J.T. ... although I agree with your short term forecast for a bullish move in equities, in the longer term (late summer through Thanksgiving), I believe that our friend, Stephen Roach of Morgan Stanley, continues to have the call correct ...
Ken Wilson
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May 13, 2002, Global: Breaking Vicious Circles
Stephen Roach (New York)
The seemingly endless virtuous circles of the 1990s are now but a distant memory. That’s especially true in the United States, where the economy once could do no wrong -- nor could its policy makers, the currency, its corporate champions, and, of course, its financial markets. The American consumer was delighted to go along for the ride, as was the rest of the world. US-centric global growth was an easy paradigm for all to embrace. Maybe too easy.
Yet those very virtues seem to have sown the seeds of their own demise. The American boom went to excess, as did its financial markets. Moreover, these imbalances spilled over into the broader global economy. That’s what America’s gaping current-account deficit is all about. As the US economy came to grips with a painful post-bubble shakeout, the rest of a US-centric world was quick to follow suit. It’s tempting to dismiss all of this as a temporary detour -- a cyclical shortfall from a still fundamentally sound macro climate. Yet the financial markets are telling us that more sinister forces may be at work.
The American magic that worked so well in the 1990s suddenly seems to have lost its appeal. There’s been plenty of good news recently -- strong economic growth (+5.8% in 1Q02), surging productivity (+8.6% in 1Q02), and positive earnings surprises (i.e., Cisco). But these seemingly encouraging developments haven’t really mattered in these days of funk. They have been increasingly viewed as transitory glimmers of a cyclical revival that may have little, if anything, to do with a much tougher secular climate that may be in the offing. It’s the specter of subpar secular returns that is finally starting to haunt investors.
Unfortunately, the logic of this interpretation is not that hard to fathom. Three forces appear to be at work, in my view. First, the benefits of disinflation have run their course. The unwinding of inflation provided a steady diet of interest rate relief that provided great sustenance for bond and stock markets. However, as disinflation has reached the hallowed ground of near-price stability, those benefits have dissipated. Moreover, if disinflation morphs into deflation, the macro could turn especially treacherous. Second, a significant shift has occurred in America’s fiscal discipline. The politics of fiscal austerity have been overrun by the noble and just war against global terrorism. That leaves the promise of open-ended Federal budgetary surpluses in tatters. The confluence of Bush Administration tax cuts, heightened spending on defense and homeland security, and weakened economic underpinnings to the revenue base has brought the budget deficit back into our macro lexicon. Third, no other economy in the world is stepping up to fill the void left by the United States.
In this context, what we have called the "search for growth" takes on even greater importance. Two possible outcomes come to mind -- the first being that the world is simply unable to come up with a new growth engine. In that case, the global economy would be facing a protracted period of subpar growth and the financial markets would have to come to grips with an era of subpar returns. Alternatively, a new source(s) of growth could be uncovered. With the industrial world likely to remain sluggish -- persistent stagnation in Japan accompanied by only a small improvement, at best, in Europe -- the search for growth is likely to become increasingly focused on the developing world. I continue to be most interested in China and India as candidates that might fill the void left by the US. But there will be no instant gratification on those fronts either. The developing world, in general, and China and India, in particular, must shift the mix of economic growth from external to domestic demand. Only then, can it assume more of leadership role in the world economy. Yet that transformation takes time -- and plenty of it.
So what does it take to break this vicious circle? The depreciation of an overvalued US dollar is at the top of my list. That may seem contradictory. After all, it was the strong dollar that many believe was key to the virtuous circle of the late 1990s -- attracting a seemingly never-ending stream of foreign capital inflows into dollar-denominated assets. But the strong dollar is now a relic of an era that no longer exists. It is America’s last bubble. The equity bubble has popped, as has the IT bubble in the real economy. But the dollar -- at least until recently -- has barely flinched. This has created an unfortunate twist in the macro performance of the US economy that has become central to a new vicious circle.
A strong dollar has now emerged as a major deflationary risk in an increasingly open US economy. It has been key in pushing US import prices down in an increasingly sluggish global economy. Total goods import prices, as measured in the national income accounts, are down 7.7% over the past five quarters. Yes, volatility in energy prices has distorted this comparison. But non-petroleum import prices are off 4.6% from their peak in the first quarter of 2001. While the monthly Labor Department data reveal a fractional sequential firming of non-petroleum import prices in March (+0.1%) and April (+0.4%), year-over-year comparisons for such prices are still running 3.3% below those of April 2001. Imported deflation is especially severe for non-petroleum industrials supplies and materials (-9.0% y-o-y through April), with paper products (-16.6%) leading the way; moreover, import prices are still declining for capital goods (-2.8%) and non-auto consumer goods (-1.4%). Agriculture (+2.0%) and motor vehicles (-0.1%) are the only major import product categories where deflation seems to have been largely arrested.
The increased "openness" of the US economy compounds the damage brought about by the ongoing deflation of import prices. As of 1Q02, goods imports accounted for fully 30% of goods GDP -- double the import penetration of the mid-1970s. With low-cost foreign producers now price-setters at the margin for an increasingly large portion of goods sold in the United States, the risk of outright deflation must be taken seriously. That’s all the more evident in light of a 0.35% average annualized inflation rate for the GDP price index over the past two quarters -- a 48-year low. With this broad measure of US inflation currently within a hair’s breath of outright deflation, the last thing America needs is another negative price shock brought about by a further strengthening of the dollar.
In my mind, it is Corporate America’s inability to exercise any pricing leverage that may well hold the key to the new vicious circle that is now gripping the US economy. In a no-pricing-leverage world, any cost pressures put the squeeze on profit margins and earnings. All too frequent gyrations in energy prices, ever-rising health care costs, and the "anti-terrorism tax" are particularly worrisome in that regard. As a result, ongoing cost cutting is necessary in order to bring aggregate supply in better alignment with the still weakened state of aggregate demand. Once better balance is achieved, then pricing leverage can be exercised with greater confidence. But there is a dark side to this fixation on cost cutting. If taken too far, it can lead to increasingly "hollower" companies that will be unable to sustain their market shares around the world. And, of course, the unflinching focus on cost-cutting makes businesses reluctant to add new costs by stepping up to rehire and boost capital spending budgets -- thereby denying the US economy much of its classic cyclical sustenance.
A weaker dollar could go along way in breaking this vicious circle. Most importantly, it would undoubtedly boost US import prices, thereby eliminating one of the most lethal deflationary forces still bearing down on the US economy. That would enable Corporate America to exercise pricing leverage without fearing immediate loss of market share. As a result, US businesses would be less reluctant to rehire and boost capital spending, thereby providing the business cycle with more leeway on the upside than it has at present. A weaker dollar could thus be the functional equivalent of a further round of Fed easing -- a welcome alternative for a central bank that has all but run out of basis points.
A weaker dollar, of course, would not be viewed with open arms by the rest of the world. It would crimp exports to the US, effectively closing off one of the key avenues of cyclical recovery to Asia, Europe, and the broader global economy. As such, it would help force a vital and long-overdue transformation on the rest of the world -- leaving once externally-led economies with little option other than to uncover new sources of economic growth. That would obviously put the onus on domestic demand -- something that has been missing from the non-US world for most of the past decade. Of course, it won’t be easy to stimulate domestic demand in the broader global economy -- it will require a heavy dose of reform and restructuring along the way. And there may well be some adverse macro consequences stemming from these initiatives. But, ultimately, it’s the only way out, in my view.
In the end, that could well be the real silver lining of a weaker dollar. It would force the rest of the world to wean itself from the United States by developing new autonomous sources of aggregate demand. Those benefits will obviously not occur overnight. But in the meantime, a dollar-assisted turnaround of imported deflation could go a long way in saving the US from outright deflation and in providing Corporate America with far greater opportunity to exercise pricing leverage. Only under those circumstances, in my view, can Corporate America be expected to step up and lead an economic recovery. Just as it was when the dollar started to tumble in the mid-1980s, a replay of such a development could well mark the onset of a new virtuous circle for world financial markets. Stranger things have happened.
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