Ken Wilson is ROTFLMAO
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July 01, 2002
Global: Double-Dip Tedium
Stephen Roach (New York)
It’s coming up on the six-month anniversary of my widely despised double-dip call (see my 6 January 2002 dispatch, "Double Dip Alert"). For a while, it seemed as if nothing could be further from the truth. After all, the US economy is now reported to have surged at a 6.1% annual rate in the first quarter of this year. Stubborn to the end, I argued that this growth spike was distorted by a post-September 11 bounce-back and was not indicative of the underlying -- and still fragile -- state of economic activity in the United States. I stand by that view today and still worry that the US economy is exceedingly vulnerable to a recessionary relapse in the second half of this year.
So what else is new? For starters, there a new and obvious problem with this call: The financial markets have swung my way and have embraced much -- but not all -- of what I have been droning on about over the past six months. Moreover, try as I might, I must confess that I can’t come up with a new and decisive wrinkle to this nightmare -- the imminent flashpoint that will make or break the outcome. The script that I laid out six months ago -- a consumer relapse catching an increasingly optimistic business sector by surprise -- still seems reasonable and quite applicable in the current climate. But now, with every media outlet in the world bemoaning America’s crisis of confidence, all this could be construed as "old news" -- the classic signal for markets to start leaning the other way. In that context, I have to confess that the double-dip call is starting to get boring.
Yet that is not the verdict of Morgan Stanley’s global macro team. At the end of each week, we all gather together via conference call for an intense debate on the state of play in financial markets. I attempt to moderate these discussions, but they often take on a life and rhythm of their own. That’s exactly what happened during our latest call. Each of our major market strategy groups -- equities, fixed income, and currencies -- stressed that the outcome of the double dip debate was central to their prognosis for the second half of this year. They urged Dick Berner and me to resolve this debate once and for all. Until we do, they collectively argued, the markets will swing back and forth between boom and dip -- but won’t stage a meaningful breakout one way or another. It’s a tortuous road that has everyone exhausted.
As much as Dick and I would like to reach closure on this debate, we both believe that the jury is still out (see his latest dispatch in today’s Forum, "Double-Dip Showdown"). The problem is that the evidence is really not decisive in support of either of our cases -- there’s still plenty of ammunition on both sides of the battle line. Dick can defend his own case, and in case you haven’t noticed, he does it very well. So here’s as fresh an update as I can muster on my side of the story:
I’ve said it from the start -- the American Consumer holds the key to any double dip. The double dips of the past -- and, yes, five of the last six recessions have been of the multiple-dip variety -- have all been triggered by a relapse in consumer demand. The macro dynamics that drive this outcome are actually quite simple: Coming out of the first dip, businesses are quick to boost production in an effort to rebuild depleted inventories. With recessionary memories fresh, earnings-constrained companies are intolerant of demand aftershocks. But such relapses are, unfortunately, not that uncommon. When they do occur, they are usually met promptly by renewed production cutbacks -- the essence of any secondary dips.
I still believe that script fits today’s US economy to a tee. Industrial production has been on the rise over the first five months of 2002 -- a dramatic about-face following outright contractions in 16 of the preceding 18 months. After the steep inventory liquidation of 2001, the post-September 11 rebound in personal consumption -- a 6.1% surge in 4Q01 -- convinced businesses that the worst was over. The subsequent lifting of production was aimed at bringing the liquidation phase of this inventory cycle to an end -- as long as the American consumer cooperated.
Yet the consumer is now laboring -- hinting at a classic demand relapse that could well trigger the double dip circa 2002. Consumption growth slowed to 3.3% in 1Q02 and, depending on the magnitude of any bounce-back in June following an anemic showing in May, consumer demand appears to have expanded at just a 2.0% to 2.5% annual rate in the quarter just ended. The bulk of the slowing over the past two quarters has been concentrated in durable goods, a partial payback for the 39.4% post-shock spike in 4Q01 that I have long felt would borrow from gains in the first half of this year.
The case for further moderation in consumer demand is compelling, in my view. Saving-short and overly indebted consumers are already feeling increased pressure from the pruning of bloated labor costs that occurs during every recession. This shows up in the form of a distinct moderation in the growth of wage and salary disbursements -- the core piece of personal income that has the biggest impact in shaping the ups and downs of personal consumption. In 2001, wage and salary disbursements accounted for fully 69% of total disposable personal income (DPI); yet over the first five months of 2002, such payments have accounted for just 16% of the cumulative growth of DPI. Moreover, my calculations suggest that real wage income was essentially unchanged in 2Q02 following an anemic 1.8% increase in the first period of the year. Tax cuts have been the major driver of consumer purchasing power thus far in 2002 -- injections of income that typically get saved rather than spent. The recent upturn in the personal saving rate seems to bear that out -- an increase from 0.6% in December 2001 to a still subpar 3.1% in May 2002.
All this takes the American consumer to the edge, but doesn’t push him or her over. It’s guesswork as to what might do so, but I have my suspicions. At the top of my worry list is another wave of corporate cost cutting -- this one taking dead aim at excess headcount, precisely the last thing an increasingly fragile consumer needs. That would put further pressure on wage income generation, enough, in my view, to trigger the final capitulation of the tired and over-extended American consumer.
The only new insight I have into this possibility is the possible link to America’s rapidly unfolding corporate governance shock. The credibility of US businesses is being challenged as never before. What keeps me awake at night is how, and under what circumstances, the bleeding stops. Each time there is a major revelation, overwrought investors want to conclude that it’s the last. The post-WorldCom rally is but the latest example of such hopes. Maybe this is as bad as it gets, but it’s hard to accept those odds at this point. Trevor Harris, our in-house accounting guru, has been clear in stressing that this story is far from over -- that Corporate America has been slow to get the message and that it may be another 12 months until most of the dirty laundry is finally aired.
Here’s where the story could take a new and different twist -- one that could heighten the chances of a double dip. In this increasingly populist climate, Corporate America needs to become far more aggressive in clearing the decks and restoring its credibility. As I see it, biting the bullet on the disclosure of lingering earnings distortions is a distinct possibility. But such a shift won’t occur in a vacuum. Such earnings capitulation would undoubtedly accelerate much of the cost cutting that is still being deferred today. Headcount reductions -- especially in the bloated managerial ranks -- would probably increase sharply. The outcome would be strikingly reminiscent of the white-collar job shedding that significantly restrained economic recovery in the early 1990s. In my view, another managerial shakeout has the potential to boost national unemployment toward 7% -- high enough to trigger heightened concerns of job and insecurity that I believe would derail an already vulnerable American consumer. Avoiding a double dip under such circumstances would take nothing short of a miracle.
There are no guarantees in the murky realm of macro forecasting. At the start of this year, the consensus of investors and forecasters was lined up in near-unanimous support of the vigorous recovery scenario. Today, it’s a different matter altogether. While few buy the full-blown double dip, recovery expectations have certainly been tempered dramatically. My guess is that there’s still more work to do in coming to grips with a considerably tougher reality.
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