... it is a beautiful day here in coastal New England, the Penn State men made it to the sweet sixteen, and it is St Joseph's Day, also the day the swallows return to Capistrano (usually) and my 56th birthday - hot damn. Ken Wilson
... hot off the press (by special request for JDN -although I have not read the articles yet) ... The latest views of Morgan Stanley Dean Witter Economists - Mar 19, 2001
United States: Can the Market Force the Fed's Hand? - David Greenlaw (New York)
The Fed meets on Tuesday to map out the near-term course of monetary policy. The latest signals from policymakers -- Greenspan at Humphrey-Hawkins and many of his colleagues since -- suggest that they see some downside risks in the overall economy but that there is no need to panic. However, the financial markets appear to be in full-fledged panic mode at the present time. The broad stock market has fallen more than 12% in just the past month. Meanwhile, two-year Treasury note yields have dipped below 4 1/4% and, at one point on Friday morning, the federal funds futures market appeared to be pricing in a March 20 easing move of slightly more than 75 bp.
From the Federal Reserve's standpoint, the economy is in the midst of bursting a Nasdaq bubble and is working its way through a typical inventory correction. Moreover, the Fed believes that it has already taken significant action and is willing to do more. But a move -- in either direction -- of more than 50 bp is extremely rare during the Greenspan era. Clearly, such action is only prompted by extraordinary circumstances. Is the current situation sufficiently dire? From our standpoint, perhaps it is, but remember that we have the lowest forecast for 2001 GDP growth of any of the 51 organizations surveyed by the Blue Chip organization. And the Fed's views seem more in sync with the consensus opinion that the US economy faces a lot of potential risks but is still pretty much on track for a soft landing -- especially considering that tax cuts are likely to be triggered at some point down the road.
The Fed is justified in claiming that its actions to this point (including a presumed 50-bp move on Tuesday) are
significant. We have compared the average movement in the funds rate during the past five recessions -- stretching back to 1960 -- for the 24 months around the onset of recession (12 months prior to the peak and 12 months following the peak) with the recent behavior of the funds rate. If we assume the Fed cuts the funds rate by 50 bp on Tuesday and then leaves the rate unchanged in April (when there is no meeting), the amount of easing - expressed in ratio terms -- would be greater than that typically seen during the early stages of recession. So, even if they just cut rates by 50 bp on Tuesday, the Fed policy response has been significant from a historical standpoint.
The bottom line is that we continue to lean toward a 50-bp rate cut at the March 20 meeting. Obviously, such an outcome would come as a disappointment to the markets. However, the Fed might try to cushion the blow by maintaining a risk assessment tilted toward concern about economic weakness and indicating that it is prepared to do more if there is a clear-cut sign that equity market woes are spilling over to the real economy. Obviously, Greenspan & Co. did not get such a sign in Friday's consumer confidence report. To be sure, the FOMC prefers to move only at regular meetings. But there is a historical precedent (1994) for taking action during the unusually long gap between the March and May gatherings. The Fed may resist being coerced by the markets, but it certainly is willing to react to economic developments. If a trigger materializes, an inter-meeting move might soon follow.
Global: A Post-Bubble World - Stephen Roach (New York)
In focusing on the stock market, it is easy to lose sight of the most important feedback loop of all -- the wealth effect and its critical implications for the real economy. This linkage offers the most worrisome conclusion of all -- that America’s equity bubble had its counterpart in the real economy, leading to unsustainable and dangerous distortions in both consumer and business decision-making. Moreover, to the extent that the global economy had become hooked on the bubble-like leadership of the US economy, the world itself may now be in a very precarious position. In a post-bubble climate, the negative feedback loop from wealth destruction to the real economy could unleash a powerful -- and painful -- purging of long-simmering excesses. It pays to begin pondering how that purging may, in fact, unfold.
In my view, there can be no mistaking the wealth-induced excesses of the American consumer. With heady rates of stock market appreciation viewed as a sure thing, all caution was thrown to the wind. Since late 1994, when the stock market began its unprecedented five-year blowout, real consumption growth (4.4%) has outstripped real income growth (3.3%) by about one percentage point per annum. Consumers, in effect, viewed equity appreciation as a permanent source of saving -- using it as collateral to finance record levels of indebtedness. In response, the personal saving rate -- no matter how it is measured -- plunged like a stone. On a national-income-accounts basis -- with saving estimated as the "residual" between income and consumption -- it stood at –1.0% in January 2001, down 7.6 percentage points from its November 1994 high to a rate not seen since 1933. On a Federal Reserve flow-of-funds basis -- with saving estimated more directly from asset deposits data -- the rate fell to a record low of +0.5% in 2000, down 5.5 percentage points from the 6.1% pre-bubble reading of 1994. Lacking in saving and loaded to the hilt in debt, the modern-day American consumer has never gone to such excess. In a post-bubble world, those excesses will need to be purged. Unfortunately, the same can be said for Corporate America.
The equity bubble also convinced businesses that a new era of technology-led productivity enhancement was at hand. Corporate managers followed the lead of consumers and also threw caution to the wind. Scope and scale were everything in the brave New Economy. Hiring surged and IT-led capital spending matched its all-time high of 13.9% of GDP in 3Q00, underscoring a classic late-cycle build-up of excess capacity. But something unexpected happened along the way -- a high-growth US economy transitioned to low growth, and a severe earnings recession ensued. Suddenly, the bloat of open-ended hiring and IT spending had to be pruned -- setting in motion a powerful wave of cost cutting, whose lags are only just beginning to kick in. In a shareholder value culture, there is no tolerance for bubble-related corporate excesses. They, too, will have to be purged, in my view.
In an era of globalization, America’s excesses were also exported overseas. An increasingly sophisticated IT supply chain provided great cover for non-Japan Asia, allowing it to drop the ball on post-crisis reforms following the 1997-98 debacle. NAFTA linkages provided an equally powerful lift to Canada and Mexico. The resulting surge of global trade -- expanding by a record 12.4% in 2000, according to our estimates -- lifted Europe and Japan as well. A bubble-driven United States was the engine of the global economy over the past several years; our estimates suggest that the US directly accounted for nearly 30% of total world GDP growth since 1994 and close to 40% if the indirect effects of trade linkages are added in. Reflecting the imbalances of this brave new world, the US current-account deficit widened to a record 4.5% of GDP -- leaving America more dependent than ever on foreign financing of its investment bubble. In a post-bubble world, an unwinding of current-account adjustments could put
considerable pressure on US external financing. The global movie of the late 1990s would then start to run in reverse.
How brave will this post-bubble world be? I look for three key macro forces to now be unleashed -- a resumption of
wage-based saving by American consumers, a significant pruning of corporate IT spending, and a diminution of the US-driven impetus to global growth. In these respects, there is a certain symmetry to the post-bubble world -- an unwinding of the same imbalances that took the real economy to excess. As I have stressed repeatedly, however, there is good reason to believe that there may well be a dangerous asymmetry to post-bubble macro responses -- especially the saving imperatives of the American consumer (see my 14 March 2001 dispatch, "Remember Amos Tvesrky!"). Needless to say, to the extent that the downside of the post-bubble world is more extreme than the upside was, the coming shakeout will be all the more wrenching.
I am always asked, Is there a way out? The question itself presupposes the "easiest" answer -- re-inflating the equity bubble. Of course, that’s hardly a way out -- it merely postpones, and compounds, the inevitable crash. Unfortunately, history demonstrates with painful clarity that there is no quick fix for a post-bubble economy. And so the day of reckoning could now be at hand. Like it or not, the bubble in the second half of the 1990s left the US economy overly dependent on the permanence of double-digit equity returns. A reversion to the historical mean of single-digit returns will be a serious shock to a high-performance US economy -- and to the global linkages that it has spawned. In a classic income-induced recession, policy stimulus has always been the answer -- and one that has worked. But this recession is all about the excesses of capital gearing -- for consumers and businesses alike. Lower interest rates and tax bills won’t change the imperatives of the balance-sheet adjustments that now lie ahead. Try as they might to deploy the standard reflationary medicine of monetary and fiscal stimulus, the authorities could well find themselves in the uncomfortably Japanese-like position of pushing on the proverbial string.
In an era of wealth destruction, I have argued that the modern-day, inflation-driven business cycle does not hold the
answer for what lies ahead. Instead, the more relevant precedent can be found in the cycles of the late 1800s and early 1900s -- those dominated more by asset bubbles and boom-bust fluctuations in capital accumulation (see my 28 February 2001 dispatch, "Tales of a Different Business Cycle"). These older cycles tended to culminate in longer contractions and then be followed by shallower upturns than the cycles we have all gotten accustomed to over the past 50 years. The lesson of the old cycles is that a purging of financial excesses -- and the related excesses of capital gearing -- takes a good deal more time than a garden-variety recession on the income side of the macro equation.
I fully realize that this endgame is being met with a chorus of denial. Dip buyers still stand ready to pounce on a market that has finally made a real bottom. "Don’t fight the Fed," is the hope and conviction that most still share. Unfortunately, all that presumes that the basic fabric of the greatest bull market of our lifetime remains intact. That’s precisely the problem. Now that the equity bubble has popped, it’s time to come to grips with the painful aftershocks in the real economy. In a post-bubble US economy, there’s no way to avoid a purging of the excesses that have built up over the past six years. The same is true of the global economy at large. Much of what was widely thought to be so permanent about the New Economy could be turned inside out. That leaves us with the most haunting question of all: How could we have let this happen?
United States: The Dark Side of Just-in-Time - Richard Berner (New York)
Mainstream thinking continues to focus on an inventory correction as the main source of the U.S. economic slowdown. To be sure, according to this view, final demand has decelerated, but only to a soft-landing pace of 2–3%. As soon as companies eliminate the inventory overhang, the economy will rebound. The auto industry is a case in point: Analysts believe that the combination of stronger-than-expected vehicle demand and aggressive production cuts have already aligned inventories with sales, and Detroit's announcements of stepped-up spring production plans fit nicely into that scenario. Many, in fact, expect that the second-quarter upswing in motor vehicle output will swamp any weakness elsewhere and that the "R-word" really stands for rebound, not recession. So why do we continue to insist that our recession call is on track?
In our view, demand, not inventories, is the issue. While there's no denying that consumer and housing demand have held up better than we expected, the fundamentals are deteriorating and will soon translate into weaker spending. We believe that the consumer is living on borrowed time, and that capital spending is poised to decline further (see my dispatches "On Borrowed Time," 12 March 2001, and "The IT Crash: How Big? How Long?", 26 February 2001). For consumers, real income gains continue to decelerate and real wealth is now declining. "Core" consumer income -- real wages and salaries -- is what really matters for consumer spending, and by June, we estimate that real wage and salary growth will fall to 2%. Real household net worth declined by 4.2% over the past year (using the price index for personal consumption expenditures to calculate the dip), and our forecast assumes that real net worth will slide a further 5% or so this year before bottoming -- a trend that already looks well under way. Five factors add up to negatives for capital spending, especially in technology: The "payback" from an IT boom, pressure on corporate profits, still-restrictive financial conditions, sagging operating rates, and the "reverse accelerator" of slower growth. Consequently, we believe that demand likely will weaken further and companies will continue aggressively to trim production to shed inventories.
Yet that production response often shapes the cyclical dynamics of recession. Reductions in worker hours, smaller pay gains, and ultimately layoffs typically accompany aggressive production cuts, and some of that has begun in manufacturing. Optimists, however, believe that New-Economy, just-in-time (JIT) inventory management techniques will make for faster, thus smaller and less painful, inventory adjustments. Indeed, they believe that the cuts ended in February with another sizable decline in industrial output. While we agree that such adjustments likely are unfolding faster than in the past, courtesy of the IT revolution, two factors may paradoxically mean that inventory adjustments today are more painful than those in the past.
One factor is adjustment speed itself. It used to be that if demand weakened, the shock would be spread over several months as a slow inventory adjustment buffered the impact on output. Today, the transmission time is shorter and likely more abrupt. As a result, a deceleration in output now translates into a more-rapid production response, and the plunge in industrial output has compressed a more-prolonged adjustment into a somewhat shorter period. While that gets the adjustment out of the way faster, the "reverse accelerator" impact of the more-rapid production decline also crowds the pressure on profits, operating rates, and pricing into a shorter time frame -- all of which are negatives for capital spending (see my 15 February 2001 dispatch, "Will Just-in-Time Speed the Economic Rebound?"). Pricing and capital spending adjustments may still be sticky, in that managers may wait to see whether the downturn is a short-lived affair before pulling the plug. Those lags are precisely why IT spending has held up as well as it has so far, but also why there's likely more weakness ahead.
Falling prices, especially in information technology, may also make inventory adjustments today more painful than in the past. If prices are rising fast enough, companies may be willing to hold inventories because the "cost of carry" -- a financing rate less the price increase -- is minimal. But if prices of the goods going into inventory are falling, making any inventory obsolete, there are strong incentives to dump unwanted stocks quickly. Indeed, the real cost of carry for technology companies, even after the Fed's aggressive easing moves, remains at prohibitive levels.
Nowhere is that more evident than in the technology supply chain, especially in the electronics manufacturing services (EMS) segment. Spawned from the drive to outsource manufacturing, the EMS companies procure, manufacture, and distribute products for all the major technology OEMs, so they live and breathe JIT every day. Nevertheless, the deceleration in IT demand produced a pileup in unwanted inventory at these companies by the end of the fourth quarter that reached record levels. Their business arrangements mean that falling prices won't hurt their bottom line; instead, the technology component producers and hardware assemblers will eat the loss. Judging by the recent torrent of negative preannouncements from those companies and their unwillingness to forecast a bottom, the inventory correction is far from over, in our view, and more production cuts and pressure on margins from lower prices lie ahead.
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