Global Lessons

Global
Global Transitions
December 11, 2006

By Stephen S. Roach | New York

After four years of the strongest growth since the early 1970s, the global economy is entering an important transition. The character of that transition is the subject of endless debate. Financial markets are currently priced for a Goldilocks-like soft landing -- a benign slowdown that tempers inflation and interest rate pressures. The risk, in my view, is that global growth could fall well short of consensus expectations -- with important implications for unsuspecting markets.

I suspect that our current baseline forecast offers only a hint of the coming transition in the global economy. While our projected 4.3% increase in world GDP for 2007 remains well above the 45-year growth trend of 3.7%, it falls significantly short of the 5.0% increase we currently estimate for 2006. The anticipated downshift is broad-based, with the US and Europe leading the way in the developed world and a slowing in Asia ex Japan -- especially China and India -- standing out in the developing world (see accompanying table). Our downwardly-revised US forecast reflects the repercussions of a post-housing-bubble shakeout, whereas the slowdown in Europe is expected to be driven by fiscal consolidation in Germany and Italy, along with the lagged impacts of ECB monetary tightening and a stronger euro. In an increasingly interdependent world, it also makes sense to mark down our growth forecasts in Asia, largely because it will be next to impossible for the region’s export-dependent economies -- especially China -- to avoid the impacts of a slowing of end-market demand in the US and Europe.

Downshifts in the US and China should not be taken lightly. By our reckoning, these two economies have collectively accounted for over 60% of the cumulative growth in world GDP over the past five years -- including direct effects (43%) and the indirect effects traceable to trade linkages (at least another 20%). A key question for the global outlook, in my view, is not whether new sources of global growth have emerged on the scene -- the so-called decoupling thesis -- but whether we have gone far enough in marking down our forecasts for the US and China.

Our US team now concedes that America has lapsed into a temporary “growth recession” -- econo-speak for a growth rate that is sluggish enough to allow the unemployment rate to start rising again (see the 11 December dispatch by Richard Berner and David Greenlaw, “It’s a ‘Growth Recession,’ Not a Lasting Downturn”). They are now looking for three quarters of just 2% annualized growth in real GDP over the 3Q06 to 1Q07 interval -- a downward revision of 0.6 percentage point from their previous forecast. This scenario has soft-landing written all over it -- a surgical strike on the housing market that leaves the rest of the US economy relatively unscathed. The growth recession is expected to be relatively short-lived, giving way to a projected 3.0% annualized rebound in real GDP in the final three quarters of 2007.

In cutting their near-term growth forecast, Dick and Dave concede that the risks remain on the downside. I couldn’t agree more. The difference between us is that I would assign a higher probability to those risks than they do. I fear that the soft-landing crowd has been too quick to pounce on the first signs of softening as confirmation of the endgame to the current downturn. Experience teaches us to be wary of the lags in jumping to premature conclusions about the scope and duration of cyclical adjustments. Take the residential construction sector, for example. Employment in the residential building and specialty trade contractors industries, combined, has now declined by 110,000 from the February 2006 peak -- reversing only 15% of the cumulative run-up that occurred over the preceding five years. With housing starts already down 35% from their peak, it seems perfectly reasonable for employment in this sector to fall a good deal further -- a headcount reduction that would constrain overall labor income generation and put heightened pressure on personal consumption.

It’s not just the nascent recession in homebuilding. Also at risk are the related businesses like furniture, appliances, mortgage finance, and real estate brokers. And, of course, there is the likely unwinding of the consumer wealth effect. Only asset-driven wealth effects can explain how a decade of frothy consumption growth (3.7% in real terms) has exceeded after-tax real income growth (3.2%) by an average of 0.5 percentage point per year. With the last bubble now bursting, I suspect that the wealth effect is about to turn negative for overly-indebted, saving-short US households -- dragging consumption growth below the pace of income generation as rational households abandon asset-based saving strategies and return to more of an income-based approach. As consumption slows, demand-driven capital spending should be quick to follow -- precisely the inference that can be taken from a weak capital goods report in October. The lesson of post-bubble shakeouts is important here: When a booming sector goes bust -- dot-com six years ago, housing today -- there are no built-in firewalls that contain the ripple effects. The US soft-landing scenario does not adequately allow for these risks, in my view.

Moreover, I am highly suspicious of the idea that the rest of the world is likely to be insulated from a US growth shortfall. China, the fourth-largest economy in the world, devotes an outsize 35% of its GDP to exports -- and the US is its biggest external market. In Japan, the second-largest economy, exports are 17% of GDP, and the US and China are its two largest customers. For Canada, the 8th-largest economy in the world, exports to the US account for fully 27% of its GDP. In Mexico, the world’s 13th-largest economy, US exports make up 24% of its GDP. And these are just the direct effects. Supply-chain linkages throughout the world -- especially to Asian suppliers of the Chinese assembly line such as Korea, Taiwan, and Japan -- will compound the impacts of a demand shortfall in China’s largest export market, the US. It would be one thing if the non-US world could draw incremental support from improving internal demand -- especially private consumption. But consumption shares are still falling in China, and a recent downward revision underscored a similar and very disappointing development in Japan. Moreover, European consumption is currently adding no more than one percentage point to pan-regional growth. With Asia and Europe lacking any vigor in their autonomous consumption dynamic, global decoupling seems all the more a stretch. That raises yet another important question mark for the global soft-landing scenario.

The China factor bears special mention -- not just because of the export linkages noted above but also because of some important developments on the internal demand front. The Chinese seem increasingly determined to cool off an overheated investment sector -- hardly surprising with fixed investment now nearing an unheard of 50% of GDP. A failure to bring an increasingly irrational capital allocation process under tighter control is a recipe for capacity overhangs and deflation. The Chinese are mindful of these very risks and are hard at work in shifting their growth focus. Reflecting the combined impacts of administrative controls and monetary tightening, there has been a discernible slowing in the growth of both industrial output and investment in the final months of 2006. I expect more of that to come in early 2007 -- sufficient to take Chinese real GDP growth down from the blistering 11.3% comparison of mid-2006 into the more sustainable 8-9% range by year-end 2007. Meanwhile, the Chinese are hard at work in laying the groundwork for a pro-consumption tilt to the growth dynamic -- consistent with the better balance that a higher-quality growth experience ultimately requires. For China, this could well mark a critical transition in its remarkable economic development -- with important implications for Asia, the broader global economy, and for what has been an increasingly China-centric dynamic at work on the demand side of major commodity markets.

The year ahead is not just about a looming transition in the global business cycle. It could also mark an important transition in the globalization debate. I suspect that the focus is likely to shift away from the brilliant successes of China and India toward an increasingly politicized pro-labor pushback from the rich countries of the developed world. The income shares of the major industrial economies are all at extremes -- record high returns to capital and record lows for labor shares. Courtesy of an increasingly powerful IT-enabled globalization that is now affecting both tradable manufacturing and once non-tradable services, job growth and real wages in the high-cost developed world remain under unusual pressure. That’s great for corporate profits but very tough for real wages. A pro-labor shift in the political power base of the industrial economies -- already evident in the US, Germany, France, Italy, Spain, Japan, and possibly Australia -- could lead to a reversal of these trends. It opens up the possibility that the pendulum of economic power might well begin to swing from capital back to labor. Such a development, in conjunction with our forecast of a significant slowing in global GDP growth, implies a weaker-than-expected top line for global businesses. That could have profound consequences for the earnings cycle that continues to underpin ever-frothy world financial markets. Moreover, to the extent any pro-labor shift has protectionist overtones, it could also prove to be a stern test for globalization, itself.

In looking to 2007, my main message is to be wary of extrapolation. After a powerful four-year boom, an important transition lies ahead for the world -- both on economic as well as on political terms. The consensus appears to be unprepared for the full extent of the transition that could well occur -- banking on the benign outcome of a soft landing in the US to be offset by accelerating growth elsewhere in a decoupled world. The official baseline forecast of the IMF is quite consistent with such a sanguine prognosis. It calls for a 4.9% increase in world GDP next year -- virtually identical to the 4.8% average gains over the 2003-06 period. The Morgan Stanley forecast of 4.3% global growth is already well below that consensus. As post-housing bubble adjustments begin to play out in the US, the lags of an interdependent and still unbalanced global economy are only just beginning to kick in. And a new group of politicians is only just beginning to take the reins of power. All this underscores the possibility that we may not have gone far enough in factoring in the downside risks to global growth in 2007. Transitions are never easy -- especially when juxtaposed against the complacency spawned by four fat years.

United States
It’s a “Growth Recession,” Not a Lasting Downturn
December 11, 2006

By Richard Berner | New York

Forecast at a Glance

	2006E	2007E	2008E
Real GDP	3.3%	2.4%	3.0%
Inflation (CPI)	3.3	1.6	1.9
Unit Labor Costs	3.3	3.2	2.7
After-Tax “Economic” Profits	22.2	3.8	4.7
After-Tax “Book” Profits	19.3	2.1	2.4

Source: Morgan Stanley Research E = Morgan Stanley Research Estimates

We’ve sharply cut our near-term expectations for US growth, with the advance in GDP averaging 2% annualized for the three quarters ending in the first quarter of 2007, or about 0.6 percentage point below our estimate of just a month ago. More important, while our estimate of roughly 1½% for the fourth quarter of 2006 is the low-water mark for growth in our baseline outlook, the pickup we now envision likely will be slow, and a return to the trend of 3% probably awaits the summer of 2007.

This “growth recession” — a period of growth appreciably below potential — likely will last long enough to reduce somewhat the lingering upside risks to inflation. As we previewed last week, the combination of slower growth and reduced inflation risks, if it occurs, will thus allow the Fed to stay on hold for much of 2007, and to ease gradually as inflation moves lower late next year and into 2008 (see “Changing the Fed Call,” Global Economic Forum, December 4, 2006).

Now that our calls are close to consensus, what are the risks for the economy and for financial markets? Most important, we do not see this period of sluggish growth as the prelude to a more lasting downturn in economic activity. And thematically, like the consensus, we envision rising personal saving, peaking inflation, and a steeper yield curve in the year ahead. But in our view these themes may play out in ways the consensus doesn’t envision, and that may make all the difference for the outlook. Here’s why.

For the economy, we see risks evenly balanced around our new, more subdued baseline. We continue to envision a ‘two-tier’ economy, with housing and Detroit now in recession, and the forces sustaining growth in the rest of the economy skirting the fallout from those industry downturns (see “The Two-Tier Economy,” Global Economic Forum, November 6, 2006). As those twin recessions fade, in fact, we expect that the pace of overall economic growth will quicken.

Importantly, however, we’re not “compartmentalists.” Instead, our two-tier call rests on four key premises. First, while we believe that the housing recession is far from over, we think that the intensity of the downturn will peak by spring 2007. Our new baseline does envision a more intense housing recession in the near term than we thought a month ago. We estimate that the decline in housing activity will cut a full percentage point from GDP both in the current quarter and in the first quarter of next year as builders are moving even more aggressively to cut supply.

But the pace of declining housing demand seems to be slowing, and that combination seems likely to reduce the odds of declines in home prices appropriately measured on a nationwide basis (see “False Dawn for Housing? Global Economic Forum, December 8, 2006). And we continue to think that the housing wealth-consumer spending link is weaker than many believe. As a result, the spillover from housing wealth to consumer spending seems unlikely to derail the consumer.

A second key premise is that the economy’s income-generating capacity has improved sustainably, and by enough to allow consumers to rebuild personal saving in the face of decelerating housing wealth while maintaining moderate gains in spending. Solid job gains, firmer labor markets and thus wage gains, and a decline to 2% headline inflation have lifted real wage income growth to a solid 4½% annual rate over the year ended in October.

November’s employment canvass implies more of the same: Nonfarm payrolls rose by 132,000, not far from the 150,000 (1.3% annualized) average in the first ten months of 2006, especially considering the strong, upward pattern of revisions seen since the summer. Demand for labor inputs is stronger still, running at a 2% rate, as the workweek has risen throughout the year after adjustment for changes in the industry composition of employment. And while sharp downward revisions to GDP-based compensation per hour data call into question the pattern of wage growth, we believe that the acceleration in private hourly earnings to 4.1% in the year ended in November reasonably represents the current pace. While personal saving hasn’t yet turned back into positive territory, the fourth-quarter combination of 6.2% annualized growth in real disposable income and 2.9% in spending suggests that it will do so soon.

The third key notion is that while global growth may be slowing, growth in domestic demand abroad is still stronger than in the United States, and thus net exports seem likely to contribute to US growth (for the global outlook, see Steve Roach’s accompanying dispatch, “Global Transitions”). We don’t buy into the decoupling story — that overseas growth is immune to US weakness. But growth in domestic demand in our two major trading partners, Canada and Mexico, remained at 4.1% and 5%-plus through the third quarter, and in the Eurozone, it eclipsed the 2½% US pace for the first time since the 2001 recession. And of course, in much of Asia and Latin America, such demand has long outpaced that in the US. US exports must grow twice as fast as imports to narrow the gap in real net exports, and we’re betting that the growing gap between US growth and that abroad, combined with the incipient decline in the dollar, will bring that about.

Finally, we think that notwithstanding a monetary policy that has become mildly restrictive, US financial conditions are still supportive of growth. If anything, the rise in stock prices, the decline in interest rates, the tightening of credit spreads, and the decline in the dollar have recently made financial conditions still easier. Credit-sensitive demand should benefit: With pent-up demand for capital spending still positive, we expect that the deceleration in equipment and software outlays to a 3.5% annualized pace in the last three quarters of 2006 will give way to a faster pace in 2007.

Against that backdrop, we see slightly less inflation risk than a month ago, because four quarters of growth averaging 2.2% will begin to reverse the narrowing of economic slack that characterized the first four years of the expansion. The gap between actual and potential growth will widen somewhat, the unemployment rate will rise towards 5% (in part as labor force growth outpaces employment), and future operating rates in industry will rise only slowly.

Nonetheless, in our view, inflation has yet to peak and likely will turn down gradually. That’s because inflation expectations remain slightly elevated, the relationship between economic slack and inflation is not a strong one, and the dollar is now declining. Measured by the core personal consumption price index (PCEPI), inflation has leveled off at 2.4%, but in the past three months has moved higher. Measured by the University of Michigan’s 5-10 year median, longer-term inflation expectations edged above 3% in December. The so-called Phillips curve may well be flatter than in the past, meaning that just as a substantial reduction in slack only pushed inflation up moderately in this expansion, a little increase in slack won’t go very far to reduce it. And while the dollar has only declined by about 2% on a broad, trade-weighted basis in the past eight weeks, the direction could offset disinflationary forces, especially with import prices of consumer goods excluding automotive products up 1% in the year ended in October.

Like the consensus, we believe that the yield curve will disinvert or resteepen from current levels, but how that happens is critical. Many think that a turn toward ease will be the dominant factor, so that short-term rates decline by more than long-term rates, in classic cyclical fashion. In contrast, we think cyclical comparisons probably won’t help analyze the current yield curve setting. We think that the Fed will anchor short-term rates, and long-term rates may rise somewhat from current levels.

Following November’s employment report, market participants dramatically scaled back the chance of Fed ease by the March FOMC meeting to 30% from 70% just a week ago. Those odds will probably shrink further in coming months. To be sure, Fed officials following this week’s FOMC meeting will surely acknowledge the recent stretch of sub-par growth and its potential disinflationary benefits. But subpar growth has yet to reverse the decline in the unemployment rate, and core inflation, especially measured by the PCE price index, hasn’t come down significantly. Thus, policymakers’ belief that inflation is still too high likely will persuade them to retain their tightening bias. Longer-term yields may rise gradually beyond 4¾% as the odds of a downturn and Fed ease fade, as rising term premiums elevate the level of real long-term yields, and as a weaker dollar may erode the appeal of carry trades.

There are several downside economic risks: The housing recession could deepen, capex is a question mark, and credit quality may begin to erode, triggering tighter lending standards. And weaker growth means more downside risks to corporate earnings. But upside economic risks and their consequences for markets should not be ignored: The housing downturn could end more quickly, the capital-spending pause may have been a false alarm, and although global growth may be slowing, US firms may be getting a bigger market share. For markets that have thrived on low volatility, these crosscurrents may begin to reverse that trend.