Who will be hardest hit by a US slowdown?

18.04.2007

By Stephen Roach

The global debate is endless (fortunately), but it’s also very simple. The key question is whether the current US slowdown has broader cross-border consequences. For financial markets, which are still discounting relatively sanguine global growth prospects for 2007-08, there is great enthusiasm for the ever-optimistic decoupling scenario – whereby the rest of the world miraculously untethers itself from the US. That remains a real stretch, in my view.

On the surface, the latest global trends seem quite consistent with a decoupling scenario. America has slowed but the rest of the world has picked up. In particular, there seems to have been a meaningful shift in the mix of growth in the industrial world. The US economy has downshifted from 3.4% growth over the 2003-05 period to only about 2% over the past year while trend growth in Europe and Japan has accelerated from around 1.5% to 2.5%.

Never mind that the improved pace in Europe and Japan is only a scant faster than the weakened trend now evident in the US. The decoupling crowd rests its case on the “second derivatives” – the juxtaposition of a deceleration in the US compared with acceleration elsewhere in the industrial world. China and India are the icing on the cake – emblematic of a seemingly open-ended boom in the developing world that remains unscathed by the US slowdown. The case for global decoupling concludes that world GDP growth – which surged at a 30-year high of 4.9% over the past four years – will barely skip a beat in 2007. Little wonder that financial markets are priced for a continuation of what many call the best global economy in a generation.

World economy yet to face a legitimate test

The fly in the ointment in this debate is that it may well be that an increasingly integrated world economy has yet to face a legitimate decoupling test. The US may have slowed but the downshift hardly represents a major derailment of the world’s major growth engine. Moreover, the deceleration has been concentrated in one of the least globalized pieces of the US economy – homebuilding activity.

Over the final three quarters of 2006, a steep contraction in residential construction expenditures knocked an average of 1.0 percentage point off real GDP growth in the US – a swing of -1.5 percentage points from the positive growth contribution of 0.5% over the preceding three years and enough of a drag to have accounted for all the downshift in real GDP growth over the same period. While the housing recession has undoubtedly reduced US demand for foreign sourced construction materials, this is hardly a major challenge to growth elsewhere in the world economy.

So far, the rest of the US economy has been relatively resilient in the face of this steep contraction in residential construction activity. That’s especially the case for personal consumption – more than 70% of US GDP and the one sector of aggregate demand that has the tightest linkages to America’s trading partners. During the final three quarters of 2006, when homebuilding activity hit the skids, annualized real consumption growth still averaged 3.2% - down only 0.2 percentage point from the growth pace of the preceding three years and fully 33% faster than overall GDP growth over the final three quarters of last year; moreover, in the first period of 2007, our latest tracking estimates suggest consumption growth held at this same impressive 3.2% pace. Business capital spending has started to weaken a bit in recent months. But the weakening has been concentrated in the equipment piece – only 7% of US GDP, or one-tenth the size of the personal consumption sector. Needless to say, as long as the American consumer continues to hold its own as a source of relative resilience, the US economy can shrug off a capex hit – and the global economy will hardly be tested.

Internal spillovers and external linkages

This outcome underscores a major source of confusion over the global decoupling call – the distinction between internal spillovers and external linkages. The former, in my view, pertain to the interconnectedness within an economy – the relationships between sectors. An obvious case in point is the lack of any spillovers between homebuilding and consumption in the US – at least, so far. I would define linkages as more of a cross-border phenomenon – in effect, the transmission of shifts in one economy to the broader global economy through global trade flows. Internal spillovers are a necessary – but not sufficient – condition for cross-border linkages. But if there have been no internal spillovers, the external linkage debate – and therefore, the global decoupling call – is all but meaningless. That remains very much the case today, in my view.

This same point recently has been made by the research staff of the IMF in the prepublication of one of the chapters in the April 2007 issue of the World Economic Outlook (see Chapter 4 on the IMF website, “Decoupling the Train? Spillovers and Cycles in the Global Economy”). Notwithstanding erroneous press accounts of this research, the IMF staff throws cold water on the notion of a global decoupling from the US. To the contrary, they stress that the “…potential size of spillovers from the United States has increased with greater trade and financial integration.” They underscore the same point I stressed above – that as long as the US slowdown remains confined to sector-specific developments such as housing, the less the chances of a more severe stalling out of the American growth engine and, as a consequence, the lower the probability of a more broadly based global slowdown.

Who has the greatest export exposure the the US?

The IMF research also provides a comprehensive ranking of the cross-border linkages to the US. Based on export exposure to the US, America’s NAFTA partners – Mexico and Canada – are at the top of the vulnerability list; for both of these economies, goods shipped to the US account for around 25% of their GDP.

China’s exposure, while considerably less than the NAFTA bloc, has increased dramatically in the past five years; by IMF estimates, US exports accounted for an average of 5.9% of Chinese GDP over the 2001-05 period – seven times the 0.8% share 20 years earlier from 1981-85. US exposure remains quite high in Asia ex Japan; for the newly industrialized economies of Hong Kong, Korea, Singapore, and Taiwan, in conjunction with the ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand), US exports accounted for an average of 10.3% of their combined GDP over the 2001-05 period.

By contrast, Japan has reduced its dependence on America, with US-bound exports averaging just 2.9% of GDP over the 2001-05 interval – well below the 4.0% portion some 20 years earlier. For the Euro area, US dependency ratios remain quite low, although they have inched up from 1.5% in the first half of the 1980s to 2.4% in the first half of 2000s. Similar modest increases in US exposure have been evident in Brazil and Argentina, and because of oil and resource linkages, US dependency ratios have also risen for Sub-Saharan Africa – from 3.0% in 1981-85 to 5.9% in 2001-05.

The results of the IMF staff research are not surprising. They are, in fact, nearly identical with similar conclusions that I and others have stressed in considering the repercussions of a US slowdown on the broader global economy (see my 30 October 2006 dispatch, “The Fallacy of Global Decoupling”). As I noted at the time, the “decouplers” – economies that can stand on their own in the event of a major growth shortfall in the US – must satisfy three conditions: They need to have a broadening base of self-sustaining domestic demand, a diversified export mix, and policy autonomy. In my view, progress is still quite limited on all three counts. Private consumption continues to lag in Europe and Asia. Moreover, the US is still the dominant global export destination; by IMF estimates, the US accounted for 20% of global merchandise exports over the 2001-05 period – a record high for the US and larger than the Euro area as the biggest portion of global trade. Nor is there much leeway for global policy makers to ride to the rescue in the event of a US growth shock; that’s especially the case in developing Asia, which is constrained by currency considerations, but it is also true in Japan, where policy rates are still very close to “zero.”

The outlook for the US consumer

In the end, this debate boils down to the one big call that has always weighed most heavily on the macro outlook – the fate of the American consumer. If US consumption growth remains brisk in the face of pressures building elsewhere in the economy – especially housing, but also business capital spending and autos – then a globalized world will, in effect, have nothing to decouple from. The surprisingly strong March labor market surveys – brisk employment and falling joblessness – underscore the ongoing resilience of labor income generation and consumer purchasing power.

Yet as Dick Berner, our resident consumption bull, recently conceded, consumers will need all the help they can get in the face of higher energy and food costs, decelerating housing wealth creation, adjustable-rate mortgage resets, and a tightening of lending standards in the aftermath of the sub-prime mortgage fiasco (see his 2 April dispatch, “Perfect Storm for the US Consumer?”). But if the US labor market continues to display extraordinary staying power in the face of adversity elsewhere in the economy, the overly-indebted, saving-short American consumer could squeak by once again – and so, too, would the rest of a still-coupled world. I remain highly dubious of such an outcome but concede that the burden of proof remains on me.

I have long been struck by the inherent inconsistency of a macro call that extols the virtues of integration and globalization, on the one hand, while celebrating the resilience of a decoupled world, on the other hand. Don’t kid yourself – if the lead engine of the global growth train goes off the tracks, the rest of the world will be quick to follow. So far, that hasn’t happened – underscoring my basic conclusion that there has yet to be a meaningful test of the global decoupling thesis. It’s up to the American consumer as to whether that test will ever occur.

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum

Two Spillovers from the Bursting of Two Bubbles: Stephen Roach

Global
Asian Decoupling Unlikely
March 26, 2007

By Stephen S. Roach | New York

As the US economy slows, most believe that Asia’s growth machine will fill the void. Don’t count on it. Policy makers in China and India are shifting toward restraint, tilting growth risks in the region’s fastest-growing economies to the downside. Nor is an externally-dependent Japanese economy likely to provide much compensation. To the extent the case for global decoupling is dependent on an Asian offset, prepare to be disappointed.

After years of doubt, convictions are deep that both China and India will stay the course of hyper-growth. There has been talk for years about the coming Chinese slowdown, but so far the downshift has failed to materialize. The 10.7% increase in Chinese GDP in 2007 was the fastest since 1995, when the size of the economy was less than one-third what it is today. Moreover, with India now showing impressive improvement in its macro foundations of growth – especially saving, infrastructure, and foreign direct investment – there is good reason to believe that there may be considerable staying power to the recent acceleration in economic growth that averaged 9% during the 2005-06 interval.

Incoming data give little reason to doubt the staying power of the Asian growth machine. Chinese industrial output growth has reaccelerated to an 18.5% y-o-y pace over the January-February period – up from the sub-15% comparison in the final period of 2006 and only a shade slower than the 19.5% gains recorded last June. While India’s industrial production growth is certainly not as brisk as China’s, the 10% y-o-y comparison in early 2007 remains well above the 7¼% pace that was evident in late 2005 and early 2006. Needless to say, if China and India stay their present course, the global economy would barely skip a beat in the face of a US slowdown. Collectively, China and India account for about 21% of world GDP, as measured by the IMF’s purchasing power parity framework – essentially equal to the 20% share the statisticians assign to the United States. Add in the recent acceleration in the Japanese economy – a 5.5% annualized increase in the final quarter of CY2006 for an economy that accounts for another 6% of PPP-based world GDP – and there is good reason to believe that the impact of America’s downshift could well be neutralized by the ongoing vigor of the Asian growth machine.

The Asian offset, in conjunction with a modest cyclical uplift in a long sluggish European economy, is the essence of the case for global decoupling – a world economy that has finally weaned itself from the great American growth engine. A key presumption of that conclusion is that Asia can stay its present course. There are two flaws in that argument, in my view – the first being that internal pressures are now building in Asia’s fastest-growing economies that could be sowing the seeds for slower growth ahead. In particular, both the Chinese and Indian economies are now displaying worrisome signs of overheating. In China, the symptoms have manifested themselves in the form of imbalances in the mix of the real economy, widening disparities in the income distribution, and a large and growing current-account surplus – to say nothing of the negative externalities of environmental degradation and excess resource consumption. In India, the overheating has surfaced in the form of a cyclical resurgence of inflation, with the CPI running at a 6.8% y-o-y rate in early 2007 – a sharp acceleration from the 3.8% pace of 2002-05.

In recent weeks, I have met with senior policy makers in both China and India. It is clear to me that in both cases the authorities are in the process of shifting their policy arsenals toward meaningful restraint. In China, the direction comes from the top in the form of growing concerns expressed by Premier Wen Jiabao about a Chinese economy that he has explicitly characterized as “unstable, unbalanced, uncoordinated, and unsustainable” (see my 19 March dispatch of the same name). Since those words were first uttered at the end of the National People’s Congress on 15 March, Chinese authorities have been quick to respond. There was a monetary tightening the very next day and the securities industry regulators have issued new rules that prevent companies from purchasing equities with proceeds from share sales. The former move is aimed at cooling off an overheated investment sector while the latter move is addressed at dealing with a frothy domestic stock market that increased by 100% in the six months ending in late February. I am more convinced than ever that Beijing is now deadly serious in attempting to regain control over its rapidly growing economy in an effort to shift the focus from the quantity to the quality of growth. This is good news for China but could be disappointing for the decoupling camp that expects rapid Chinese economic growth to remain resistant to any downside pressures.

India is similarly positioned. The Reserve Bank of India does not take overheating and cyclical inflationary pressures lightly. I was actually in Mumbai the day the RBI tightened monetary policy last month (13 February), and it was clear to me in my discussions at the central bank that it meant business. The RBI’s official statement following that action said it all: “(A) determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion.” Our Indian economics team underscores the risk of another monetary tightening prior to the 24 April policy meeting. At the same time, the government’s annual budget contained measures that would cut tariffs on food and other price-sensitive manufactured products. Indian authorities are fixated on a mounting cyclical inflation problem and appear more than willing to take a haircut on economic growth to achieve such an objective. Our current economic forecast reflects just such an outcome – a downshift to 6.9% GDP growth in 2008 following average gains of 8.7% over the 2005-07 period.

There is a second factor at work that is also likely to challenge the view that hyper growth is here to stay in Asia – the region’s persistent reliance on external demand as a major driver of economic growth. This is less a story for India, with its relatively small trade sector, and more a story for the rest of Asia. China is at the top of the external vulnerability chain. Its export sector, which rose to nearly 37% of GDP in 2006, surged at a 41% y-o-y rate in the first two months of 2007. Moreover – and this is an absolutely critical point in the decoupling debate – the United States is China’s largest export market, accounting for 21% of RMB-based exports. As the US economy now slows, the biggest piece of China’s export dynamic is at risk. So, too, are the large external sectors of China’s pan-Asian supply chain – especially Taiwan, Korea, and even Japan. Lacking in self-sustaining support from private consumption, the Asian growth dynamic remains highly vulnerable to an external shock. That’s yet another important reason to be very suspicious of the case for global decoupling.

Decoupling and global rebalancing go hand in hand. A decoupled world is very much a rebalanced world – and vice versa. Recent trends admittedly lend some support to the decoupling thesis – especially a booming Asia economy but also a seemingly remarkable cyclical revival in Europe. The European upsurge is a welcome development, but perspective is key. At most, it will add 0.2 to 0.3 percentage point to our baseline case for world economic growth. Asia, especially China and India, is a very different story. This is a much larger segment of the global economy and is growing at rates that are three times as fast as those in the developed world. An Asian economy that only barely widens its growth multiple relative to the rest of the world could well drive global decoupling on its own.

That’s unlikely to be the case, in my view. Not only does Asia remain vulnerable to a US-centric external shock, but the region’s two most powerful growth stories – China and India – are now both very focused on matters of internal sustainability. The Premier of China has put his reputation on the line in attempting to bring an unstable, unbalanced, uncoordinated, and unsustainable Chinese economy under control. The Indian government is equally focused on an anti-inflationary policy tightening. Looking backward, both of these economies have been on an exceptionally strong growth path that – if left to its own devices – could play an increasingly important role in powering a decoupled world. Looking forward, however, it’s likely to be a very different story. With growth prospects in China and India tipping to the downside at the same time the US economy is slowing, the global economy is likely to be a good deal weaker than the decoupling crowd would lead you to believe.

The World Drops Its Guard: Stephen Roach

Global
February 26, 2007

By Stephen S. Roach | New York

A new level of complacency has set in. It’s not just a financial-market thing -- extremely tight spreads on risky assets and sharply reduced volatility in major equity and bond markets. It’s also an outgrowth of the increasingly cavalier attitude of policy makers. That’s true not only of central banks but also -- and this is a major concern of mine -- by the global authorities charged with managing the world financial architecture. Meanwhile, by flirting with the perils of protectionism, politicians are ignoring some of the most painfully important lessons from history. After four fat years, convictions are deep that nothing can derail a Teflon-like global economy. That’s the time to worry the most.

I am especially concerned about a new lax attitude that has crept into the mindset of the so-called stewards of globalization -- namely, the IMF and the broad collection of G-7 finance ministers. Last spring, in an uncharacteristically bullish lapse, I became more optimistic on the global economy than I had been in a long time (see my 1 May 2006 essay, “World on the Mend”). I was especially encouraged that the Wise Men had finally woken up to the perils of ever-mounting global imbalances -- namely, the widening disparity between America’s gaping current account deficit and large and growing surpluses in China, Japan, Germany, and the major oil producers. With great fanfare at the April 2006 G-7 and IMF meetings, institutional support was thrown behind a new framework of multilateral surveillance and consultation -- in my view, materially raising the odds of an orderly, or benign, rebalancing of an unbalanced world.

Unfortunately, the multilateral approach is now rapidly losing momentum. The first joint consultations between the US, Europe, Japan, China, and Saudi Arabia were held last summer, and there was a noticeable lack of “deliverables” following this effort. IMF Managing Director Rodrigo de Rato’s mid-November 2006 report on the “work program” of the Fund’s executive board was a further disappointment, relegating the problems of global imbalances to just one paragraph of a 49-paragraph document. And in the past few months, many of the individual participants at the various G-7 finance ministries and central banks have admitted privately to a lack of progress and conviction in the multilateral approach. With the global economy and world financial markets turning in yet another good year, suddenly, the urgency to act is now seen as less critical by the stewards of globalization. Complacency has claimed an important victim -- thereby undermining the major rationale for my bullish change of heart on the global prognosis.

Meanwhile, central banks -- basking in the warm glow of success on the inflation-targeting front -- are pouring more and more fuel on the global risk binge. America’s Federal Reserve seems to settling for a long winter’s nap -- likely to keep monetary policy on hold through at least the end of this year, according to our US team. While the Fed has expressed repeated concerns about last year’s minor upside breakout of inflation, it has also been quick to stress the coming deceleration on the price front. We could well be in the midst of a period like that which prevailed in the early 1990s, when the US central bank left the federal funds rate unchanged at 3% for a 17-month stretch from September 1992 to February 1994. Unfortunately, that experiment did not end well for the financial markets, as one of the Fed first “normalization campaigns” led to the worst year in modern bond market history.

An inflation-targeting Bank of Japan seems to be of a similar mindset. That’s mainly because of the distinct possibility of a minor deflationary relapse, with year-over-year comparisons in the CPI likely to move from being fractionally positive (+0.1% in January) to slightly negative by March. Moreover, with the economy still judged to be on shaky foundations -- especially the ever-cautious Japanese consumer -- political pressure on the BOJ to refrain from any policy action has been intense. After having succumbed to that pressure in January, Governor Toshihiko Fukui appears to have expended great political capital in orchestrating the BOJ’s second baby step away from its anti-deflationary ZIRP campaign. In the end, a one-party Japan has little tolerance for central bank independence -- especially in light of a still very fragile state of affairs on the inflation front. I suspect, as does our Japan team, that the mid-February policy adjustment will be the last move of the BOJ for a long time.

That leaves the European Central Bank as the only one of the three major central banks that is likely to make any type of a policy adjustment in 2007. Elga Bartsch, our resident ECB watcher, puts the upside at 50 basis points of rate hikes. This suggests that European monetary authorities -- the most dogmatic of the inflation targeters in central banking circles -- believe they are now only two policy moves away from their own normalization objectives in a still low-inflation world. This view, of course, is predicated on the belief that the European economy continues to surprise on the upside. Should that view be drawn into question for any reason -- hardly a trivial possibility in light of the recent increase in the German VAT tax, the lagged impacts of euro appreciation, and the ripple effects of Italian fiscal consolidation -- the risks to the ECB policy path could quickly tip to the downside.

There’s nothing wrong with this picture from a strict inflation-targeting perspective. But that’s just the point, in my view. At low levels of inflation -- and persistent risks of deflation in Japan -- inflation targeting produces an exceptionally low level of nominal interest rates. That, in turn, continues to fuel the great liquidity binge that underpins an extraordinary degree of risk taking still evident in world financial markets. Central banks have circled the wagons in taking an agnostic position on this state of affairs. As a former senior central banker put it to me indignantly the other day, “Who are we to judge the state of markets?” That’s indicative of what I believe is a very narrow perspective of the role and purpose of central banking. Most importantly, it relegates financial stability to a secondary consideration at precisely the time when financial globalization and innovation could be inherently destabilizing.

The orthodox view of modern-day central banking is premised on the belief that hitting the narrow target of CPI-based price stability is sufficient to address anything else that might come along. Never mind that this approach has produced a most unfortunate string of asset bubbles -- first equities, now property, and next those that may well be bubbling up to the surface in the form of a tightly correlated compression of spreads on a host of risky assets (i.e., emerging market debt and high-yield corporate credit). Never mind the explosion of worldwide derivatives, whose notional value has now reached some $440 trillion (OTC and listed, combined) -- over nine times the size of the global economy. Central bankers will tell you that the liquidity and risk-distribution benefits of derivatives far outweigh the lack of transparency and limited information they have on the incidence and concentration of counter-party risk. Never mind the power of the carry trade, which has been given a new lease on life by the politically-compromised Bank of Japan. Never mind the potential “canary in the coal mine” that may well be evident in America’s sub-prime mortgage market. All in all, increasingly complacent central banks are telling us that these concerns are not actionable issues for monetary policy. That could well be a blunder of tragic proportions.

A similar complacency is evident on the political front. As the pendulum of economic power in the developed world has swung from labor to capital, the pendulum of political power is now swinging from the right to the left -- not just in the US but also in France, Germany, Italy, Spain, Japan, and Australia (see my 8 January 2007 dispatch, “Power Shift”). As pro-labor politicians now move into action, trade protectionism is increasingly getting the nod as a legitimate policy response. Nowhere is this more evident than in Washington D.C. I have spent a good deal of time in the US capitol the past couple of weeks and sense that Congress’s anti-China sentiment is most assuredly intensifying. The new Democratically-controlled Congress is not in a rush -- its momentum on trade policy, in general, and China, in particular, is methodical yet increasingly contentious. I have taken the other side in the debate at several forums in Washington -- but to little or no avail. This takes complacency to an even more worrisome level. US politicians feel completely justified in ignoring some of the most painful lessons of history. And, ironically, the broad consensus of investors feels equally justified in ignoring the possibility of a protectionist outcome. Such an inconsistency is yet another example of a world in denial.

I’ve been relatively constructive on the global outlook over the past 10 months. The call didn’t work out all that badly -- the world economy turned in another great year and, after a brief bout of risk-aversion last May, the markets did fine as well. That was then. New and worrisome political forces are coming into play at precisely the time when the stewards of globalization have gone back into hibernation. Meanwhile, central banks are refusing to take away the proverbial punchbowl when the party is getting better and better -- instead, egging on the risk-takers when risky assets are priced for all but the absence of risk.

Enough is enough -- from where I sit, it no longer makes sense to maintain an optimistic prognosis of the world. This is more of a structural call than a cyclical view. I remain agnostic on the near-term outlook, and certainly concede that the Goldilocks-type mindset currently prevailing could put more froth into the markets. But complacency is building to dangerous levels — always one of the greatest pitfalls for financial markets. And yet that’s precisely the risk today, as investors, policymakers, and politicians all seem to have dropped their guard at the same point in time. The odds have shifted back toward a more bearish endgame. I have a gnawing feeling we’ll look back on the current period with great regret.

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.