The U.S. is in recession
May 28, 2001
Barron's Features
"Off the Tracks"
interactive.wsj.com.
The U.S. is in recession, says a Wall Street economist, and pulling out won't be easy
An Interview With Stephen Roach ~ If a story belongs to the man who tells it best, then the Gloomy Scenario
currently belongs to Roach: No one makes the case more forcefully than the Morgan Stanley chief
economist that the U.S. economy is in for an extended bout of trouble. This macro-tale of woe should gain
credibility from the fact the 55-year-old prognosticator hasn't always taken the bear's-eye-view. In fact, at other
times his outlook has bordered on rosy, as when he correctly forecast in '98 that the U.S. would weather the
Asian crisis relatively unscathed. But this time, he says, is different. That I don't quite see things the Roach way
should add a bit of spin to what follows.
Gene Epstein
~~~~~~~~~~~~
Barron's: Steve, first the bad news before we turn to the not-so-bad. According to you, this economy is already in
recession, if recession means an actual decline in gross domestic product.
Roach: Yes, I see a modest contraction that will last through the second and third quarters of this year, followed by
a
puny rebound in the fourth quarter.
Q: The first Monday of this year, however, you courageously declared the recession had already begun. But first
quarter GDP growth was mildly positive. How come?
A: Well, the data don't always conform with the brilliance of your analytics. One thing that I did not expect:
The consumer is just hanging on by his or her nails in a fashion that is both puzzling and perhaps incisive as to what
happens down the road. But I think ultimately that will sow the seeds for the capitulation to come. Because I think
the consumer needs to temper his or her spending.
Q: Why do you think the behavior of the consumer was surprising in the light of soaring growth of wages and
salaries?
A: I just think that consumers at the end of the day are driven by a combination of income effects and wealth
effects. The wealth effect was very negative late last year and again in the early months of this year.
Q: Negative wealth effect in what sense?
A: At the margin, the big swing factor in terms of what's been driving the consumer from the standpoint of overall
net worth or wealth has been the spectacular runup in the stock market since late 1994. In 2000 we had our first
down year for the stock market in six years. It is clear that piece of consumer support had gone from being
spectacularly positive to neutral at best. The explosive growth of consumer indebtedness for both mortgage
and installment credit combined validates the notion that consumers are rapidly taking on debt to finance that extra
spending that they could not finance with their paychecks.
Q: Speaking of debt, why do you say explosive increase in debt? We are not looking at an explosion in debt when
measured by the cost of servicing debt.
A: Well, looking at debt-service-to-income ratios, in late 2000, the ratio ticked up to 14.3% of disposable
income. The prior high was about 14.4% in late 1986. That compares with a low in the '94 period of about 12%.
So after sort of hanging out at relatively subdued levels, consumers have really taken on a fair amount of
new indebtedness.
Q: But as you know, a lot of that so-called debt consists of outstanding balances on credit cards that consumers
wipe
out at the end of each month. So wouldn't you agree that in terms of comparing those numbers, the recent high has
got
to be lower by a significant amount?
A: Yes, it's possible. But I get so suspicious of taking all these numbers, sort of stripping out the reasons why
they don't tell us something worrisome about the future. It really has become almost a cottage industry for
people to cleanse the statistics of numbers that don't fit their script. And so you are left with a savings rate that
looks
fine, a debt ratio that is not a problem. Until all of a sudden you wake up and say wait a second, we have a
problem.
Like the Nasdaq bubble we thought was rational and now in retrospect looks quite otherwise.
"The notion that we held as recently as a year ago that a long-term potential growth rate for the U.S. was around
4% will prove to be overly optimistic."
Q: The Nasdaq bubble was obviously a bubble. But putting your point in perspective, through 1999 and into 2000,
real consumer spending was growing at a 5%-6% annual rate. Now it's running closer to 3%. As to where we have
been and why we are where we are, you obviously are quite right. Second-quarter-2000 GDP growth was running
6.1% year over year. Now we are way down from that. But that's not enough for you. You feel there is more
punishment on the way.
A: Yes. The way I would depict it, the consumption growth rate was surging at 4.5% per year from mid-'95
through mid-2000. The last two quarters were down to 3%. So we slowed the growth rate by about one-third. But
if
all the downside to consumption is 3%, then there is good reason to believe I'm going to be wrong and the
economy
will go through a major slowdown. It will be a soft landing and we will skirt recession. So to get the
recession math to fall into place, I would say that consumption growth has to flatten to zero. And I do expect that
to
happen in the two middle quarters of this year. This was not a financial bubble that can be neatly, surgically excised
from the system without having collateral damage on the real economy. The bubble went on for so long. It
went so high. It was so broad. It was not just Nasdaq. Nasdaq was the icing on the explosive cake. We had five
years in a row of 25% returns in the Whilshire 5000. At the end of that five- year period, I truly believe that
consumers became convinced incorrectly that the stock market had become a new and permanent source of
savings.
At the same time, corporations acted in a similarly irresponsible fashion, believing incorrectly that anything and
everything they bought in the realm of information technology would deliver the types of returns that the equity
market and Nasdaq in particular would reward beyond their wildest dreams. And now I think the movie
starts to play in reverse. The stock market was not a permanent source of saving that people thought it was. And it
was not the permanent source of excessive or high return and productivity enhancement that business thought it
was.
Q: You are not quite saying, however, that God will strike hell down from the heavens. I guess you are saying that
we are going to have a mild recession as recessions are measured. And we are going to be bumping along through
2002 at a rate of economic growth that will cause a rebound of the unemployment rate back up to about 6% from
its
current 4.5%.
A: I think that's right. Just as we went through a five-year period of growth that was more rapid than any
of us could have imagined going into it. We are going to go through at least a three-year period where growth will
be
surprisingly sluggish. And the unemployment rate will go up in that climate toward 6%. That's the payback for
excess. The system has to be allowed to begin what I think will be a long, arduous process of mean reversion back
toward more sustainable levels of personal savings rates, current-account imbalances and-investment-to-GDP
ratios. You just can't pretend to purge these excesses that have built up in five or six years in a matter of weeks or
months.
Q: But it is not such terrible punishment, is it?
A: No, it is not. It's really not. I think the notion that we held as recently as a year ago that a long-term potential
growth rate for the U.S. was comfortably around 4% will prove to be overly optimistic. And I think if we exit 2002
and we are able to sort of hope that we will move back to a potential growth rate in the 2¾%-3% zone, I think that
will be the best we can hope for. That's not bad. It's a lot better than where we were at the start of the 'Nineties.
But
it is not on the sort of path of open-ended vigor that we were led to believe, or the path of these long-term rosy-
scenario budget estimates are assuming will be the case as well.
Q: Speaking to the two ways in which this economy is going to get punished even more than it has been, you're
referring to the stock market and then in a related way about the high-tech unwinding. Regarding the stock
market, the negative wealth effect has not reaped its revenge completely.
A: No. I think the combination of a lingering negative wealth effect and increasingly negative income effect as
workers lose their bonuses will result in significantly weaker consumption as we move through this year and into
next year. Consensus earnings expectations are still around 15% for the S&P 500. I think those
expectations are in trouble. So the stock market is now very hopeful that the Fed's reflationary efforts, a very
aggressive Fed easing, together with a likely tax cut is going to generate a great, good old- fashioned V-shaped
recovery. And I am not there on that. I think this reflation trade is going to end up being disappointed and the stock
market is going to leg down.
Q: Do you think the stock market is expecting a return to 4%-plus growth?
A: A 15% to 16% rebound in S&P earnings next year would require a return to hot economic growth. Even in my
L-shaped view of the world, I can allow that for a quarter or two. But the underlying growth rate of the economy
would have to stay in the 1% to 2% range.
Q: Did the rally surprise you?
A: I rely a lot on the wisdom of my brilliant colleagues like Byron Wien and Barton Biggs. They clearly were
expecting a rally in a significantly oversold market. And we have gotten that. The question is, does this rally have
legs? And the operative view on the markets today is, sure it does. Because the Fed is on the case. We have
witnessed the most aggressive Fed easing in a 4½-month time frame than any of us have seen in our professional
experience. You don't want to fight the Fed. And then you add the likelihood of a sizable tax cut. But my macro
view
of the world says the Fed is going to have difficulty getting traction with its policy actions.
Q: So you are saying that the Dow is not going to stay above 11,000 for much longer.
A: My guess, and this is always hazardous for an economist, is no.
Q: Might the market remain in a long-term trading range, bouncing from 11,000 down to 9000, and then again
maybe
back again?
A: It could. The thing that we know about the macro outlook that I think would be consistent with a range-bound
market is that the economy itself in fact would be in a subdued growth range that would constrict the earnings
range.
Q: But you are convinced that a range-bound stock market is still enough to bring even greater revenge from the
negative wealth effect.
A: I think so. Because we've come off a history of five years of 25% increases. Never before have we had more
than two years of 20% gains. And relative to that perspective, last year's down year and then sort of
range-bound-to-
down from here for a while longer will clearly have an enormous impact. There is one more thing I have to add that
is really critical. And this has to do with the structural changes in the demography of the role of savings in the United
States. The household sector is getting closer to retirement than ever before, so from that time frame the security of
savings is different today than it was, say, 10 years ago. You can actually envision a point in your life, if you are the
average American consumer, where you may actually have to use your savings to finance life in your golden years.
At the same time, you are more exposed to equities as an asset class than ever before. And you find as the
stereotypical American worker, that you are increasingly on a defined-contribution as opposed to defined-benefit
pension plan. So you've rolled the dice here. You've made a huge bet on being able to set yourself up for the future
and live really well during the last few years. And lo and behold, if this new and permanent source of savings does
not turn out to be quite as secure as you thought, then you suddenly need to save more, and consume less, the need
to
sort of restore out of your paycheck. So we can't just presume that what the wealth effect giveth on the upside it
taketh on the downside. The effect could be asymmetrical.
Q: Isn't there something a bit mysterious about the way people factor wealth into their mental accounting? At its
peak, the S&P 500 was about triple where it was in '95. Now it's fallen to nearly two-and-a-half times as high,
which still means gains of better than 15% a year. So isn't it possible that many investors aren't as upset as you
seem
to think?
A: Econometrics suggests that these things take time. There are long lags, as you correctly indicate. I just go back
again to the reality of the latter half of the 'Nineties. Was it a coincidence that we had the most extraordinary binge
in
consumption at a time when the stock market was surging in a fashion that it had never done in recorded history?
Q: Would you also consider two other unusual events? The first was the combination of low inflation born of high
productivity and the 30-year low on the unemployment rate, which brought a surge in wages and salaries. The kind
of income people spend. The second event, which was the highest housing-affordability ratio in 25 years, born of
low inflation, low mortgage interest rates and high incomes, rising incomes. People buying homes tends to mean
they
are going to buy a lot of rugs and appliances and even cars from their income. Invest in those consumer durables.
A: And don't forget DVDs.
Q: My point is that we often say that the stock market was the only unique event. But there were two others that
may
have had an even more dramatic impact on consumption. Especially since the very wealthy stockholder is mostly
not
spending his gains on consumer goods.
A: You are entirely right. I do not want to attribute this whole thing to the stock market. There were a lot of stars
that came into alignment in the latter half of the 1990s. But to me the most extreme relative to the norms was the
bull
market in stocks. And regarding your point on wage and salary income, a lot of that came through the powerful job
creation of the economy. Which you could also impute correctly to companies hiring with reckless abandon to
expand the scale and scope in accordance with the mantra of the New Economy.
Q: Getting to the employment effect, we've been suffering a growth recession, where gross domestic product
increases, but not by enough to create enough new jobs to equal the number of new entrants into the labor force.
So
we've had a rise in the unemployment rate from last year's 3.9% low to April's 4.5% high. Isn't that 0.6% rise in
joblessness just a reflection of the fact that growth has been running below trend?
A: So far, I think that's exactly right. But the risk going forward is that we will see increasingly a realization by
return-starved corporations that they need to reduce the labor content and especially the managerial content of their
bloated work forces. So over the next few months we are going to see jobless and unemployment-insurance claims
that are going to look unusually high.
Q: But if high-tech is the target, the number of people directly involved in these industries number no more than
about three million. And so far, it's hard to find any major layoffs in the high-tech categories.
A: I think that is right. The big shoe to fall on the job scene is not going to come from dot.com America or even
the high-tech producers, but from the so-called Old Economy companies who bought the hype of the New
Economy
hook, line and sinker in 1998-99. They were absolutely convinced that they had to reinvent themselves as e-based
companies with a new distribution network that existed almost in parallel with their traditional old platform. And I
think in retrospect that will go down as just an enormous strategy blunder that was made by corporate America at
the
top of the bubble.
Q: Can you offer some killer anecdotes about that, or is it that you can't offer killer anecdotes because even though
you know a few, too many of these companies are the clients of Morgan Stanley?
A: Well, it is safe to say that service companies -- whether they are retail, transportation, telecommunications,
media or even, right close to home, financial services -- all bought the story that they had to transform their
businesses into e-based businesses. And it is hard for me to even identify a company that did not believe as
recently
as nine months ago that they had to reinvent themselves in this way.
Q: And what you mean is, the standard bricks-and-mortar companies felt that they had to create Website
subsidiaries
in order to compete with Website businesses that were trying to take away their business.
A: Yeah, we had the name for it, the bricks and mortar went to clicks and bits.
Q: Can you estimate the size of the managerial bloat that got created?
A: Over the six-year period from '95 to 2000, the nonfarm economy created 12.3 million jobs, 75% of them
white collar. That would require a lot of de-bloating.
Q: One of the problems with this scenario is that firms are often reluctant to cannibalize themselves. So isn't it
possible that they put their toe in high-tech with great reluctance, and never really staffed up in the way that you
imply?
A: What Nasdaq 5000 was telling was that you had to cannibalize. You had to spend on technology. You had to
reinvent yourself. You had to create a new e-business irrespective of the duplication of the existing cost structures.
Because if you didn't you would not be delivering the type of return to your shareholders that they could get with
another security. You had no choice.
Q: Let's consider the de-bloating process for a moment. New unemployment insurance claims have been
averaging about 400,000 per week, which is not especially high when you scale it against the huge growth in the
labor force. I assume that when the de-bloating begins in earnest, claims are going to jump to 450,000 per week
and
probably even higher.
A: That's right.
Q: The unemployment rate of 4.5% will start climbing very quickly to 5% or higher. And we'll no longer be able to
identify the movement in these figures as simply lagging indicators of the slow growth we have been experiencing.
A: Yes, I think there will be a transition point in the next four to five months where joblessness becomes viewed
as less of a symptom of a weak economy and more of an approximate cause of further weakness to come.
Q: Now that it's cut the target on the fed funds rate from 6½% to 4%, what's the central bank going to do next?
A: I think the Fed will clearly remain on the path of cutting short-term interest rates, but not quite as aggressively
as it has so far. Because otherwise it will quickly find itself in the Japanese-like position of heading toward zero
and running out of basis points. I see the funds rate coming down at least another 100 basis points to 3%, and
possibly a little bit lower than that by yearend. But the Fed won't get the bang for the basis points that it got in past
periods of cyclical retrenchment in the U.S. economy. And I think the Fed would quite correctly like to keep
a sizable amount of its ammunition in reserve for that proverbial rainy day.
Q: Concluding words?
A: Sure. There is a profound difference between where we were in the financial crisis of '97-98 and where we are
today. Back then the problem was made in Asia by a bunch of small economies and it really dealt with the excess
of
speculation in capital flows. This one is made in America, it is not made in Asia. It deals with the excesses of a
bubble economy that permeated in the real economy. And unlike in '98, when America was the engine that pulled
the
world out, this time the engine is off the tracks. |
