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The Glass
By Dr. Cees Bruggemans, Chief Economist, FNB
23 January 2007
The glass: is it half full or half empty?
There are a number of crucial dimensions, where one has a choice between being realistically cautious or being just as realistically upbeat. Obviously the 2007 outcome will differ greatly as to which realism one professes.
For the past two years there has been much handwringing that the US housing market would implode, forcing abrupt abstinence on the US consumer, pulling the US economy into recession.
With the US economy traditionally seen as the only global locomotive of note, this suggested a major synchronized global slowdown to be imminent, accompanied by all the financial turbulence this implied.
But there were also other voices. While agreeing the US housing market would cyclically subside, these analysts observed healthy US business balance sheets and fixed investment demand. Also, they noted the presence today of strong multiple global locomotives. This combination would prevent US recession and sustain global growth.
The one scenario led to substantial US rate cuts (and a weaker Dollar) in 2007. The other scenario extended the US interest rate pausing, with eventual renewed growth recovery potentially triggering even more Fed rate tightening, sustaining a firm Dollar.
The first scenario could see global turbulence (with potentially explosively higher precious metals).
The second scenario might be more a 2006 copycat, with the world economy testing its growth potential and inflation on the upside, inviting more central bank aggression, potentially triggering periodic bouts of spiking risk intolerance. The latter would be especially lethal for emerging markets with high current account deficits, the prevailing South African reputation.
In other words, for us 2007 was supposedly to be a choice between feast and famine. For a country that has traditionally progressed through political disasters and economic windfalls, this prospect wasn't unduly out of character. We do well to search for extremes, given our structure and past.
Even so, both views were extreme outliers, between which a multitude of variations were still possible.
On entering 2007, the US housing boom is clearly rapidly unwinding, but as in England and Aussie before there is no major implosion. The broader US economy has remained resilient, tempering the broader growth slowdown.
Even so, lower gas and oil prices, slower US growth, ongoing Asian supply additions and their ramifications worldwide have been assisting the unwinding of inflation back towards Fed and ECB comfort levels.
Lower long-term US rates and Dollar are already boosting US growth, for now reducing the need for Fed rate cuts.
Yet US inflation could subside enough, and unemployment rise just enough, for the Fed to remain unwilling to raise rates in 2007, keeping interest rates in suspended animation. This would be most benign for the US economy and financial markets.
It would also be good for global growth and markets. It would probably reduce the likelihood of bouts of spiking risk intolerance and the ambushing of more risky assets.
For South Africa, this outcome would suggest ongoing global growth favouring its export potential, but more importantly ongoing appetite for its financial assets.
It would allow South Africa to keep running at maximum speed domestically, even with a somewhat bloated current account deficit beyond 5% of GDP, yet enjoy sufficient external funding to prevent financial turbulence via weaker Rand, higher inflation and interest rates.
This doesn't imply a free hand entirely. Shortcomings would still need to be addressed to keep things sustainable longer term, such as making the domestic boom less consumption and more investment-intensive, and to indulge in less export handicapping.
Still, instead of having to prepare for overheating or underheating of our external finances and the economy, we might well continue to encounter benign conditions preventing extreme outcomes. That would make the central Rand forecast 7:$ and not 5:$ or 9:$.
Whether our inflation will then behave equally benignly will crucially depend on big bets about the Mid-East.
Will Iraq's evolution be accompanied by pre-emptive Iranian measures still spiking oil prices higher? Or can we get by with tippy-toeing through this minefield without setting off any stuff?
Oil at $50-$60 would ensure our CPIX inflation peaking by Easter just short of 6% and thereafter rolling over. It should encourage the SARB to start pausing in its rate tightening cycle.
This would allow the economy to keep running at maximum potential growth, ensuring strong ongoing company earnings. Along with benign global financial conditions and strong appetite for our assets, this should keep on favouring our asset prices.
On the other hand, disruptions in the Mid-East could ripple unpredictably wider in the world economy, and set off cross-currents for us that may be difficult to read ahead of time.
The bird in the hand is always more attractive than ten in the bush. Benign global conditions could continue the capital windfall conditions in place since 2002, carrying us yet farther on that fair wind.
Ever so realistically.
Original article published at www.fnb.co.za.
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