The latest views of Morgan Stanley Economists - The Global Economics Team - Apr 16, 2001
Global: False Dawn - Stephen Roach (New York)
Investors are saying "Enough, already." After nearly a 70% plunge in the Nasdaq, a 32% drop in the Wilshire 5000, and a 28% decline in the global (ex US) ACWI index, cash-rich investors are champing at the bit. They want to believe the worst is over. Last week, the markets offered a tantalizing hint of just such a possibility: Global equity markets have now run up about 7% from their 4 April lows, commodity prices are showing signs of bottoming, and bonds have corrected in response. Well-trained but battered dip-buyers know what to do. They just need to be convinced that the firestorm has blown itself out.
To the extent that financial markets have any connection to economic fundamentals, I fear investors are looking at a false dawn. In the U- or L-shaped world I envision, a classic vigorous recovery is just not around the corner. Instead, economic growth in the United States and elsewhere around the world is more likely to be entering a protracted period of sluggishness, characterized by the fits and starts of shallow and brief recessions, punctuated by decidedly anemic recoveries. Investors betting on more of a V-shaped rebound -- and that certainly seems to be the collective mindset for consensus expectations of 2002 -- are likely to be disappointed. In my view, risks to the underlying macro trajectory -- GDP growth, earnings, and inflation -- remain skewed decidedly to the downside.
That’s certainly the case in our baseline view of the world economy. Our latest iteration finds us slicing another 0.1 percentage point off world GDP growth for both 2001 (to 2.6% from 2.7%) and 2002 (to 4.1% from 4.2%). The most recent cut to this year’s numbers stems from a reduction in our growth prognosis for Emerging Europe to 1.7% (from 2.4%); this reflects a crisis-induced –7.2% collapse in Turkey -- double the decline we had previously been projecting. Our latest cut to next year’s forecast largely reflects yet another nod in the direction of a U-shaped outcome for the United States -- following on Dick Berner’s previously announced reduction of projected 2002 growth to 3.1% (from 3.5%).
Sure, these cuts amount to only "another tenth" for this year and next. But, after a while, they start to add up. Our 2001 estimate for world GDP growth now stands at 2.6% -- 0.9 percentage point below our forecast at the start of this year and within a rounding error of the 2.5% threshold typically associated with global recession. I have long been on record arguing that, when the dust settles, our global growth scenario will have breached this barrier. For all practical purposes, we are now just about there. Similarly, I believe that we have just begun the long march downward in our 2002 global growth prognosis. I am also on record in placing the downside to next year’s global growth forecast in the 3.0–3.5% range, and I stand by that view.
If these downside risks continue to play out as I suspect, there’s nothing but disappointment in the cards for investors who want to make the ever-alluring V-shaped bet. Our current estimate of 2.6% global growth for 2001 is already 1.1 percentage points below the 30-year 3.7% trendline for the world economy. Yes, the world should do somewhat better next year than this year. But the lower
bound of the range noted above (3.0%) would still represent a shortfall of another 0.7 percentage point from trend, and the upper bound (3.5%) would basically represent nothing more than a return to trend. In either case, the world economy would not recoup this year’s shortfall from trend. Even if we don’t cut our current global 2002 baseline forecast of 4.1% growth in world GDP growth any further -- a low likelihood, in my view -- we will have recouped only about 35% of this year’s below-trend shortfall. That’s what
U-shaped recoveries are all about.
Nowhere is this more apparent than in our prognosis for the US economy. Month after month, as Dick Berner tinkers with the numbers, he ends up with more of a U-shaped outcome than he originally envisioned. His latest forecast change of week ago is a case in point -- leaving his near-term call
essentially unchanged but slicing 0.4 percentage point off the 2002 GDP forecast. If anything, I suspect, Dick’s latest take on 2002 may still turn out to be too optimistic. As the corporate earnings recession deepens and businesses cut costs in response, layoffs can only rise. That should put the Teflon-like American consumer under increased pressure: Encumbered by a negative saving rate, record debt loads, and a post-bubble hole in his/her balance sheet, the coming squeeze from the income effect brought about by rising unemployment points to a consumer that is destined for capitulation. Add to that the aftershocks from America’s IT-induced capacity overhang and its massive current-account deficit, and I think the US economy will be lucky to escape
with a U. At a minimum, the lags point to plenty of downside in the pipeline -- very much at odds with newfound recovery hopes now percolating in financial markets.
Our Euro team is reluctantly coming to a similar conclusion. Both Eric Chaney and Joachim Fels are increasingly disappointed over the ECB’s steadfast resistance to easing monetary policy in a sharply deteriorating global climate. The European monetary authorities are making two errors, in our view. The first is in failing to appreciate rising global risks. Needless to say, our forecast draws the first
assumption into question. A second mistake is the ECB’s insistence that any such risks would have a limited impact on Euroland activity. With exports more than 15% of pan-regional GDP -- making Euroland more open than the US or Japan -- and European multinationals heavily exposed to US
markets through balance sheet linkages, Europe can hardly be thought of as a haven in an increasingly shaky world. With the Euro manufacturing sector already on the brink of recession and pan-regional consumption now starting to slow, our Euro team fears that ECB intransigence could lead to
heightened risks of deflation in 2002 -- underscoring the
downside risks to our 3.3% Euroland growth forecast for next year.
The Japanese economy remains an enigma. Sadly, there’s nothing all that new about the country’s latest recessionary relapse. But what is new is that it is unfolding at precisely the moment when the US economy is on the cusp of renewed recession. That means that 30% of the global economy (as measured on a purchasing-power-parity basis) is either back in recession or on the brink of one. In light of Japan’s mounting political turmoil, little clarity on macro policies of demand management and/or structural reforms can be expected for quite some time -- all the more the case ahead of the 29 July Upper House elections and the likelihood of a general election in the autumn. Lacking in reflationary firepower and facing the ongoing rigidities of a deeply entrenched social contract, Robert Feldman fears Japan will continue to hold to the L-shaped trajectory of stagnation through 2002. That keeps the yen wildcard center stage as an Asian risk factor -- yet another deflationary pothole for the global economy.
Nor can non-Japan Asia be expected to provide an autonomous source of growth for the global economy. In fact, given the region’s lack of reforms and limited support from domestic demand, its IT-related export linkages to a faltering US economy only heighten the downside for Asia. Andy Xie has
stressed that the American consumer remains the linchpin of the pan-regional outlook. If that’s the case -- and I suspect it is -- then watch out below. Our concerns, noted above, about faltering US consumption could spell serious
trouble in East Asia. Korean GDP growth has already slipped into negative territory, and signs of weakness are increasingly evident in Taiwan, Singapore, Hong Kong, Malaysia, Indonesia, and Thailand. Only China remains a source of resilience in this region. But the risk is that may not be enough to prevent a significant downgrade to our forecast of a 6.6% increase in non-Japan Asian GDP in 2002.
Finally, there are ominous signs brewing elsewhere in the Americas. NAFTA linkages are just starting to have repercussions in Canada and Mexico, with production in both countries falling sharply in the early months of 2001. With US exports amounting to 32% of Canadian GDP and 25% of
Mexican GDP, it’s hard to envision how the sharp compression in US demand won’t put a significant squeeze on income generation and consumption in both countries. Elsewhere in Latin America, Argentina -- the third-largest economy in the region -- remains on crisis alert. Recent history is not
comforting insofar as output losses for crisis economies are concerned. That underscores the downside to our 2.5% growth forecast for Argentina over the 2001-02 period, as well as the potential for collateral damage to Brazil, Argentina’s largest trading partner and the biggest economy in Latin
America.
All this paints a very different picture of the global economy than dip-hungry investors want to see. At best, I see the world now entering the flattish portion of the U. It’s the beginning, not the end of an extended period of sluggishness for the US-led global business cycle. To the extent financial markets now rally in hope that the worst is over, more disappointment is likely in the months ahead. This looks like a false dawn.
United States: April May Be the Cruelest Month for the American Consumer - Richard Berner (New York)
Resilient consumer demand has been the brightest light in an otherwise dreary winter economic landscape, keeping the
economy out of recession. Real consumer outlays in the first quarter grew at a 3–3 1/2% pace as sales of discretionary big-ticket durables such as cars and trucks and electronic gear, and of nonessential nondurables such as dining out and clothing, more than held their own. But in my view, time is
running out on the seemingly unflappable American consumer. Among the reasons: Job and income growth is slowing dramatically, Uncle Sam's tax bite is getting bigger, energy prices are poised to rebound, and balance sheets are eroding.
In a nutshell, I believe retrenchment lies ahead. Here's why.
Most important, the foundations of income and job growth are becoming increasingly shaky. "Core" real wage and salary
income growth has slowed to just 2% at an annual rate, and further deceleration is likely. Job gains turned into losses in March, and the rising level of jobless claims hints that further slippage lies ahead. In addition, real wage growth slid below 1% annualized in the first quarter from 2.8% in the fall, as earnings growth faded and headline inflation (measured by the personal consumption price index) jumped. The prognosis is no brighter here. A sinking stock market isn't just trimming perceptions of wealth. It has left many stock options worthless, depriving some consumers of cash from their exercise. We won't know for a couple of years just how large that source of discretionary income recently
has become, but it's hard to imagine that the mother of all bull markets did not spawn a huge surge in spendable cash for more than just top management.
Moreover, April may be especially cruel for taxpayers, as surging tax payments sap spendable income. Dave Greenlaw
estimates that April 2001 tax payments may rise by 15% from a year ago as final settlements on last year's capital gains, options income, and mutual fund distributions come due. In addition, Ted Wieseman notes that as of March 23, tax refunds this year are running 1.7% behind 2000's tally (see "Tax Time," and "More Tax Time," both in Inside the US Economy, April 10, 2001). In all, final payments could be some $20 billion higher this year than in 2000, trimming about 0.3% from disposable income.
Rebounding energy quotes will also probably drain discretionary spending power. California's energy woes are the most visible sign that further trouble lies ahead (see "California: No Longer Dreaming," Global Economic Forum, April 12, 2001), but energy prices seem likely to rise again on a nationwide basis. Last year's surging natural gas prices failed to call forth significant supply increases, as it takes more than a year for new exploration to bear fruit.
A hot summer would likely strain electricity generation and
thus natural gas supplies, pushing prices back up. Gasoline inventories are below last year's levels, and the second summer of Phase II regulations for reformulated gasoline is likely to hike prices up at least to last year's levels, or 17% over April's trough. Wholesale gasoline quotes are already up 7% in the past two weeks.
Adding to the pain, the wealth effect likely will finally work in reverse. While stock prices (measured by the Wilshire 5000) have rebounded some 8% from their early-April lows, broad price gauges are still below levels of two years ago, 20% off their peaks in early 2000, and 10% below their levels at the beginning of the year. Prices would have to rally significantly and for a while to undo this damage. So why hasn't this damage to balance sheets yet created more consumer caution? First, the duration as well as the
magnitude of a slide in equity values is important in gauging the impact. Fed research hints that the bull market's persistence and record-setting gains may have stretched out the traditional lags between changes in wealth and changes in spending, but that the connection is robust (see "A Primer on the Economics and Time Series Econometrics of Wealth Effects," Morris A. Davis and Michael G. Palumbo, Finance and Economics Discussion Series Paper 2001-09, Federal Reserve Board, Washington, DC). Second, the 8.1% rise in home prices has cushioned the blow to household balance sheets from the loss in equity values. For the average consumer, the equity in his or her home is a more important asset than equity portfolios, and is potent
collateral (see "On Borrowed Time," Inside the U.S. Economy, April 10, 2001). Yet home prices are unlikely to rise as they did in 2000; indeed, there are anecdotal reports that the housing boom is turning to bust in some metropolitan areas.
Until now, ample credit availability has enabled consumers to escape these harsh fundamentals. Indeed, the recent spending spree has all the classic earmarks of "lifestyle defense." That is, fundamentals are eroding, but consumers borrow or slow repayment of debt to avoid cutting back from past spending norms. Soaring consumer credit and home equity loans testify to consumers' willingness to finance spending with debt; the former jumping at an 11.5% rate in January and February, and the latter at a 15.5% clip at commercial banks in the period between December 31 and April 4. However, lenders may now balk at supporting these habits, as consumer credit quality is beginning to erode. Charge-offs on consumer loans at commercial banks jumped by 40 basis points in the second half of 2000, and Morgan Stanley specialty finance analyst Ken Posner notes that consumer bankruptcies recently soared by 37% over the past year. A jump was expected following the mooting of more stringent bankruptcy laws, but this level is double the expected surge in filings.
Small wonder that consumer anxiety about the economy and personal finances edged higher in early April. Confidence
measured by the University of Michigan index fell by nearly four points, and consumers' appraisal of current conditions fell to levels last seen in November 1993. Favorable attitudes toward buying the big-ticket durables on which consumers binged in the first quarter fell to their lowest level in eight years. There's little doubt in our mind that a pullback in such durable outlays will quickly contribute to weaker spending. But big-ticket durables aren't the only spending category at risk. Retrenchment in some major discretionary services outlays also seems likely. Recreation outlays, including amusements, cable TV, and Internet access, which accounted for 11% of the nominal growth in services spending last year, may well see a pullback. And purchases of brokerage and other financial services are
already showing vulnerability. Both are much more cyclical than commonly assumed.
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