... meanwhile, from the Morgan Stanley Dean Witter’s global economics team ...
December 18, 2000
Overview: Looking to 2001
Stephen Roach (New York)
As the year draws to an end, the outlook for the world economy has darkened considerably from the boom-like conditions spawned by the global healing of 1999 and early 2000. Investors for the most part still see the outlook through rose-colored lenses. Financial markets are generally priced for a soft landing, largely consistent with our baseline prognosis of a 3.5% increase in world GDP in 2001. As we have stressed for some time, however, the risks remain decidedly on the downside of this optimistic scenario, and we would continue to place a 40% probability on a hard landing in 2001.
Our team of economists is in general agreement that the US economy should prove to be the major tension point for the global economy in 2001. This is quite an about-face from the role played by America over the past five years as the unquestioned engine of global growth. But there can be no mistaking the telltale signs of the classic business cycle, as the US now flirts with the bust that invariably follows the boom (see my essay below, "A Cyclical World"). Dick Berner and our US team continue to focus on corporate earnings risk as the major means by which macro excesses are about to be vented. The combination of rising costs -- labor, energy, and borrowing -- and diminished pricing leverage points to pressures on profit margins that can only be exacerbated by the rapidly unfolding downshift in volume growth. To the extent further earnings disappointments give rise to another downleg in the US equity market, an ever-deepening reverse wealth effect could well reinforce the downside of the real economy.
The policy response to US macro risks should be key for financial markets. David Greenlaw explores the fiscal policy
implications of this softer economic climate and concludes that any tax cuts from the new Bush Administration are unlikely to either temper the risks or dramatically alter the extraordinary buildup of federal surpluses over the next decade. Ted Wieseman examines the Fed’s challenge in managing macro risks as seen through the lens of the money supply; he concludes that it could well take 75 bp of monetary easing in the first half of 2001 -- consistent with our current Fed call -- to bring subpar money growth back into a range that would be more consistent with trend growth in the US economy.
Our global team identifies three key stress points for the world economy in response to America’s cyclical downshift. Non-Japan Asia is at the top of our watch list, hardly surprising in light of the region’s lack of support from domestic demand impetus and extreme reliance on export-led economic growth. Andy Xie and his team see competitive currency as non-Japan Asia’s only option to counter a US-led global slowdown. Unfortunately, that’s a zero-sum result for the world as a whole; the benefits of Asia’s expanded market share will come at the cost of other exporters in the world. Repercussions throughout the NAFTA zone are a second avenue by which an American growth shock will undoubtedly be felt; Andrea Prochniak details the extent of the US-centric trade linkages in the region. Jim Johnson underscores the downside risks facing Canada, where US exports account for fully 32%
of its GDP. Gray Newman, head of our Latin American team, stresses that the impacts of any trade risks to Mexico will
undoubtedly be swamped by concerns over the outlook for the peso; as oil prices often in response to slower global growth, peso risk can hardly be ignored. Japan is likely to be a third source of global risk in 2001, according to Robert Feldman and his team. But in this instance, the culprit is less the US and more the unfinished business of a nation that has dragged its feet on structural reform for well over a decade. Unfortunately, the return to crisis in Japan is a possibility we don’t take lightly in 2001.
Europe emerges as a source of relative resilience in an otherwise shaky world. That’s not to say that Europe won’t suffer the aftershocks of a US-led global slowdown. Eric Chaney paints a picture of emerging inventory excesses that bear a striking similarity with conditions in the US. But he is quick to make two important distinctions between looming macro adjustments in the two regions: First, due to limited trade linkages with the US, small wealth effects, and already-enacted tax cuts, the compression of Euroland economic growth is likely to be considerably less than that which is occurring in the US. Second, the impacts of
structural change in Europe -- especially product market deregulation and labor market reforms -- should begin to take on the trappings of those experienced by the United States over the past 20 years; these are documented by Elga Bartsch (German pension reform) and Christel Rendu (French labor market reform). As for Emerging Europe, Riccardo Barbieri and his team are more sanguine about downside risks than is our Asian team; nevertheless, we believe both Russia and Turkey are set for significant slowdowns in 2001.
All this points to a significant shift in the mix of global growth in 2001, a conclusion that could well have an important bearing on the currency outlook. As US leadership fades, there is no obvious candidate to step in and fill the void. But with Europe likely to be more resilient in an otherwise shaky global climate, Joachim Fels and Stephen Jen argue that the long beleaguered euro is likely to appreciate in response. The counter to this, of course, is a significant challenge to a 5 1/2-year bull run for the dollar, a development that many believe has been the key underpinning to America’s virtuous circle. John Montgomery details the role that a potential slowdown in the global M&A cycle could have in reinforcing the downturn for the dollar. Should the greenback finally reverse course, America’s loss of economic leadership could be accompanied by a wave of underperformance of dollar-denominated assets in world financial markets. Yet Joe Quinlan’s analysis of European affiliates operating in the US, in the context of a stronger euro, throws some cold water on the notion that euro-denominated assets could emerge as a safe haven in an
otherwise treacherous financial climate.
The world economy and financial markets are ending the year on a very different note than was evident at the beginning of 2000. Boom-like expectations have faded, and the debate is focusing increasingly on whether the world can avoid a classic bust. One way or another, that debate will be resolved in 2001. Our baseline case offers the most palatable way out for investors -- the ever-cherished soft landing. Yet for an increasingly connected, yet surprisingly unbalanced $32 trillion global economy, that scenario won’t be all that easy to pull off. The call is far too close for comfort.
Global: A Cyclical World
Stephen Roach (New York)
Long ago, in the Land of the New Economy, the business cycle was put to rest. After all, "new" was synonymous with
hyper-flexibility -- and with the perfect information that all but ruled out cyclical swings in aggregate economic activity. Unfortunately, "new" also turned out to be synonymous with excess -- excesses in both financial markets and the real economy. And that ended up being the ultimate catch for the New Economy. Excesses are what cycles are all about.
In retrospect, it all started with the boom that was spawned by global healing. The post-crisis vigor of 1999 led to a false sense of security. As growth accelerated in an increasingly synchronous global economy, long-needed structural reforms were put on hold. Banking reform lagged, especially in the crisis-damaged economies of non-Japan Asia. Restructuring of nonfinancial corporates also lagged, especially in Japan and Korea. Courtesy of crisis-induced currency devaluations, Asia was more than content to enjoy the illusory fruits of export-led growth. At the same time, proposals to reform the international financial architecture stalled, leaving the world just as vulnerable to the proverbial next crisis as it was in 1997. In short, the lessons of the greatest financial crisis in 60 years were left unlearned.
Meanwhile, a similar strain of complacency afflicted the great healer, itself -- the United States. An ever-frothy stock market enticed American consumers to spend well beyond their means. Personal savings were all but vaporized in response, as the wealth effect became an increasingly powerful source of support to aggregate demand. The stock market drew much of its sustenance from explosive growth in expenditures on information technology, widely perceived to be Holy Grail of the New Economy. Lacking in the domestic saving that is normally needed to finance such an investment boom, America became increasingly reliant on foreign capital to close its saving-investment gap. And the US current account -- the mirror image of the capital account -- moved deep into deficit.
The boom-like illusion of 1999 and early 2000 is over. Global vigor has been supplanted by an unusually swift deceleration. And the stresses and strains that were papered over by fast growth are now being unmasked by slow growth. In many cases, the fractures and fault lines are turning out to be considerably deeper than expected. That’s especially the case for highly leveraged telecoms -- once perceived to be a perma-growth sector of the New Economy. And that may only be the tip of the iceberg. If the US and global economy tip into recession in 2001, it will be the first cyclical contraction of the Information Age. And the IT infrastructure -- a new layer of fixed costs for a once variable-cost service sector -- could crimp corporate earnings as never before. As managers move to defend profit margins, the secular forces driving IT demand should increasingly give way to cyclical pressures. In the Land of the New Economy, that was never supposed to happen.
Each business cycle is different. Not only is this the first cycle of the Information Age, but it is also the first such episode to be shaped by the globalization of the inventory cycle. Courtesy of outsourcing, demand shortfalls in one country or region now have the clear potential to be transmitted throughout the global supply chain. That’s the way the US demand shock now appears to be playing out. Rising inventory-to-sales ratios in the US -- especially for durable goods -- are now starting to constrain domestic US
production. But such a trend should also trigger production adjustments in America’s NAFTA partners; an ominous build-up in Canadian inventories in 3Q00 underscores the risk in this regard, and recent cutbacks in Detroit’s assembly schedules could prompt similar adjustments in Mexico’s maquiladora sector. Moreover, on the other side of the world, a sudden loss of export momentum in Taiwan, Korea, and China -- dominated by a shortfall of IT shipments to the US -- seems to be yet another manifestation of the global inventory cycle. The worldwide reverberations of a US downshift are only just beginning to play out.
The good news is that business cycles cut both ways. Booms sow the seeds of an eventual bust. And the resulting downturn sets the stage for the next upturn. The downshift that is now under way is being driven by several cyclical forces that are easily reversed -- especially monetary tightening and rising energy prices. As the US and global economy slows in response, the resulting shortfall in aggregate demand should lead to monetary easing and falling energy prices. The confluence of those forces would be the functional equivalent of a large counter-cyclical tax cut. Such a stimulus should set the stage for a solid global upturn in 2002.
The return of the business cycle does not negate the powerful structural transformation that is currently at work in the global economy. But it puts the world in a very different light: It underscores the time-honored tradeoff between structural and cyclical forces. For world financial markets, that poses a critical reality check. New Economy or not, the business cycle is back.
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