher and the rand/US dollar unusually moved marginally lower, indicating perhaps additional forces at work. As we had previously pointed out, foreign holders of RSA rand denominated bonds had sharply reduced their exposures to the rand earlier last week; though they had returned to the market as net buyers on Thursday and were only marginally net sellers on Friday.

The rand US dollar- Actual daily values and daily values as predicted by the MSCI EM Equity Index

Net foreign bond sales-purchases (R millions), daily data September 2011

Longer term interest rates in SA have reversed a declining trend. The four year R157 recently touched a 6.3% yield then moved higher early last week on these net foreign bond sales but then yields declined later in the week.

It is also of interest to note that emerging market US dollar bond spreads over US Treasuries also widened sharply in recent weeks as global risk appetite diminished in the wake of the European bond crisis. These wider spreads are also consistent with both weaker EM equity markets and a weaker rand (which acts as a proxy for emerging market currencies that are less easily traded and hedged).

The RSA 157 (four year bond) yield (Sept 2010 - Sept 2011)

RSA157 yields (week ending 16 September 2011)

The rand continues to be well explained by global economic and financial forces. It remains a play largely on global risk aversion that is well represented by emerging market bond spreads and emerging market equity valuations. These two series remain highly correlated on a day to day basis. As we show below, when risks rise equities fall and vice versa. The rand can be expected to recover its strength should global investors recover some of their appetite for risk. South African specific risks or even expected movements in short term interest rates do not appear to have added much (if anything) to an explanation of the recent direction of the rand.

EM equity Index (MSCI EM) and EM bond spreads- September 2010 to September 2011 (daily data)

Long term interest rates and the rand: All explained by global risk appetites

Foreign investors significantly reduced their exposure to rand denominated RSA bonds over the past two days. They were net sellers of over R7bn on Tuesday and sold a further R2.55bn yesterday. This quarter foreign investors had become enthusiastic net buyers of rand and other local currency denominated emerging market bonds in response to the weakness and volatility in euro denominated bonds. Clearly what had added to rand strength and forced interest rates lower in July and August took something away from the rand over the past two days and reversed recent moves in longer term interest rates.

Net foreign purchases - sales of rand denominated bonds

The term structure of SA interest rates has shifted out over the past few days with the yield curve becoming significantly steeper over the one to five year terms.

The yield on the benchmark four year R157 increased from 6.52% on 31 August to 6.94% on 14 September representing an increase of about 60bps since lows reached on 8 September. The impact of foreign sales can also be seen in the one year rates implicit in the yield curve.

The one year rate, as expected 12 months ahead, has increased from the 7.82% implied on 31 August to 8.15% yesterday. Further along the yield curve the implied shorter term rates are little changed. Further steepening in the yield curve might follow the meeting of the Monetary Policy Committee (MPC) of the Reserve Bank next week. The MPC may choose to clarify its intention to reduce the repo rate in due course. It may even cut rates next week but this must be regarded as unlikely. It should be said that if the case for cutting rates is a stronger one – given the weakness in the global and domestic economies – the case for cutting sooner rather than later will also be a strong one.

The rand however continues to be very well explained by global risk appetite, as fully reflected in the direction of the EM equity markets. Our model, which has successfully explained the rand/US dollar with the MSCI EM Index as the only explanatory variable, predicts the current value of the rand as R7.45.

The rand as explained by the EM Equity Index

Thus despite the influence of the bond market the rand is very well explained by the trends in equity markets and we presume will continue to do so. The risks in the EM equity markets are fully reflected in the spread offered by the EM dollar denominated bond index. As we show below, as the risks associated with the Eurozone debt and banking crisis increase (reflected by a widening yield spread over US Treasuries) the equity markets move in the opposite direction. And as EM equity markets go, the rand tends to move in the opposite direction.

The MSCI EM Equity Index and the EM bond spread

Daily moves in the EM Index and the rand, 30 June to 14 September

European debt crisis: Are we closer to the denouement?

How much would European Banks be required to write off of their loans to European governments? That is presuming a bad (not worst case) scenario of a 70% write down of Greek, Portuguese and Irish debt and losses of 30% on Spanish and Italian debt. The recent stress tests of 90 European banks and an IMF analysis of the CDS market provide some ball park numbers. The estimate is of the order of EUR260bn: a large amount but not nearly as much as the EUR700bn written off by European banks in the aftermath of the 2008-09 global financial collapse.

A consoling thought is that aside from the failures of their sovereigns, banks in Europe have little other additional exposure to private borrowers that they might have to write off. They have done very little additional lending lately, quite unlike the run up to the global financial crisis when lending growth was robust at close to a 10% annual growth rate.

Equity investors have made their own severe judgments as to the losses European Banks will incur. The Stoxx Europe 600 banks index is down just over 25% since1 August. Société Générale, France’s second-largest listed bank, has lost half of its market value since the beginning of August. Shares in Crédit Agricole, France’s number 3 bank, have dropped 35% while those of BNP Paribas, the largest French bank, are down 32% over the same period. More important perhaps than the absolute fall in the value of their shares, is that the market value of some of these banks is much diminished. This suggests very poor prospects for these banks and very little capacity to raise additional capital from their much damaged shareholders. Since 1 August the market value of Soc Gen has fallen from EUR25bn to its current value of EUR11.79bn while BNP is now worth EUR32.4bn compared to EUR52.4bn on 1 August. As far as shareholders are concerned they have already had to write off very large amounts of capital in their banks.

The question then becomes whether or not the European governments have the will and even perhaps the financial capacity to do what presumably the market place would be unwilling to do, and that is to recapitalize their banks. The alternative is a permanently impaired banking system unable to make the essential contribution to credit availability and economic growth that banks make. And a word of sympathy for banks – that is their shareholders – is in order. You can blame the lending officers of the banks for supporting US mortgage backed credit. You can hardly blame them for lending to their own governments – indeed they are obliged by regulation to do so because they are treated as being the safest of assets.

It can be expected that should some formal Eurozone governments’ defaults be acknowledged of the grave order indicated above (a possible but by no means certain event) governments will have to replenish the capital of their banks. Furthermore the liquidity strains of these banks will continue to be fully satisfied by the ECB – as they have to date. It is this support that has prevented a further melt down in Spanish and Italian debt as well as support for the banks using such debt as collateral for ECB support.

The responses of the US Fed and the US Treasury to the banking and financial crisis has very clearly pointed the way forward for European governments and the ECB. The very effective responses of the Swedish and Norwegian governments to their own banking crisis of the early 1990s are perhaps even better examples of crisis management closer to home.

The share markets may be pricing in not merely a bad case scenario of significant write offs of European government debt. They appear to be pricing a worst case scenario in which European governments and the ECB stand by and watch the European banking and financial collapse. This is a development that would not only harm its banks irreparably but would damage as irreparably the capacity of European governments to raise debt, a notion too ghastly to even contemplate. European leadership and technical central banking skills are surely capable of avoiding the worst case and be able to deal with what is a bad case fully discounted in the market place.

Hard Number Index: Has the gloom been overdone?

With the release of unit vehicle sales and the size of the note issue for August 2011 we are able to update our hard Number Index (HNI) of the state of the SA economy. As we show below the HNI confirms the SA economy is maintaining its growth momentum. The HNI for July and August 2011 show very little change. The economy appears to moving ahead at a constant speed.

The HNI is an equally weighted mix of vehicle sales and the notes in circulation, adjusted for inflation. The vehicle sale cycle has turned lower – while still indicating good growth. As we reported previously vehicle sales in August recovered well from July 2011 levels – however this pickup in sales was not enough to reverse the declining growth trend.

As we also show, the HNI provides a much more up to date measure of the current state of the SA economy than the Business Cycle indicator, released by the Reserve Bank (which is only updated to May). As may be seen the HNI and the Reserve Bank Indicator tuned up in the same quarter of 2009. It may also be seen that the Reserve Bank indicator turned lower in May 20011; though the subsequent progress of the HNI strongly suggests that this economic activity indicator will have followed the HNI higher since then.

The Hard Number Index and the Reserve Bank Coinciding Business Cycle Indicator (2000 = 100)

Vehicle sales smoothed (2000 = 100) and smoothed growth rates

However what was negative for the HNI on the vehicle front was made up almost completely by the strength in demand for extra notes by the public and the banks. Adjusted for inflation, this growth in the note issue has picked up good momentum as we show below. This trend must be regarded as a very helpful one for the SA economy. Growth in the demand for and supply of notes indicates an improved willingness of the public to spend more. It has proved to be a very good indicator of the state of the SA economy. It suggests that the gloom about the prospects for the domestic economy may be overdone.

The global economy: A semblance of normal service

The equity markets in New York appeared to gain some late afternoon relief yesterday from the Institute of Supply Management (ISM) survey of the state of nonmanufacturing activity (the NMI) in August. The survey is an influential and comprehensive one covering the very large proportion of economic activity in the US that is service rather than manufacturing based.

To quote the report:

“The NMI registered 53.3 percent in August, 0.6 percentage point higher than the 52.7 percent registered in July, and indicating continued growth at a slightly faster rate in the non-manufacturing sector. The Non-Manufacturing Business Activity Index decreased 0.5 percentage point to 55.6 percent, reflecting growth for the 25th consecutive month, but at a slower rate than in July. The New Orders Index increased by 1.1 percentage points to 52.8 percent. The Employment Index decreased 0.9 percentage point to 51.6 percent, indicating growth in employment for the 12th consecutive month, but at a slower rate than in July. The Prices Index increased 7.6 percentage points to 64.2 percent, indicating that prices increased at a faster rate in August when compared to July. According to the NMI, 10 non-manufacturing industries reported growth in August. Respondents’ comments remain mixed. There is a degree of uncertainty concerning business conditions for the balance of the year.”

Thus it may be presumed that the US economy is still growing but at a modest pace. ISM numbers above 50 indicate positive growth rates. In other words the US economy is not in recession which will have come as something of a relief to the increasingly bearish mood. The employment numbers and hiring intentions indicated in the survey however remain a continued source of economic weakness and uncertainty. The employment sub-index registered 51.6 – therefore also indicating growth but was down from the 52.5 level recorded for July 2011.

Clearly very weak employment growth is the Achilles heel of the US economy and presumably of the re-election ambitions of President Obama. He will address the combined houses of Congress on Friday – on his plans for the economy – but by all accounts expectations are not high about any immediate policy breakthroughs. What could do a great deal for business confidence in the US would be clear directions from the President and his administration that the long term fiscal and debt issues facing the US are being addressed in a serious and realistic way. The concern is that the focus of policy will be on additional short term stimulus measures unlikely to find approval in the House.

The European debt crisis continues to add uncertainty and volatility to the markets with the Spanish government (with the active support of its main opposition) leading the austerity stakes (including support for a constitutional amendment to entrench fiscal conservatism) and the Italian government trailing behind by a day or two – though seemingly able to push through its own austerity programme through the Italian Senate today.

The reactions in the bond market are shown below. As may be seen Spanish 10 year bond yields have now fallen below Italian yields, having traded well above them this year. Such are the rewards for fiscal realism. As may also be seen these yields have been kept under control with ECB support this month. That the key governments under market stress seem able and willing even to bite the austerity bullet will help the ECB to maintain its support. Perhaps it will also encourage Germany to support a Eurozone bond market and the euro in Parliament: the German Constitutional Court has just ruled that this is the responsibility of the Bundestag Budget Committee – so rejecting claims that such support would be unconstitutional.

Euro 10 year bond yields in 2011, daily data

Euro 10 year bond yields in August 2011, daily data

Interest rates: From expectations of a hike to a reduction

The money market is now pricing in a significant probability of a 50bps cut in the repo rate by early next year. The three month interest rates offered by the SA banks on forward rate agreements have been declining sharply since mid August and they declined further last week indicating a more than 50% chance of a 50bps cut within six months.

The probability of a 50bps cut in the SA three month interest rate

It seems clear that the focus of the Reserve Bank is now firmly on the state of the SA and the global economy rather than on any short term blips in the inflation rate, over which the Bank has little influence. Without a series of unexpectedly good news about the global economy (and the SA economy, especially about demands for credit), these lower interest rates (now factored into and expected by the financial markets) will become a very necessary reality.

New vehicle sales: Business boost

The producers and distributors of new vehicles enjoyed significantly improved trading results in August 2011. Domestic sales were up to 51 436 from 45 686 units sold in July 2011. On a seasonally adjusted basis this represented an impressive increase of 5 471 units in the latest month after flat to declining sales on a seasonally adjusted recorded after March 2011. This recovery, if sustained, would see monthly sales of between 46 000 and 48 000 units to August 2012. This would be regarded as a very satisfactory outcome for the largest contributor to manufacturing output in SA.

New unit vehicle sales (seasonally adjusted and extrapolated)

The recovery in August 2011 sales arrested but did not reverse the declining growth trend that became apparent earlier this year.

Sales to businesses, including passenger car sales to rental car companies, new light commercial vehicles, bakkies and minibuses, were particularly strong, while sales of medium and heavy trucks were especially buoyant in August. Export sales of 24 835 units were recorded in August which must also be regarded as satisfactory given uncertainties about the sate of the global economy.

Vehicle sales thus continue to be one of the SA economy’s brighter spots. That growth in demand seems now to be coming more from the investment decisions made by businesses is very welcome given the weakness to date in the willingness of the private sector to add capacity.

JSE earnings: No flash in the pan

JSE Index earnings per share in current prices have now regained the previous record levels attained before the global financial crisis and the subsequent global recession, which caused earnings to decline very sharply. As we show below, real JSE earnings, adjusted for rising consumer prices, have also recovered very strongly (though are not yet back to pre crisis levels). This should be regarded as a very encouraging signal about the quality of the companies listed on the JSE.

In the figures below we also compare these earnings to what we measure as cyclically adjusted earnings. These are earnings that attempt to look beyond current earnings and the current state of the economy to establish the long term trends that should drive long term valuations. In current price terms JSE earnings per share by end August 2011 have regained their long term trend (a trend that factors in the post financial crisis decline). In real terms JSE earnings per share have a little way to go to regain their long term trend but are well set to do so.

JSE ALSI Index earnings per share- reported and cyclically adjusted

Real JSE ALSI Index earnings per share- reported and cyclically adjusted

The real earnings series pictured above deserves close attention. It should be noticed that in real terms JSE real earnings per share only regained their 1980 levels as late as 2005. This recovery in real earnings that began only in 2000 and continued to 2008 represented an extended period of exceptional growth. It was a huge boom in earnings and dividends for shareholders, which was closely linked to higher metal and mineral prices that had suffered from an extended period of deflation since the early eighties. The role of Chinese and Asian growth in stimulating demand for commodities has been crucial for the surge in commodity prices and the earnings of resource companies that account for close to half of all JSE earnings.

The important question that was asked at the end of the earnings boom in 2008 was whether or not earnings in real terms could ever recover their 2008 levels. Or in other words, could the surge in JSE earnings between 2000 and 2008 (that extended to all sectors of the JSE) form a new base from which JSE earnings could grow further in real terms?

The recent recovery in real JSE earnings, that are now almost back to their previous record levels, provides impressive support for the view that JSE real earnings have indeed established a new higher base. This is testament to the global reach of the companies listed on the JSE that are much more exposed to the global economy than the SA economy.

The outlook for JSE earnings in real or US dollar denominated terms will continue to depend upon the global economy from which commodity prices, equity valuations and the rand itself will take their cue. The global economy has recovered from the recession of 2009 and commodity prices have recovered accordingly. We show below that global commodity prices suffered even more than did equities from the financial crisis. However recently commodity and metal prices have held up better than equities, helping to support the view that global growth will not turn markedly weaker.

The S&P 500 and the CRB Commodity Price Index (2008 = 100)

We show below that the JSE earnings cycle by end August 2011 (with many of the first half earnings reported) has realised growth rates to date of about 40%. As may also be seen the trends in this growth rate has not declined but appears to have stabilised at these levels. Thus if recent trends are maintained, helped essentially by stability in commodity prices, further growth can be expected. When we extrapolate recent trends it suggests that significant further growth in earnings per share may well be realised.

The JSE Earnings per share cycle to 31 August 2011

If this were to be the case for JSE earnings per share (as mentioned such earnings outcomes would have to be supported by sustained growth in the global economy) the JSE would be very well and further supported by very good earnings fundamentals.

The JSE earnings per share cycle, smoothed and extrapolated

Growth, money and credit: The case for a cut gets stronger

The updates to the money supply and bank credit statistics (to July 2011) and GDP numbers (second quarter 2011) indicate that while the economy grew in recent months, it was at a declining rate. As is the inconvenient practice in SA, the GDP output and income numbers arrive unaccompanied by the other side of the national income identity, the aggregate expenditure estimates. And given that the current state of the SA economy can be attributed to little demand rather than to limits on the supply side of the economy, it is particularly inconvenient not to have details and explanations about the state of aggregate demand in the economy.

The GDP statistics indicated that activity closely connected to demands from households grew satisfactorily in the second quarter. Government consumption spending accounting for 15.9% of the economy (on employment benefits and consumables such as stationery and travel expenses etc) grew by a robust 5.7% (seasonally adjusted and annualized, as are all rates in this discussion, unless otherwise stated) in the quarter, while activity in the wholesale, retail and transport sectors (13.7% of GDP) grew by 4.1%. Activity in the very important financial and associated business service sectors (21% of GDP), grew by a more pedestrian 2.9%.

The laggards were primary production: agriculture (3.3% of GDP) and mining (7.2% of GDP) that declined at a 7.8% rate in the quarter with mining output falling at a 4.2% rate in the quarter. Industrial output declined at a seasonally adjusted 5.2% annual rate while manufacturing output, with only a 12.7% share of GDP, declined at a disturbing 7% rate. It should be appreciated that mining volumes and mining revenues can tell a very different tale, as they did in this quarter, when mining sales and profits were buoyed by rising prices, while the volume of output that could be exported was seriously constrained by railway capacity. As an indication of an improved top line for SA business the gross operating (profit) surpluses of business grew from R315bn in the first quarter to R346bn in the second. This surplus in money of the day was 11% greater than a year before. Employees took home an extra R7bn in the second quarter, representing an increase of 10%.

Thus the share of operating surpluses in gross value added continued to rise, to 48% while employees share was 44%, with the balance of value added attributed to taxes on output. South African business continues to become more profitable hiring fewer, better paid employees, whose share in value added has declined (despite higher real remuneration). Productivity therefore must have increased, aided by less expensive capital (which was freely available with a lower risk premium).

Money and credit: The housing factor

The underlying weakness in aggregate domestic demand is confirmed by the direction of money and credit supplies. As we show below the growth in the money supply broadly defined (M3) has picked up from mid recession growth rates of a year before. But the annual growth rates may well have stalled about the 5%-6% year on year rate. The private credit extended by the banks (approximately the other asset side of the balance sheets of banks) indicates a similar picture of growth, stabilizing at the 5% to 6% rate. The weakest aspect of bank lending, as may be seen, is mortgage lending. Growth in mortgage lending (while positive) appears to be declining to a roughly 3% year on year rate. This does not speak well of the housing market and the demand for extra building and renovation activity. Without a recovery in the housing market the top lines of the banks, about 50% dependent on mortgage lending, is unlikely to improve.

On the evidence of a slowing economy and growth in money supply and credit (which is barely keeping up with inflation), the case for lower interest rates to stimulate demand would seem uncontestable. The money market has begun to factor in the possibility of a cut in short term interest rates by the first quarter of next year. The odds of a 50bps cut in the repo rate are still below evens (about a 35% probability).

Unless the outlook for the domestic and global economies improves and money supply and credit growth pick up soon, these probabilities of a cut in rates will rise. Hindsight confirms what we have long argued, that interest rate settings in SA have been too high for too long for the sake of the economy – without any obvious influence on the exchange rate or the inflation outlook.