By Cees Bruggemans, Chief Economist FNB

15 September 2008

Ten times out of five, the stock market is a good recession predictor globally. A lot of false starts are taken in stride.

So also with predicting revival breakouts.

Lots of bear rallies are often interpreted as that first shoot of spring. Such feints for the upside, however, aren’t always the real McCoy. More churning and downside exploration may be needed before the real upturn finally comes along.

But in retrospect, with 20/20 hindsight, it inevitably happens that the judgement of millions proves to be on the money when the real stock market revival leads the eventual economic recovery by a fair margin.

So we need a genuine share market signal.

What we got instead last week was a descent to 25 000, with more upheaval expected this week as New York bank Lehman Brothers declares bankruptcy and Bank of America is in takeover talks with Merrill Lynch.

Just six months ago our share market peaked over 33 000.

That’s nearly 25% down. True, that latest sickening lurch for the bottom was New York induced, with Fannie Mae and Freddie Mac’s problems and rescue also registering.

But none of this has anything to do with us, surely?

Commodity prices, especially energy and metals, are falling. Important parts of the global economy are in a slump. Perception thereof is so overwhelming it triggered speculators to capitulate. Enough so to confirm a serious downdraught in global commodity demand, despite record mining company results.

So that’s two serious negatives, suggesting both the financial and trade cycles are still against us.

Within our stock market data, however, there is an important clue which shouldn’t be missed. Since early July, selling mining counters (as commodity prices went into sharp decline) and buying cyclical recovery stocks (retailers, financials, industrials) has become popular.

So even though mining profits are skyrocketing, these are considered a good sell. And though the cyclicals are going through profit warnings, reprice them in anticipation of better times ahead.

So that’s two negatives pregnant with a solid positive, now exactly two months old.

Meanwhile, bad economic data keeps piling up. Confidence indexes plunging. Credit growth slackening. Car sales growing weaker. Nominal house prices about to go negative with a 5%-10% plunge still ahead.

Good news is that the budget surplus has disappeared suggesting the fiscal shock absorber is doing its job. But the surplus went due to a big public sector wage settlement (an unplanned 10.5%), Eskom (hardly cyclical) and political pragmatism.

If the fiscal stance isn’t quite the cyclical predictor of yore because of the many specials, monetary policy went apparently on hold last month. That could point to something. Except that the SARB has paused twice before, only to resume tightening.

Still, pausing invites a sigh of relief from the most indebted. And June may have been the last rate hike. Yet few will rush out to start buying again.

Only rate cuts may ultimately turn sentiment, and then probably with a lag, by shortening the replacement cycle of cars and other durable consumer goods.

Even so, banks are reporting steeply higher bad debts, accompanied by anecdotal evidence of turning down a larger share of new borrowing requests.

The credit cycle is still tightening lending criteria. Until this relaxes, the deadening grip could firm.

Also a bad sign, there are too many genuine sales. Many retailers are having slow months, stuck with involuntary inventory accumulations. These need to be cleared away. Many manufacturers are also overstocked.

The inventory cycle has yet to fully cleanse. Until it has, GDP will be leaned upon through output forgone.

So what are we waiting for?

Businesses need to clean out their stables thoroughly (inventory cycle). Foreign trade partners need to turn their respective corners (trade cycle). But with some countries entering recession, there may be more headwinds for us for many months still.

As these events play out, we can expect policy at some point to relent, confirming the inflation emergency is ending and growth in need of revival, thereby affirming the stock market’s early-bird signal of changing its composition of leaders and laggards.

For that one wants to see the first rate cut, with intimations of more to come, as is now starting to happen elsewhere in the world. Such action would also loosen up our replacement cycle and replace belt tightening with belt loosening.

Once that happens, banks can eventually start to lighten credit criteria, thereby boosting cyclical revival.

But for now none of that, with the SARB’s leading indicator in its 15^th month of decline and giving little sign of ending the slide.

Yet it has a history of predicting economic turns well ahead of time.

If our turn is to happen by mid-2009, some 18 months after the onset of this slide (compared to 14 month downturn averages), interest rate cuts need to start happening sooner rather than later.

Policy easing is presumably around the corner, if only the bad news can cease.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics