TAFADZWA CHIBANGUZA: Metals and engineering sector needs support amid strengthening headwinds

The outlook for the metals & engineering sector has deteriorated markedly after a strong start to the year.

In the first quarter of 2022 production in the sector expanded by a notable 3.6%, driven largely by supportive global economic growth. In addition, domestic monetary policy support and the effect of some of the post-Covid economic recovery plans encouraged green shoots.

It should be noted that monetary policy was the dominant fundamental. At the time the Steel & Engineering Industries Federation of SA (Seifsa) warned that though the growth in the first quarter of 2022 was a welcome development, analysis of the sub-industries that contributed to the sector’s growth showed this was largely a response to demand from sustaining capital investments in the sectors the metals & engineering sector supplies, and not from expansion (growth capital).

The former is generally volatile, and at the time was induced by supportive monetary policy, while the latter is what is necessary to drive sustainable growth. This contention is supported by the fact that the sub-industries that contributed to the growth were electrical machinery (14.5%), general purpose machinery (7.4%), and transport equipment (6.2%). On the other hand, structural steel products, which feeds into capital projects, contracted (-1%) in the quarter.

During the first quarter inflationary pressures were already building in the global economy. However, this was initially driven by aggregate demand increasing faster than supply chains could respond. The invasion of Ukraine by Russia on February 24 set the proverbial cat among the pigeons in economic and inflation terms.

In the spectrum of leading, coinciding and lagging economic indicators, the metals & engineering sector is classified as coinciding. That is, its performance is indicative of the prevailing economic fundamentals. It is also extremely sensitive to these prevailing global and domestic economic events. In fact, our estimates already point to production contracting by between 1.1% and 1.3% in the second quarter, with notable downside risks for the full-year outlook.

This view is informed by a number of themes that are shaping the global and domestic economic fundamentals, including:

• The aggressive monetary policy tightening in the US in response to multiyear record inflation outcomes recorded in that country. The inversion of the yield curve (spread between the two-year and 10-year bond having turned negative) is cause for concern, because in the past this has tended to lead to an economic slowdown in the US. Increasing US rates also set the pace for global monetary policy and short-term increases in the cost of capital, which is inversely related to investment. This will cause a tapering of global economic activity.
• The Russia-Ukraine war has immediate (geographic) implications for the EU economy. A concerning development is the weaponising of gas supply by Russia, which will have recessionary consequences for Germany, the largest economy in the EU and SA’s second-largest trading partner. The dominance of Russia and Ukraine in the food inputs and commodity complex is driving inflationary pressure globally, reinforcing the need for central banks around the world to increase interest rates.
• China’s aggressive zero-Covid policy, in which the last round of lockdowns has affected the economic hubs of Shanghai and Beijing, which will contribute to slowing the global economy. China’s role as the factory of the world and an important market for commodity-exporting countries means a slowdown in Chinese economic activity has direct negative implications for commodity prices and the economies of the countries concerned.

These themes will dominate the global economic narrative and the slowing of global economic growth. Steel production is highly correlated to growth and the early warnings signs of a slowing growth rate are evident in the decline in iron ore prices, a key ingredient in steel production.

In dollar terms the iron ore price decreased by about 28% in the first six months of the year, and by almost 50% in the year to July. This despite a reduction in seaborne supply from Ukraine. Domestically, basic iron and steel sales declined 8.1% in the first six months, while other fabricated metals declined 8.5% and structural steel products dropped 1% over the same period.

Compounding the global headwinds are weak domestic fundamentals that are also feeding into the outlook. The energy crisis, which was the worst on record in the second quarter of the year, is a major constraint and downside risk to the outlook. As a real sector economy electricity availability is an essential input into the metals & engineering sector, which comprises energy intensive users of electricity that have to cut production when power is in short supply.

The sector also includes producers that are less energy intensive, but whose processes are dependent on electricity so load-shedding means a complete halt to operations. The recent energy reforms announced to resolve the energy crisis are a welcome development, but for the remainder of 2022 we anticipate a constrained grid as the reforms take effect. Speedy and focused implementation of the reforms is therefore imperative.

The state of local government and the lack of service delivery is another major domestic constraint. Companies in the metals & engineering sector are spread across the length and breadth of the country and are adversely affected by service delivery failure at local government level. The inefficiencies of local government push up costs for producers, eroding their competitiveness.

A rising tide lifts all boats, but the inverse is also true. In a less supportive global economic environment, and with headwinds intensifying, domestic economic policy and reform has to do a lot of heavier lifting to support the economy. Domestic intervention to counter these headwinds and support the metals & engineering sector is essential.

The greatest constraint on the SA economy right now is the stranglehold failing state-owned entities and organs of state have on key areas of the economy, and the damage they are inflicting on economic performance. This is applicable in the energy, transport, water, policing, healthcare sectors, and services at municipal level.

A dedicated national programme to remove these bottlenecks presents an opportunity for the state to partner with the private sector. Such a country repair programme would also create a form of demand and economic activity domestically. The private sector has the necessary skills, capacity and financial resources, and because these inefficiencies breed costs it is in the natural and economic best interests of businesses to participate. Removing the bottlenecks will help put the economy on a sustainable growth path.

A clear national strategy on industrialisation is also required. At this stage policy interventions are pulling in too many different directions, making it difficult to find a clear path forward. The much-touted large-scale infrastructure programme must also proceed, with provisions for the participation of local industries where competitive capacity exists. Coupled, these project plans need to be clearly communicated with precise timelines to allow domestic producers the runway to plan their production and any expansion that may be necessary.

The infrastructure programme also needs to be sequenced and ongoing. The stop-start and big-bang order approach of the past does not work for sustainable industrialisation.

• Chibanguza is COO of the Steel & Engineering Industries Federation of SA.