Global: The Recovery Bubble
Stephen Roach (New York)
Wow! In a breathless leap of faith, the stock market has made a remarkable bet on the coming economic recovery. So, too, has the bond market. In one important respect, the bet is a good one: I have yet to see a recession that wasn’t followed by an economic recovery. The debate, of course, is not over the inevitability of recovery. Instead, the issues pertain more to the timing and subsequent vigor of the coming upturn. The financial markets are screaming for an imminent "V." I’ll continue to take the other side of that call. Here’s why.
First of all, lest there be any mistaking the message from the markets, consider the following: As of the 5 December close, the S&P 500 was up 21% from its 21 September lows. The cyclical technology bet is particularly impressive. The Morgan Stanley High Tech Index is up an astounding 54% over this same interval, identical to gains in the semiconductor (SOX) index and far outdistancing the still-impressive 31% increase of the Cyclical Index. Steve Galbraith, our US equity strategist, reckons that technology stocks are now selling at 50 times forward 2002 earnings -- identical to the valuation excess hit at Nasdaq 5,000. Sure, there’s always the possibility that consensus earnings estimates are too low. But as Steve has also noted, even a three-standard-deviation positive surprise in tech earnings (unprecedented in the long history of the market) would leave the multiple of these stocks at about a 50% premium to the overall market. If it looks like a bubble, feels like a bubble, and acts like a bubble, maybe it actually is one … again.
The bond market has also gotten on board with the recovery drill. Yields on 10-year Treasuries have soared from just under 4.2% to nearly 5%, with most of that move apparently reflecting a back-up in real interest rates -- a classic sign of impending economic recovery. Yields on a 10-year TIPS (Treasury Inflation-Protected Securities) have gone from 2.9% to nearly 3.5%, their highest level since the July recovery trade. The recent strengthening of the dollar rounds out the story. With the trade-weighted dollar now up nearly 3.5% from its post-Attack lows, foreign exchange markets are betting that any global recovery will be US-led.
While the markets have drawn support from a data flow that has turned "less bad," I continue to believe that the imminent-recovery play is a head fake. As I see it, there is still a compelling case that the US economy will hit an air pocket in early 2002, drawing the entire recovery bet into serious question once again. Three factors should be at work: First, demand has been pulled forward in the current quarter, borrowing from gains that might have otherwise occurred in the first half of next year. Several such distortions are likely -- including the impacts of zero-interest-rate car loans, aggressive pre-holiday discounting by retailers, and a warm-weather-assisted boost to construction. Second, in the aftermath of the 11 September terrorist attacks, there have been some unusual nonrecurring gyrations in government spending activity, both at the federal (defense) and state and local (property destruction) levels. Third, a significant negative shock to consumer purchasing power appears to be at hand -- the downside of flexible compensation.
The looming income shock is worth belaboring, especially since it is a first-time event for the American consumer. For six years running, year-end flexible compensation awards -- performance bonuses, stock options, and profit sharing -- have been a one-way kick to the upside. Driven by the combination of corporate earnings and share prices, an increasingly large portion of the American workforce had been turned into stakeholders. A Federal Reserve study found that fully 88% of a large sample of US companies included some form of flexible compensation in total reward packages in 1998 -- up significantly from the portion prevailing during the last downturn. The incidence of participation was found to vary by type of benefit; 34% of these companies have stock-options plans, whereas 50% offer profit sharing and fully 75% award performance bonuses (see "Recent Trends in Compensation Practices," by D. Lebow, L. Sheiner, L. Slifman, and M. Starr-McCluer, Board of Governors of the Federal Reserve System, July 1999).
It didn’t take long for the American consumer to get hooked on the upside of flexible compensation. With awards typically granted in the fourth quarter of each year, a first-quarter spending pop became a recurring feature of aggregate consumer demand. Over the 1996-2000 interval, first-quarter consumption growth was 0.8 percentage point, on average, faster than it was in the preceding two quarters. However, in 1Q01, the first-quarter consumer demand kick was absent -- personal consumption rose just 3.0% (annual rate), following average gains of 3.7% in the second half of 2000. But that could have just been a warm-up for what lies ahead. The reason: Our estimates suggest that after-tax corporate profits plunged 21.4% (year-over-year) in 4Q01 -- in sharp contrast to a 1% increase in 4Q00. With the bottom falling out of earnings as 2001 comes to a close, the same can be expected of flexible compensation awards. Focused on cost-cutting, Corporate America has no other choice, in my view. And so the American consumer -- the linchpin of any recovery call -- faces a double whammy in early 2002. Not only is there the demand payback to contend with, but there is also the downside of flexible compensation. I suspect that the confluence of these two forces will prove to be a formidable impediment to the V-shaped recovery that financial markets seem to believe is just around the corner. But try telling that to Mr. Market.
The same can be said of the capital-spending bet that is implied by the resurgence of technology stocks. From the start, this recession has been mainly about a massive overhang of excess capacity -- especially the information technology (IT) binge that accompanied the Nasdaq bubble. Yet the pruning of excess capacity still has a long way to go, in my view. Typically, a secular downturn in capital spending pushes the business-fixed-investment-to-GDP ratio down to around 10%. That ratio has now fallen from its pre-recession peak of around 13% to a 3Q01 reading of 12.0%. That means it still has plenty of room on the downside. Our baseline forecast calls for steady declines in capital spending through mid-2002, after which the ratio will, indeed, close in on 10%. Yet that’s hardly the imminent rebound in business fixed investment that the powerful tech rally in the stock market now seems to be discounting.
Moreover, I see three reasons to believe that any IT recovery, when it does come, will be quite subdued relative to the norms that were established in the late 1990s. First, I remain convinced that the notion of a three-year IT replacement cycle is more vendor-driven hype than substance. In an earnings constrained climate, companies will have every incentive to stretch out the service lives of their existing IT stock; if that means some software upgrades need to be postponed, so be it. Second, courtesy of restructuring and consolidation -- especially in financial services, telecom and a broad array of other transactions-intensive service providers -- the IT user community is shrinking. That suggests there will be fewer buyers of IT once the cycle bottoms. Third, courtesy of global terrorism, IT budgets are likely to shift increasingly into cyber-security programs. This may already be happening. A recent Morgan Stanley tally of chief information officers for America’s 225 largest technology users found that 29% of the user community attached the highest priority to computer security in October 2001; that’s up sharply from the 16% who claimed that was the case in September.
Once it gets going, financial market momentum takes on a life of its own. That certainly seems to be the case today. The markets are screaming V-shaped recovery -- and one that’s just around the corner. I didn’t buy that view a year ago and I don’t see it now. Yes, the difference between now and then is critical. Last year, recession was a forecast. This year, it’s a reality. Now that recession has been officially declared, the recovery call has taken on a new legitimacy. Forward-looking financial markets are now eager to get on with it and discount the inevitable recovery. Unfortunately, I fear something may have been missed in this rush to judgement -- not just the rest of this recession but a recovery that is likely to come later and without the vigor that most are now expecting. |
