Global: Out of the Blue?
Stephen Roach (New York)
To most, it seems to have come from out of the blue. Japan and Germany -- the world’s second and third largest economies -- moved into recession territory in late 2004. Even the US experienced a marked slowdown in GDP and productivity as the year came to an end. The Baltic Freight Index -- a good proxy for global trade -- has rolled over. OECD leading indicators are flashing a similar warning sign. And, of course, yield curves have flattened, driven by a stunning compression of rates at the long end of the maturity spectrum. The spin-doctors are out in force dismissing all these signs as aberrations. Could they be wrong?
Actually, the case for an unexpected weakening in the global economy is not all that hard to fathom. It is part and parcel of the persistent strains of an unbalanced world that I have been droning on about for the past few years. Vulnerabilities in Japan and Germany are symptomatic of one of the greatest flaws in this lopsided world -- big economies that are utterly lacking in the core support of self-sustaining internal demand. Private personal consumption contracted at a 1.3% annual rate in Japan in 4Q04, and the qualitative assessment from German government statisticians also points to a decline in domestic demand in the final period of the year. Lacking in support from internal demand, any shortfalls in external demand can be especially problematic. Not surprisingly, the requisite currency realignment of global rebalancing -- three years of dollar weakness matched by sharp appreciation of the euro and the yen -- has once again exposed the soft underbelly of externally-led recoveries in both Japan and Germany.
Meanwhile, the two most powerful engines of the global economy -- the US on the demand side and China on the supply side -- could be facing some potentially tough adjustments of their own. For America, it may now be payback time for the extraordinary monetary and fiscal stimulus measures that formed the bedrock of Washington’s post-bubble defenses in 2001-03. The interest-rate-sensitive components of the US economy -- consumer durables, homebuilding, and business capital spending -- collectively surged 8.8% in 2004; that was literally three times the 2.9% growth in the remainder of the economy and compares with average gains in these components of just 2.5% over the 2002-03 interval. Putting it another way, while these three segments made up about 25% of the level of US GDP in 2003, they accounted for about double their share, or 51%, of the overall growth of US GDP in 2004. Due to the long-lived nature of such big-ticket items, these are the sectors where growth typically comes in spurts -- where overshoots are inevitably followed by undershoots even in the most constructive of macro climates. That’s all the more likely with the Fed still biased toward further monetary tightening. Consequently, while last year’s policy traction was impressive, in all likelihood it borrowed from future gains -- hinting at a payback that could well come back to haunt the US and the rest of the US-centric world.
In China, the slowdown continues apace as the authorities remain determined to temper the excesses that emerged a year ago when fears of overheating became widespread. Driven by a combination of administrative and macro policy tightenings, Chinese industrial output growth slowed from 19.4% in the first two months of 2004 to 14.4% by December -- seemingly a classic soft-landing. But steering this dynamic, blended economy is hardly easy -- even for well-practiced Chinese central planners. Excess liquidity and a Shanghai-centric property bubble underscore the risks on the downside. Nor are incoming data on Chinese industrial output in January all that comforting. While the lunar New Year holiday always makes Chinese statistics difficult to read in January and February, average daily output growth -- which attempts to adjust for holiday-related plant closings -- slowed to just 8.9% in January. Holiday-related distortions argue for extreme caution in disentangling the noise from the underlying signal in the Chinese data flow in the first two months of any year. But, in and of itself, the “adjusted” comparison for January 2005 marks the weakest growth in Chinese industrial output since the final stages of the last global recession in late 2001.
Moreover, there is corroborating evidence from the Baltic shipping index that suggests there may something more to the weakness in Chinese production than just a holiday-related distortion. The Baltic Dry Index -- long a good proxy of the fluctuations in global trade and, therefore, of growth in the externally-led Chinese economy -- hit its peak growth comparison of greater than 250% y-o-y in early 2004. That, of course, was precisely the same time when the Chinese economy was overheating. In early 2005, however, that comparison slipped back into negative territory -- the first such swing from positive to negative growth since the 2001 recession.
Needless to say, if there is not a sharp rebound of Chinese production in February, that would be yet another disconcerting development on the global growth front. The case for unexpected weakening in the Chinese economy mirrors similar developments in Japan and Germany. China is lacking in self-sustaining support from domestic demand. Its auto sector is now in the bust phase of a classic business-cycle adjustment and there are mounting downside risks to an over-extended housing sector. To be sure, China enjoys special market-share opportunities as the increased scale and scope of its export platform plays an increasingly dominant role in the sourcing of global demand. However, that does not provide the Chinese economy with permanent insulation from tough global headwinds. In my view, an externally-led Chinese economy also remains very much a levered play on the American consumer. Should the US consumption dynamic downshift further in 2005, the China slowdown could well breach the downside of the soft-landing threshold.
Not surprisingly, the spin doctors are hard at work dismissing the case for downside risks to the global economy. As usual, Federal Reserve Chairman Alan Greenspan is leading the charge of the pro-growth camp. In his recent monetary policy report to the Congress, he all but dismissed the growth concerns embedded at the long end of the Treasury yield curve and, instead, drew comfort from growth-friendly expectations now discounted in interest-rate spread markets. He argued that optimistic signals from these market-based measures of risk assessment -- namely, unusually low spreads on high-yield, emerging-market, and investment-grade debt instruments -- were more reliable than qualitative indications of lingering corporate caution. Interestingly enough, at no point in his testimony did he even mention the possibility that the unusual spread compression might be an outgrowth of an overly-accommodative monetary stimulus that has encouraged such “carry trades.” Let the record show that this was precisely Greenspan’s tact in late 1999 and early 2000 when he stressed the optimism of long-term earnings expectations as justification for ongoing support to a US stock market bubble that was entering its final stage of excess.
The key question is whether the late 2004 global slowdown is a portent of tougher times ahead. Financial markets don’t think so, in my view. They are still priced for a “Goldilocks-like scenario” -- a global growth outlook that is neither too hot nor too cold. As such, the investor consensus is looking for a glacial updrift in inflation, a modest degree of further monetary tightening, a slight back-up in longer-term interest rates, and generally well-maintained growth underpinnings for corporate earnings and stock prices.
Our own economics team at Morgan Stanley is pretty much in sync with this benign prognosis. We have largely dismissed unexpected recessions in Japan and Germany as temporary aberrations, leaving our 2005 growth estimates in both economies basically unchanged. Our team is still worried more about the manifestations of stronger global growth -- namely, rising inflation in the US, liquidity-induced speculative excesses in China, ECB rate hikes in Europe, and demand-driven upside risks to oil prices. As such, we speak more of bond bubbles than of the possibility of a further reduction of long-term sovereign interest rates. As I see it, the key presumption of this global view is our belief that the unshakable American consumer will power yet another wave of US-centric global growth. In a still unbalanced world that is not only starved for alternative sources of internal demand but also lacking in additional options for policy stimulus, it is hard to make the case for a different spark to global growth.
In my view, the risks are on the downside of this upbeat assessment. I worry that the global slowdown of late 2004 may well be signaling tougher times ahead for a still unbalanced world. We are currently forecasting a 3.6% increase in world GDP growth for 2005 -- a deceleration of slightly more than one percentage point from our 4.7% estimate for 2004. If this forecast comes to pass, it would basically mark a return to the world’s post-1970s growth trend. Implicit in this view, is that there will be no payback from the growth spike of 2004 -- that the sharpest increase in world growth in some 20 years did not borrow from gains in the future. That could be a risky bet -- especially since last year’s growth spurt, as noted above, was concentrated in the “lumpiest” segments of the US economy such as consumer durables, homebuilding, and business capital spending where growth paybacks are the rule.
Recent history offers a mixed record as to how this all might play out. In looking back over the past 35 years, there were three global growth spikes comparable to that of 2004 -- those of 1973, 1984, and 2000. In two of those instances -- 1973 and again in 2000 -- the overshoots were followed by equally dramatic undershoots that eventually culminated in the global recessions of 1974-75 and 2001. The resurgence of 1984 was the clear exception -- an outgrowth of a powerful counter-cyclical policy stimulus that was put in pace during the deep recession of 1981-82 that was followed by another five years of trend or above-trend global growth. Which will it be in 2005-06?
History, of course, only offers a hint of the future -- never a template of what lies ahead. But the lessons from the recent past are intriguing, nonetheless. The long cycle of the 1980s was, in my view, an outgrowth of a sea change on the inflation front -- as the wrenching double-digit price increases of the late 1970s and early 1980s gave way to some 20 years of disinflation. That was a truly special period, when the accomplishments of macro policy were at their zenith in breaking the back of a debilitating inflation. The cycles of the early 1970s and the early 2000s should be seen as the “bookends” of this disinflation. In my view, these bookends also mark far more difficult periods for macro stabilization policies -- especially liquidity-prone central banks that fueled CPI-type inflation in the 1970s and asset inflation in the late 1990s and early 2000s. Just as it took a long time for the world to face up to the perils of the Great Inflation of the 1970s and early 1980s, I still worry that an unbalanced world has not come completely to grips with the more recent excesses of the Great Bubble. The sputtering of the global growth engine in late 2004 may not be just a statistical accident. It may well be a sign of tougher times to come on the road to global rebalancing.
Needless to say, if these downside risks to global growth play out, ever-complacent financial markets would be in for a rude awakening. That would especially be the case in the event of an upturn in inflation (see Dick Berner’s dispatch in today’s Forum, “The Next Inflation Surprise”). That hints at the potential for stagflation -- long the most lethal outcome for bonds and stocks, alike. Out of the blue? Stranger things have happened.
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