Dreamcatchers
Stephen Roach (New York)
Morgan Stanley
Apr 21, 2003
The dream merchants are hard at work peddling the tale of another
economic revival. The magic of postwar relief is widely billed as the
catalyst. A veil of uncertainty will be lifted — so goes the argument
— prompting businesses and consumers, alike, to unleash the animal
spirits of pent-up demand. Just as America led the charge to
Baghdad, the US economy is now presumed to lead the way to
global recovery. Prewar malaise will give way to postwar healing,
and presto — world financial markets will unwind many of the
trades that have been in place for the past six months. Just like that.
To me, this is a leap of faith of Herculean proportions. While I
certainly concede it is possible to get from Point A to Point B, I am
hard-pressed to believe that the path will be seamless or expeditious.
As I see it, there are five myths to the recovery call of 2003, each of
which draws the postwar healing scenario into serious question:
First and foremost, is the myth of another US-led recovery in a
lopsided global economy. I fully realize that’s precisely the way it’s
been for so long, that most now take this American-centric growth
dynamic for granted. Yet global imbalances have now reached the
point where another burst of US-led growth would be inherently
destabilizing. Reflecting a US economy that accounted for fully 64%
of the cumulative increase in world GDP over the 1995 to 2001
interval, the US current-account deficit hit a record $548 billion in the
final period of 2002, or 5.2% of GDP. If the world stays the path of
its US-centric growth dynamic and if America’s federal budget goes
deeper into deficit, as certainly seems likely, the US current-account
deficit could easily surge toward 7% of GDP. These are external
imbalances that the global economy has never before had to face, let
alone finance. Yet the postwar healing scenario presumes that
massive and ever-widening external imbalances don’t matter at all
— and that they can be easily financed at current exchange rates
and other relative asset prices. I don’t buy that. The only way out of
this trap, in my view, is for a long overdue global rebalancing — less
growth in the United States and more growth elsewhere around the
world. Unfortunately, there are no signs that such a rebalancing is in
the cards.
The notion of a capex-led recovery in the United States is a second
myth of the global healing scenario. I don’t doubt for a moment that
balance sheet repair is well advanced for Corporate America. What
I have a problem with is the belief that such progress will spark an
imminent revival in business capital spending (see my 5 March
dispatch, “Capital Spending Myths”). There are three serious flaws
to this argument, in my view: First, most US businesses are still
lacking in pricing leverage. That means, reflective of a world awash
in excess capacity, the risks are still biased more toward deflation
than inflation. In keeping with this depiction, the capacity utilization
rate for US manufacturers fell to 72.9% in March 2003 — more
than seven percentage points below the 30-year average of 80.2%
recorded over the 1972 to 2002 interval. A capex-led revival would
only exacerbate this overhang of excess supply — the last thing a
deflation-prone world needs. Second, history tells us that capital
spending never leads a US cyclical recovery — it responds to
perceived improvements in end-market demands, mainly for
consumers. Such demand visibility is not exactly evident these days.
Third, since information technology now accounts for fully 55% of
total real spending on US capital equipment, many hold the view that
long-deferred IT upgrades will spark a capex-led recovery. This
overlooks the enormous consolidation occurring in the IT user
community, suggesting that there will be fewer buyers if and when
the IT replacement cycle turns. The notion of an IT-led upsurge also
sweeps away one of the most painful remnants of the
bubble-induced excesses of the late 1990s. All in all, I suspect that
Corporate America will remain quite cautious in committing to a new
wave of IT projects.
A third myth of recovery is that America has fixed its saving
problem, thereby removing one of the key impediments to sustained
economic revival. Nothing could be further from the truth. Sure, the
US personal saving rate has now moved up to 4.0% — well off the
rock-bottom level of 0.3% hit in October 2001 but still only about half
the 9.0 % pre-bubble average that prevailed over the 1970–94
interval. But that’s beside the basic point. The modest rebound in
personal saving has been funded by a massive reversal in the
government’s saving position, as the federal government’s budget
has swung from a surplus of 2.3% of GDP in early 2000 to a deficit
of 2.3% in late 2002. As seen though the lens of the national saving
rate — the combined saving of households, businesses, and the
government sector — the United States is in terrible shape.
America’s net national saving rate — which also subtracts the
depreciation charges associated with the replacement of worn-out
capital — fell to an all-time low of 1.3% in the second half of 2002;
by way of comparison, this same metric averaged about 5% in the
1990s and considerably higher in recent years. This is a proxy for the
domestically-generated saving left over to fund investment, the
sustenance of any economy’s longer-term economic growth
potential. Lacking in such domestically-generated saving, America
has no choice other than to import surplus saving from abroad and
run a massive current account deficit in order to attract such capital.
But that’s not all. As the US federal budget now plunges far deeper
into deficit — reflecting the combined impacts of a weak economy,
war and postwar spending commitments, and ill-timed multi-year tax
cuts — America’s net national saving can fall only further. Another
myth of the global healing scenario is to presume that this just
doesn’t matter.
A fourth myth of recovery is to pretend that the deflationary scare is
over. After all, this was a low-probability scenario from the start,
goes the argument. And as global healing presumably sparks a turn
in the business cycle, it seems appropriate to revert to the
time-honored fixation on inflation. A bit of a reality check is in order
here. In case you haven’t noticed, America is still sliding down the
slippery slope toward deflation. Sure, a war-related surge in energy
prices is boosting headline inflation. But the core rate of inflation is
receding sharply. Excluding food and energy, the US Consumer
Price Index was unchanged in March 2003 and was up at only a
0.8% annual rate in 1Q03; that’s well below its cycle peak of 2.8%
in late 2001 and sufficient to bring the year-over-year comparison in
March down to 1.7% — nearly a 40-year low. There are three
ingredients to the case for deflation — a weak cyclical climate that
continues to restrain aggregate demand, a post-bubble legacy of
excess supply, and the unrelenting pressures of globalization which
are leading to intensified competition in both tradable goods and
services. The perils of global deflation, which first reared their ugly
head in Asia, still pose considerable risks to America and Europe, in
my view. This is not the time to sweep those risks under the rug.
A fifth myth of recovery is the notion that postwar healing in the US
is about to spark an economic revival elsewhere in the world.
Unfortunately, the world is still headed the other way. Our European
and Japanese teams still see little, if any, positive growth in 2Q03.
The recent data flow on the Euro-zone production front wasn’t quite
as bad as we had thought, but the trend remains consistent with only
fractional GDP growth, at best. Moreover, while the just-released
annual revisions to the Japanese industrial production data were on
the upside, as expected, the underlying trend still looks quite
stagnant. Meanwhile, SARS-related downside risks seem to be
cropping up everywhere in Asia ex Japan. Hong Kong’s economy
has come to a virtual standstill. Singapore’s government recently
noted that tourist arrivals are down some 61% (YoY) in the first 13
days of April. And Taiwan, Korea, and Malaysia are all bracing for
SARS-related impacts. China remains the outlier in the region,
especially on the heels of its stunning 9.9% increase in 1Q03 real
GDP growth. However, in a weakening regional and global climate,
even the sustainability of China’s growth dynamic can now be drawn
into question. Total trade — exports and imports, combined — hit a
record 61% of GDP in the first period of this year; that’s up from
50% in 2002 and essentially double the 32% reading of a decade
ago. Moreover, the growth in exports, alone, accounted for 71% of
overall GDP growth in the four quarters ending in 1Q03; this not only
underscores China’s extraordinary dependence on the combination
of external demand and surging outsourcing activity but it also
reveals a notable lack of autonomous support from domestic
demand. In short, there’s little reason to believe in the myth that the
non-US world is about to provide its own spark to the global growth
outlook.
The basic problem with the postwar healing scenario is that the
world was facing many of these problems long before the war in
Iraq. War, and the stunning victory that has since ensued, changes
none of that. After all these years, a US-centric world now makes
for an increasingly dysfunctional global economy. Moreover,
courtesy of SARS, runaway US budget deficits, and lingering
structural problems in Japan and Europe, the major risk is that the
imbalances are about to get worse — possibly a lot worse. There’s
nothing like the romance of postwar recoveries and cyclical revivals.
For those of us who choose instead to remain cold, calculating, and
unemotional, the world still looks like a very treacherous place. Call
me a dreamcatcher.
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