Global: Was It All Just a Bad Dream?
Stephen Roach (from Beijing)
In just one week, financial markets have gone from despair to hope. Rewarded for leading the battle into Iraq, the US has led the way. With oil prices having plunged by 20%, stocks up 9%, yields on long Treasuries up 40 basis points, and a beleaguered dollar seemingly on the mend, it is tempting to conclude that the angst of a week ago was nothing more than a bad dream. Is it time to focus on postwar recovery?
The answer to that question, in my view, is an unequivocal “no.” While I certainly concede that the jury is out on the great recovery debate, I would argue most emphatically that it is entirely premature for investors to put war and business cycle risks behind them. We’re all taught that financial markets were put on this earth to embarrass as many as possible for most of the time. Yet I would argue that it is truly an extraordinary leap of faith for investors to conclude that American military supremacy will lead to the “perfect victory” -- an outcome that can then be seamlessly translated into economic and financial market vigor. It’s times like this where the analyst has to keep cool and stay focused on fundamentals -- not emotion. As I see it, the market volatility of the past week smacks more of the latter than the former.
The fundamentals, in my view, must still be scrutinized through the lens of a classic shock analysis. As I have stressed repeatedly, there are two aspects to this framework -- pre-shock vulnerability (or lack thereof) and the magnitude and duration of the shock itself. On the first count, there can be no mistaking the vulnerability of a US economy that has slowed to its stall speed -- a GDP growth pace below 2% by my reckoning. Our latest estimates put real GDP growth at about 1.2% in the current quarter, little different from the sluggish 1.4% gains in the final period of 2002. Moreover, we look for essentially “zero growth” in 2Q03, bringing the three-quarter growth rate slightly below 1%. To me that has stall speed written all over it -- a weak growth pace that deflates the cyclical cushion needed to buffer the economy against ever-frequent shocks.
But what about the shock? Surely, with oil prices now off 20% from their recent highs before the first missile was even launched, the likelihood of a swift march into Baghdad conjures up images of 1991, when postwar crude prices plunged into the mid teens. While anything is possible, it is important to keep in mind that 2003 is not 1991. In particular, energy supplies are a good deal tighter and Venezuela is missing in action. Meanwhile, at $30 a barrel, today’s spot oil prices are still more than 50% above where they were in January 2002 -- hardly invalidating the notion of a shock. In other words, my recession-warning model -- a stalling US economy that has been hit by a shock -- is still flashing a high alert.
I’ve said all along, however, that there is more to this shock that just gyrating oil prices. To me, it’s more about geopolitical angst in a post-9/11 climate. Courtesy of global terrorism, the proliferation of weapons of mass destruction, and the breakdown of once steadfast alliances, today’s world is a far more unstable and much scarier place than it was in the aftermath of the Gulf War of 1991. It is that less tangible dimension of this shock that could well linger long after the battle of Iraq subsides. And the resulting fear factor could continue to constrain discretionary decision-making in the real economy for some time to come. For a US economy lacking in pent-up demand, the vigor of cyclical recovery may be especially difficult to come by under those circumstances.
In that regard, I continue to be very suspicious of the capital-spending bet that many believe will lead the postwar recovery charge (see my 5 March Global Economic Forum dispatch, “Capital Spending Myths”). Awash in excess supply and lacking in pricing power as a result, Corporate America is hardly in need of new capacity. Moreover, history tells us that this sector lags the rest of the economy at cyclical turns -- in fact, it has never been a leader. Moreover, America’s capital spending cycle is now an IT cycle; consolidation in the IT user community and the painful legacy effects of a popped bubble should continue to constrain this key segment of business spending for some time to come, in my view. Lacking a capital-spending dynamic, that puts the onus of US cyclical recovery back on the back of the tired and over-extended American consumer. In the end, that’s where the rubber always seems to meet the road. Needless to say, the recent softening of US labor markets is especially disconcerting in that regard. Once wealth-dependent, income generation is all that consumers have left. In that vein, rising joblessness could be the biggest threat of all in 2003.
Those are the fundamentals that I continue to focus on as we head into war -- fundamentals that leave me decidedly on the bearish side of the cyclical call for the US economy. And my concerns over persistent post-bubble excesses, deflationary risks, anemic national saving, exploding budget deficits, and massive current account gaps leave me equally concerned over the secular call as well. Victory in Iraq changes none of that, in my opinion. That leaves me in the uncomfortable place of worrying that we may be too fixated on the immediacy of the battle and too dismissive of the tough fundamentals that linger. I also worry that we could easily lose sight of the tectonic shifts that are now occurring in the world order -- and the instability and insecurity that lies ahead.
Although I was a young boy at the time, I will never forget hearing the words of President John F. Kennedy as he spoke to a fearful nation on the eve of the Cuban missile crisis. While my exact recall may not be perfect, the line that has forever haunted me warned Americans of the risk that “…the fruits of victory could quickly turn to ashes.” More than forty years later, that message is well worth remembering. In the meantime, don’t forget about the fundamentals.
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