... hey Steve, I posted to you on "All About SUNW" re Stephen Roach this morning ... that was before I read Friday's Morgan Stanley ... this is great stuff ...
Ken Wilson
May 24, 2002
Global: Common Ground
Stephen Roach and Richard Berner (New York)
Debate has long been a hallmark of Morgan Stanley’s macro research culture. True to form, over most of the past five months, Dick Berner and Steve Roach have taken opposing views of the cyclical outlook for the US economy. Steve is still a "double dipper" -- perhaps the last of this dying breed. Dick, on the other hand, has been -- and continues to be -- a leading advocate of a much more vigorous economic prognosis for the United States. There is a certain irony to this sharp difference of opinions. Dick and Steve have known each other for close to 30 years, and have worked together -- at the Federal Reserve, Morgan Guaranty Trust Co., and Morgan Stanley -- for much of that time. Over most of that period, they have stood shoulder to shoulder on the economic outlook. In early 2001, for example, they were among the first on Wall Street to embrace a recession call for the US economy. Steve has essentially stayed with this call in the form of the double dip, whereas Dick has moved on to cyclical revival.
Yet there’s no escaping the reality checks that incoming economic statistics always offer for such debates. The early returns -- highlighted by a stunning 5.8% increase in 1Q02 GDP -- have certainly gone against the double dip and in favor of Dick’s vigorous-recovery scenario. But Steve remains convinced that much of the vigor in early 2002 may have borrowed from subsequent gains, suggesting that a relapse is yet in the offing. The jury is still out on that count. Notwithstanding these differences, it is equally important to stress the areas of agreement that Dick and Steve share in assessing the fundamentals of the US economy and their implications for the global economy and world financial markets. We highlight below five key aspects of this common ground:
Imbalances matter
We both agree that the US current account deficit is the single most glaring imbalance in the United States and in the broader global economy. By our reckoning, America’s external gap likely will exceed 5% of GDP in the second half of 2002 -- piercing the threshold that typically triggers a major adjustment. At the same time, we would also stress that large and growing surpluses elsewhere in the world -- especially Japan and China -- are equally out of kilter. We also share the view that the long-overvalued dollar is now in the early stages of what could turn into a 20-30% depreciation over the next three years. Similarly, we both believe that G-7 policymakers are tacitly cheering for a decline in the dollar. You’d never know it from their public statements, but it seems as if they have come to conclude, as have we, that dollar depreciation would hopefully defuse this key element of tension in an unbalanced global economy.
We differ, however, on how the adjustment could unfold: Dick Berner would emphasize a gradual unwind, as investors will have a hard time finding dramatic outperformance in Europe or Japan. Consequently, he doesn’t see this imbalance as an obstacle to US recovery. Steve Roach worries more about a hard landing for the dollar, as market participants lose confidence in US policies and the economy’s underlying growth potential. Both of us hope for the soft landing -- arguing that it would be a big plus for the world economy. The hard-landing alternative for the dollar would be a different matter altogether.
The terror economy
We both worry that another terrorist attack could undermine consumer and business confidence. Dick believes that the economy is gaining strength, and thus would be progressively less vulnerable to such a blow, while Steve sees the recovery as more fragile and easily pushed into a double-dip by another such shock. However, we are both concerned that the costs of increased safety and security will increasingly divert national output toward unproductive activities, thereby limiting the US economy’s future growth potential. Inasmuch as Dick is more of a secular productivity bull than Steve, Dick would view the terrorist threat as less of a macro tipping point. Steve has also taken the view that America’s current military build-up associated with the war against terrorism will not provide much of a lift to the US economy. In large part, that’s because the hardware piece of the defense sector is now so small -- accounting for just 0.9% of GDP in 1Q02 -- that any "multiplier effects" normally stemming from spillover effects into job creation and income generation would be relatively limited.
Managerial bloat
We both think that Corporate America has enmeshed itself in a kudzu of bureaucracy that will require Herculean efforts to dislodge. Managers currently account for 15% of the total work force and fully 25% of all white-collar workers in America; moreover, managerial hiring surged by 2.9% in the recession year of 2001 -- in sharp contrast to the 0.5% decline in the non-managerial ranks. Steve thinks that this lingering bloat in the business cost structure will continue to sabotage profits; he is especially worried about the lingering excesses of labor costs, with worker compensation still holding at 55% of national income -- well above longer-term norms. Dick, however, thinks that much of the heavy lifting of cost control has already occurred and that trimming the managerial ranks will represent the final assault on this Corporate Everest. In his view, the good news is that flexible compensation schemes are already pruning the excesses of bloated managerial compensation costs. Ironically, last year Steve worried about the dark side of such schemes -- that they would curb consumer-spending power. That they haven’t confirms their relatively small share in both consumer incomes and corporate costs -- or suggests something else may be at work in supporting consumer demand.
Steve worries that the coming managerial shakeout will be reminiscent of that which occurred in the "jobless recovery" of the early 1990s -- a protracted period of subpar employment and income growth that pushed unemployment up and kept consumer demand surprisingly restrained in the first three years of that recovery. Dick feels that fears over a jobless recovery are overblown -- that improved earnings will enable Corporate America to step up and do enough hiring to keep the scale of productive operations in line with the likely expansion of demands. Both, however, concur that another managerial shakeout is inevitable. It’s the macro impacts of such an occurrence that remain open to debate.
Inflation not a problem
In a world that he sees as having no pricing leverage, Steve thinks deflation is the bigger worry -- notwithstanding the prospects for a weaker dollar. By one key measure -- the GDP chain-weighted price index -- the US is already on the brink of outright deflation; annualized inflation on this basis slowed to just 0.35% over the past two quarters, a 48-year low. Steve has argued that a depreciation of the dollar may well be America’s last line of defense against deflation. With nonpetroleum import prices down 3.3% in the 12 months ending April 2002, this is hardly idle conjecture. If the dollar failed to fall, imported deflation in an increasingly open US economy would undoubtedly persist -- probably pushing the aggregate inflation rate down through the "zero threshold" by the end of the year. Dick, sees the price endgame in a different light. He believes that the disinflationary impulses from recession and a strong dollar have played themselves out. Indeed, on the basis of the GDP-based chain-weighted price index for gross domestic purchases excluding food and energy (a metric that Commerce Department statisticians say is their preferred price gauge), inflation over the past two quarters held at a 1.5% annual rate -- identical to its five-year average. And he would go on to argue that cyclical forces that lift pricing power are beginning to get traction and will begin to swamp the secular disinflationary story -- triggering a gentle updrift of inflation into 2003. However, courtesy of an alert Fed and a flexible, productive economy, Dick believes that inflation will remain subdued.
Both Steve and Dick concede that the outcome of the double-dip debate could well be decisive as to how financial markets will play inflation risks in the months ahead. Fears of another dip could intensify deflationary concerns and be bullish for bonds. A more vigorous growth outcome, on the other hand, could well lead to an inflation scare that would be quite bearish for bonds. Inflation or deflation scares notwithstanding, both economists share the view that the upside to US inflation will be limited over the next few years. Ultimately, that should go a long way in capping any upside risks to interest rates -- short and long, alike.
A world of single-digit returns
Dick argues that corporate earnings aren’t the stock market’s problem -- valuation is. Steve thinks both are market hurdles. Both of us worry about a post-Enron tainting of the equity culture in America that could take years to reverse. Both of us also believe in reversion to the mean, that it will take time for earnings to grow into valuations, and that investors are still too optimistic about medium-term earnings growth. Implications: It’s what our investment strategist Steve Galbraith calls a "back-to-basics" stock market. Dividends and yields matter again, and fixed income securities deserve significant weightings in balanced portfolios.
In our view, it’s hardly a coincidence that two economists at the same firm arrive at very similar investment conclusions -- even though their views of the economy seem to be miles apart. We converge on that common ground through one of the central features of our research culture -- a passion for independent thinking that gets reconciled through a spirit of collective engagement. Even the most casual reader of Morgan Stanley research over the years knows full well that we have never stressed a monolithic House view insofar as the macro call is concerned. Our economists and market strategists are not paid to agree. Nor are they paid to disagree. They’re simply asked to get it right. Always in search of those out-of-consensus insights that take us to these ultimate truths, we don’t shy away from debating each other as we probe the macroanalytics of the future. The debate, itself, may well be the most valuable feature of our research culture. It pushes us to develop a deeper appreciation for our respective positions. It is the ultimate learning experience. And hopefully it enriches the process by which we strive to obtain actionable and rewarding investment conclusions.
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