The latest views of Morgan Stanley Dean Witter Economists, March 2, 2001
Global: The 500-Pound Gorilla - Stephen Roach (New York)
A $10 trillion US economy is only starting to grasp the drama that is unfolding in the stock market. The denial has cracked first in Corporate America. As the earnings carnage deepens, cost-cutting is back with a vengeance. Businesses are moving aggressively to prune the excesses of both labor and capital. Layoffs are mounting and IT-led capital spending budgets are being slashed. But it’s early in the game on both counts, according to our prognosis. Under our mild recession scenario, headcount reductions will take the unemployment rate up another 0.8 percentage point over the next year, four times the paltry increase that has already occurred. And business fixed investment seems likely to decline for at least another couple of quarters, doubling the duration of the downturn that began in the final period of 2000. If the recession turns out to be deeper, or longer, than we are currently forecasting, capital and labor adjustments will only intensify. In my view, that’s certainly the risk as this recessionary dynamic continues to unfold.
While businesses are responding to the earnings implosion, consumers remain steeped in denial. Consumer confidence has, of course, fallen like a stone. But the bulk of the erosion reflects fear of the future rather than a deterioration in the here and now. And a gathering sense of job insecurity -- no doubt triggered by the recent outbreak of layoffs -- is the darkest cloud looming over consumer expectations. But I am struck by the reluctance of the household sector to come to grips with the 500-pound gorilla that has taken center stage -- the unrelenting decline in the stock market.
The negative personal saving rate -- it was just reported to have fallen to -1.0% in January 2001 -- says it all. The American consumer has not been in this position since 1933, when the saving rate was estimated at -1.5%. Needless to say, that’s hardly a comforting comparison, coming in the depths of the Great Depression. But there can be no mistaking the message of some 68 years later: Consumers are still spending well beyond their means, as those means are defined by wage-based disposable personal income. That’s not to say there hasn’t been a recent slowdown in the growth of consumer demand: Gains in real personal consumption expenditures averaged 3.6% in the second half of 2000 -- well short of the 4.4% average pace over the five-year, 1996 to 2000, interval. But the adjustments in consumption have lagged the retrenchment of income generation, suggesting that the American consumer is more dependent than ever on the wealth effect of the stock market.
As the market decline now closes in on its one-year anniversary, I find it astounding that the wealth effect continues to play such a supportive role in driving consumer demand. Yes, the wealth effect works with well-known lags. But, by now, it would have been reasonable to have expected the saving rate to begin leveling out. Yet it has fallen another one percentage point in the four-month period ending this January. Notwithstanding the correction of the past year, individual investors continue to act as if the stock market remains a permanent source of saving. During the glory days of 1995-99 -- when the broad market rose by an unprecedented 25% per year -- that supposition could be justified. But now it can’t -- and yet the saving rate continues its seemingly unrelenting descent.
I remain convinced that history will judge the negative personal saving rate to be one of the great anomalies of our time. Don’t let the apologists tell you this is a mere measurement problem. That’s a broadside that can be leveled at virtually every macro statistic in the books -- especially the productivity numbers. While there may well be biases to the government’s estimates of economy-wide saving, I am hard-pressed to believe that those biases have worsened enough in the past several years to explain away the problem. The fact remains that the personal saving rate has fallen by 7.6 percentage points since the end of 1994, when it stood at 6.6%. Over that period, average real spending growth (4.4%) outstripped income growth (3.3%) by one full percentage point. The greatest bull market in recorded history has tempted consumers into living well beyond their traditional income-based means. And an increasingly negative saving rate says they are further than ever from breaking that habit.
That day will come, I’m afraid -- and it could be sooner, rather than later. The trigger will undoubtedly come from a shock that strikes at the heart of consumer purchasing power -- from the income side of the equation. In the current recession, such an outcome would not be surprising. As layoffs mount, wage earnings will come under pressure, leading to a heightened sense of uncertainty for the consumer. An increasing segment of the workforce will fear that it might be next and sense that their once open-ended stream of income generation will come under pressure. In that type of climate, I am convinced that consumers will wake up to the folly of their ways and begin the painful process of relearning the art of saving out of their paychecks.
Like all recessions, this one is a wake-up call. Corporate America is only beginning to see the handwriting on the wall. Consumers have pushed the "snooze button," pretending it’s all a bad dream. The biggest risk is that of a mean-reverting personal saving rate. By the way, in the 45 years prior to 1994, that mean was 8.6%. Our calculations suggest that even if the saving rate were to revert only halfway back to its historical mean -- and if that reversion was to stretch out over several years -- it would lower trend consumption growth by about two percentage points per annum. That would make this recession the deepest and longest of modern times. That’s too painful a possibility for most to contemplate. But as the US economy slips into recession, the negative wealth effect of a faltering stock market hints at just such a possibility.
Over the next several years, the personal saving rate must go up. I take that as a given in assessing the big changes that loom on the macro scene. A stock market that merely reverts to historical returns -- let alone goes through a protracted bear market -- clearly underscores that implication. So do the demographics of an aging American society -- ever closer to its golden years and, therefore, more dependent on saving than ever before. A shift in pension regimes from defined-benefit to defined-contribution leads to the same conclusion -- conscious saving strategies will matter more than ever. If the stock market can’t be counted on as a permanent source of saving, the paycheck will have to fill the void. And that would turn the world inside out. Of course, if the bull comes back, there’s nothing to worry about -- the gorilla will retreat quickly to the jungle.
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United States: Consumer Con Game? - Richard Berner (New York)
Consumer confidence by any measure has slipped dramatically in the past three months, and such plunges are typically a harbinger of consumer retrenchment. Yet consumer spending bounced back in January and seems resilient. Is the decline in confidence a false alarm, or is it just a matter of time before consumers pull back? In our view, the fundamentals underpinning consumer spending are slipping, the economic climate is becoming more uncertain, and we expect a relapse in spending growth soon. For now, however, the consumer is helping to keep the economy a little stronger a little longer than expected. While we believe that the economy is moving into recession, it appears that the economy grew slightly instead of contracting in the first quarter, as we earlier
expected.
Certainly Fed officials pay close attention to consumer confidence and sentiment readings. December's 9-point plunge in the University of Michigan index of consumer sentiment (released just before year-end) doubtless was a factor in the Fed's dramatic early-January easing move, and the ongoing declines are a feature of policy action and discussion. Chairman Greenspan mused publicly on how we would know whether confidence had been breached sufficiently to trigger retrenchment. And most recently, he and Fed Vice Chairman Ferguson again highlighted officials' need to be vigilant over the sharp decline in sentiment. Mr. Ferguson noted: "One factor pointing to a risk of unacceptably slow growth is the uncertainty about consumer sentiment, which has been a feature of the recent period. Usually, consumer sentiment closely mirrors contemporaneous economic conditions, and it generally moves closely with the growth in household spending. [However, a] somewhat puzzling feature of the recent period has been that, despite the sharp weakening in sentiment, household spending appears thus far to have held up well. How these apparently conflicting signals will be resolved going forward is not at all apparent from today's vantage point, and will bear close scrutiny."
Mr. Ferguson is not alone in his puzzlement, and it is worth asking whether such readings do contain any information. After all, confidence readings may merely be a proxy for job and income growth, wealth, and inflation -- the same factors that explain consumer spending. Our own empirical work suggests that one can explain 95% of the variation in sentiment with stock prices, inflation, interest rates, the unemployment rate, the index of help-wanted advertising, and a diffusion index of employment change. Many of these factors affect income and wealth, the two major determinants of consumer spending, and so the sentiment readings may not offer significant additional information. Moreover, sentiment indexes are often quite volatile. For example, the sharp drop in confidence readings in autumn 1998 in the midst of the global financial crisis proved to be a false alarm. And near the end of the 1990-91 recession, both the University of Michigan and Conference Board confidence gauges bounced up sharply and then plunged again, falsely signaling renewed recession.
So how will the conflict be resolved -- does this confidence drop augur retrenchment or is it another false signal? I believe that the drop in confidence does augur modest retrenchment. The fundamentals underpinning consumer spending are eroding, if slowly. Two forces are promoting a deceleration in income. First, the lingering effects of the energy shock are reducing real wage gains. Second, the squeeze on earnings growth as the economy slows is prompting ever-slower growth in jobs. As a result, it appears that real wage and salary growth is slowing to 2% or less from a 4% pace over most of last year. This, for consumers who seem to have bet on much stronger debt-servicing capacity when arranging their borrowing. Moreover, as Steve Roach notes in his accompanying Forum ("The 500 Pound Gorilla"), the asset side of the household balance sheet is under attack: Sinking stock prices are turning what was a positive wealth effect into a negative one, notwithstanding the lift to wealth from rising home values.
Confidence measures are worth monitoring for two reasons. First, they provide timely readings on the direction of the consumer fundamentals with which they correlate. The University of Michigan Survey Research Center offers two readings for sentiment within the current month. Second, beyond their timeliness, confidence readings do seem to have some independent predictive ability. Our preliminary statistical analysis corroborates findings of others that such measures do add to the explanatory power of relationships between spending and wealth and income. That extra explanatory power may derive from the fact that in uncertain times, consumers may turn more circumspect, and other factors simply don't capture that precautionary behavior. It's worth noting that consumer confidence appears to correlate best with year-over-year changes in spending, which, notwithstanding January's bounce, continue to move lower. Real spending rose by 3.8% in the year ended in December, and appears to moving to below 3% in the first quarter.
For now the consumer is helping to keep the economy a little stronger a little longer than expected. While we believe that the economy is moving into recession, it appears that it grew slightly instead of contracting in the first quarter. Fed Chairman Greenspan this week signaled that this mixed performance warrants watchful waiting but no urgency to ease monetary policy. For equity markets hungry for more liquidity, the wait until the March 20 FOMC meeting will probably seem like far more than three weeks.
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