Last year saw a return to market volatility levels previously experienced in the recovery years of the 1990s’ dotcom bust. Markets are always volatile when there is uncertainty and there is much uncertainty right now — led by developments in the United States and European economies.
While there were significant losses in US housing and credit markets, it is unclear if the country’s economy will slip into recession. Business confidence indicators are particularly low, but retail sales and inflation recently improved. The Federal Reserve Bank cut interest rates by 1%, but there is considerable debate about how much further rates can be cut, given buoyant consumer spending and inflation rates.
The US credit market fallout left banks and the broader financial system vulnerable, forcing the Federal Reserve Bank to create cheaper money supplies. The credit bubble was originally created by very low interest rates, which encouraged consumers to overspend and banks to lend recklessly. This deflated the bubble too quickly and the broader financial system could not cope.
The problem for the bank is that inflation and consumer spending remain resilient. Only time will tell if the housing and credit market woes will slow the economy sufficiently to justify cutting interest rates. If the economy remains resilient, it will fuel inflationary pressures and exacerbate the Bank’s problems.
Until the credit markets settle, inflation comes under control and interest rates and the economy are back on a more certain path, the markets will remain volatile. Although it’s hard to know if the bank will engineer a soft landing, it’s pretty easy to predict continuing market volatility — at least for the first half of 2008. While questions in the US are about avoiding recession, the key consideration for emerging economies is whether the record growth rates of the past few years can be achieved again.
Average growth in emerging markets is in high single digits, with fast growers like China sporting double digits. Strong underlying fundamentals of prudent macroeconomic management, high consumption and increased infrastructure development signal another solid year of growth.
But while growth expectations for emerging equity markets are significantly higher than those in developed markets, they do not escape daily volatility. Continuing growth in emerging markets will support commodity prices, which bodes well for the South African economy.
Precious metals had another good year in 2007, with gold returning about 25% and platinum more than 30%. Gold prices will continue to be buoyant as the US dollar weakens on further cuts in interest rates by the Federal Reserve Bank and demand grows in developing economies. Platinum prices are supported by eco-friendly legislation requiring new cars to be produced with catalytic converters that reduce environmental pollutants.
Copper prices, also an important consideration for South Africa, had a less exciting year in 2007, managing a mere 1,2% year-to-date return. Copper prices were depressed, mainly on the expectations of slowing world demand and the possibility of a US recession.
As the Bank continues to cut interest rates and uncertainty recedes about growth in the US economy, copper prices should rebound. The commodity price outlook is supportive of South Africa’s export earnings and the local currency — but the economic outlook is a little trickier.
While considerations in the US are not about whether the Bank will cut interest rates further but by how much, considerations in global emerging markets are not about whether there will be strong growth but how much there will be. In South Africa the path for interest rates, inflation and economic growth is less clear.
South Africa is one of only two central banks in the world hiking interest rates. While some central banks think the downside risk to growth is higher than the threat of inflation, others have begun reducing rates.
Several emerging market central banks allowed their currencies to strengthen and, in doing so, cushioned the impact of inflation from oil and food prices and suffered less pressure to hike interest rates.
Whether the South African Reserve Bank will allow the rand to strengthen, whether we have reached the end of the interest rate hiking cycle and whether economic growth will remain afloat next year are key considerations for South Africans in 2008. Because interest rates take about 12 to 18 months to feed through to the economy, the impact of the recent hikes will be with us until early 2009.
For the South African economy to return to a strong growth path in 2008 and beyond, the Reserve Bank must be at or near the end of its interest hiking cycle; the Federal Reserve Bank must engineer a soft landing in the credit markets; the US economy must bounce back; and emerging markets and metal prices must remain buoyant.
Rejane Woodroffe is chief economist and head of international portfolios at Metropolitan Asset Managers