Adventure of Strategy

Cees Bruggemans is one of my favorite economists. He's the chief economist at First National Bank in South Africa. Sometimes tongue in cheek with a wit as dry as the wind in the Sahara, his weekly emails are thought provoking, interesting .... never boring. It is also interesting to read perspectives on the global crisis from a 'guru' in a market that is not in North America or Europe but is most certainly affected by what happens there, so a close observer of developments. I hope that Cees does not mind that I reproduce his weekly email just received in its entirety. The address to request to be put on the mailing list is at the bottom.

Cees: You really need to discover RSS feeds. Email is so "20th century" and not all of us are on Facebook, either!  :-)

By Cees Bruggemans, Chief Economist FNB
30 March 2009

As we languish in recession purgatory this year, with deep pessimism about the next cyclical revival rife and universal ("what will become of us", goes the lament), perhaps things are looking up more than we think.
 
Team Obama (Geithner, Summers, Bair), with the Fed willingly in tow, is now seriously engaged in stress testing US bank balance sheets and vacuuming toxic assets, in the process encouraging recapitalisation of the banks even while bolstering effective demand in the US economy through fiscal and monetary aggression.
 
The rest of the world is also so engaged, if not always equally ardently, but then freeloaders and free riders always come in many shapes and sizes.
 
Any way, the world is re-engaging, the global recession is probably bottoming in coming months (going by early consumption and industrial indicators), and cyclical recovery beckons by yearend (give or take small margins of error in which inventory cycles move, institutional banking repair proceeds, emergency fiscal packages take hold unequally, financial markets respond joyfully, deeply disturbed psychological conditions calm down, and suppressed animal spirits revive).
 
It took a while but the global show seems to be back on the road again, perhaps a bit of a vaudeville act, but what would you expect, with unforgiving electorates, a wayward Congress, shrill critics, so many bit players and allies none of whom singing from the same music sheet?
 
With the worst (meltdown, depression, deflation) apparently not going to happen (sorry to disappoint some of you folks), something quite different is apparently coming into view.
 
Just exactly what will be its nature, if not financial meltdown, asset price deflation and deep depression?
 
The rich world's financial stumble has deeply repressed economic activity in three-quarters of the world economy (its most developed industrial heartland plus a sizeable emerging periphery, including Eastern Europe, parts of Latin America and Southern Africa, bits of emerging Asia, and most commodity producers).
 
This experience, however, didn't really floor China, whose exports and industrial activity may be down, but whose consumer spending and infrastructure fixed investment keeps pumping.
 
Whereas Japanese and German GDP are expected to decline by 5%-7% this year (due to heavy export and industrial dependency), European and American GDP should decline by 3%-4%, the pressured emerging periphery should be down marginally by 1%-2%, while China should keep growing by 5%-8% (depending on whom you want to believe).
 
The world is therefore terribly imbalanced, with large parts heavily underperforming and severe resource slack mounting, enormous monetary and fiscal policy aggression shaping things, China on bended knee but unbowed and many commodity producers curtailing their supply capabilities.
 
This is the profile with which the world economy is contemplating recovery in 2010. What kind of recovery will that be?
 
China's growth, being early industrial in nature, is the most commodity-intense, so any growth revival there means great things for global commodity demand.
 
Meanwhile, global commodity supply has been severely curtailed by many producers this past year, implying an early revival for commodity prices, with recent weeks giving an early foretaste of things to come, oil for instance besting $50.
 
If China is the pull factor for commodities, then Team Obama, Fed chairman Bernanke and their global compatriots are enormous push factors.
 
The monetary and fiscal aggression with which the global banking crisis and industrial panic is being countered may potentially lead to currency disturbances, new carry trade opportunities and may for quite a while feed anxiety about future inflation surges.
 
In the process, what is coming into focus is a likely weaker Dollar and commodity price boosts, also from an early speculative revival point of view.
 
It may be that US consumers are truly abstentious now, but it won't necessarily last. Firstly, it probably isn't in their nature longer term. Secondly, Team Obama is working overtime to get them to forget their abstentious ways and to re-engage. Thirdly, American capitalism is mobilising its considerable persuasive powers to also assist consumers in this endeavour.
 
Of the three, American capitalism is the most powerful by far, Team Obama will be most insistent, and the consumer may prove to be least committed to consumption abstinence in favour of higher precautionary saving once the debt and job threats subside and stock markets recover.
 
But the initial global recovery will not be primarily stacked on the US consumer's recovery (though their contribution will again be crucial in the medium-term).
 
Instead, today's global industrial subsidence is mostly a business inventory overreaction (it will end shortly) and a business fixed investment panic attack (going by the 50% collapse in German and Japanese capital goods orders in recent months).
 
As Willem Buiter opinioned last week (and I did two weeks ago in my Turpentine Solution piece), those cancelled global capex plans may be revived quicker than you think, once the panic starts to subside, not least because so many countries have ambitious long-term fixed investment agendas that can't wait.
 
Once bank repair is well in hand, credit flows have resumed (initially Fed assisted but increasingly again bank-based), fiscal emergency packages provide support, the inventory drawdown has ended, and replacement delay is eroding, economic revival will be upon us.
 
How fast? Surely it will be a slow boat?
 
Why? Some 80% of the world economy will be way below potential, with substantial resource slack, and strong cyclical boosters in evidence. Already forgotten the post-1933 US experience, when GDP growth was pumping again (if from heavily depressed levels)?
 
Even though it may take three years for the US to return to trend growth (Rogoff), and far longer to get back to potential growth (reducing US unemployment from 10% in late 2010 to 5% by 2017 when Obama finally exits office), world growth will be accompanied by minimal inflation and near zero interest rates in many countries.
 
Even when monetary easing is eventually reduced, it won't aim to kill off the growth revival, given so much resource slack to be taken up first.
 
In this coming economic revival commodity price inflation and global equity price revival should be early features.
 
With global commodity demand bottoming these next few months and reviving from next year, with commodity supply still curtailed, an early commodity price revival looms.
 
Whereas commodity producer fortunes were rapidly reversed this past year after a ten year build-up, it seems likely another long revival looms for them shortly.
 
History, it seems, will be repeating itself, but perhaps with unexpected twists.
 
For one, as the rich world starts the new growth cycle from such depressed conditions and with so much resource slack, its labour-based inflation is likely to remain dormant for years to come.
 
Meanwhile the commodity price revival may be even more vicious than its cyclical predecessor because the global demand/supply imbalance will in fact be more severe.
 
Thus, commodity producers could experience an early resurgence in their fortunes (terms of trade improving as their commodity export prices lead industrial import prices). This in turn should improve anew their attraction for capital flows, not least because of their currently depressed currencies (effectively restarting the carry trade phenomenon).
 
The Rand in recent weeks has already started to be tarred with the brush of also being a commodity producer, along with Aussie, Kiwi and others, gradually drifting firmer of late in 9-10:$ territory.
 
Other currencies benefiting from Western-initiated policy disturbances are the Norwegian Krone and Swedish Krona. Historically, this has a familiar ring to it. Been here before, haven't we?
 
With mining companies cutting back on dividends and most large global companies hoarding cash today as if their lives depended upon it, given the deep confusion reigning, all this must come across as somewhat unreal.
 
But so was the shock of going down. It thoroughly disoriented everyone. Don't be surprised if this condition lingers quite a while even as the world prepares to move on. That's what trauma does to you.
 
For South Africa, deep in recession now, with a growing output gap, falling inflation and a reduced current account deficit, the prospect sketched here is the familiar one of bust and boom. For 150 years it has been wired into our DNA, and its global origins should be recognized rather than denied.
 
The outlook is crucially depended on growing global resource slack (fact), policy aggression to get the world back on its feet (fact), its imminent success (debatable as to timing), China's resilience (a given to some, debatable to others), commodity supply curtailment (fact), commodity price revival (green shoots sprouting) and carry trade resurrection favouring the global periphery as risk appetite returns (evidently).
 
If from next year our terms of trade revive cyclically once again, with foreign capital access easing, the Rand could firm yet more than currently foreseen.
 
Similarly, our inflation may again become more suppressed than even now expected and potentially undershoot 5.5%, despite Dollar oil prices rising anew.
 
With the SARB likely completing its monetary easing this year, with the prime interest rate ending in 10%-11% territory by 3Q2009 compared to a 15.5% peak a year earlier, our economic fundamentals will be ready for a growth and asset price revival. This will initially be Wall Street led, but eventually we should be imparting our own quality to its ascent as company earnings revival takes hold, probably from 2010.
 
Our resource slack by then will be substantial, the consumer cyclically repressed, our current account deficit cyclically low (though structurally high), inflation heading for a cyclical low, macroeconomic policy boosters pumping at maximum capacity and the economy a ready empty vessel waiting to accommodate any global windfall inflows.
 
The historic comparison may well be with 2003-2007 and possibly 1979-1982, 1968-75, and the post-WW2 period.
 
Only time will tell if this will be truly the case or whether a far more subdued revival will present itself. Don’t rule out surprises, though, given the many global imbalances, the strong policy actions, but also the imponderable behaviour paradigm likely to be driving things in coming quarters.
 
Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics