Global: Payback Time
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By Stephen Roach (New York)
Morgan Stanley
Jul 12, 2004
World financial markets have only just begun to raise questions about the sustainability of the current global upturn. Forward earnings expectations imbedded in global equities have been ratcheted down slightly in recent weeks and global bonds have rallied back to levels prevailing at the start of the year. In the first half of 2004, a vigorous global upturn was taken for granted — as were the earnings vigor, inflation risks, and central bank tightening that such an outcome would spawn. Now some doubt is starting to creep in on all counts — and with good reason, in my view.
The issue is an old one but ultimately the most important bone of contention in the forecasting community — the staying power of the current upturn in the global economy. Reflecting the impetus of one of the greatest policy-stimulus campaigns in modern history, the global economy roared back with a vengeance in 2004. By our latest estimates, world GDP is likely to increase 4.6% this year — just shy of the 4.7% spike in 2000, which was the strongest gain since 1984. Certainly, the vigor of this year’s global resurgence caught most forecasters by surprise — especially those of us in the pessimistic camp, such as yours truly. Fortunately, I was outvoted by most members of the worldwide team of economists that I head. For the record, our forecast for 2004 global growth at the start of this year was 4.2%, not all that different from the official estimate of the IMF at 4.1%. The world economy has obviously been stronger than we had thought — especially in Japan, Asia ex Japan, and Latin America — but by forecasting standards, this does not qualify as an extreme error.
The growth spurt of 2004 is now old news. Financial markets were quick to embrace it and probably went to excess in discounting the boom scenario that an extrapolation of this trend might suggest. And with good reason — at least in the eyes of momentum-driven investors. Upside earnings revisions set a new record and a surprising acceleration in core inflation fueled concerns in fixed income markets over an aggressive monetary tightening. Brimming with mounting confidence over such possibilities, a growing sense of complacency became evident in world equity markets. Moreover, spreads remained tight in most segments of the fixed income markets, even though government yield curves started to discount the coming monetary tightening. In the eyes of most investors, it looked as if nothing could stop a classic cyclical revival from morphing into a full-fledged synchronous boom in a long sluggish global economy.
That was then. Suddenly, the world tilted. Surging oil prices were a classic early warning sign. China’s efforts to slow an overheated economy were another. The imperatives of Fed-policy normalization were the icing on the cake. After spending most of the past year, revising our global growth numbers up, downward revisions are now starting to creep back into our baseline forecast. We just lowered our 2004 US GDP growth estimate to 4.6% (from 4.8%) — the first reduction in a year. I wouldn’t be surprised to see similar adjustments to some of our Asian numbers, especially for Korea and Taiwan. And there are new disquieting signs coming out of Russia, which suddenly has been blindsided by the double whammy of problems in a high-profile bank and a major energy producer. And, of course, the debate over the China slowdown rages — not whether it will occur but whether the coming landing will be soft or hard. The latest indications on China’s industrial output growth — a further deceleration to a 16.2% Y-o-Y gain in June — paint a picture of a Chinese economy that is only in the early stage of either type of landing.
All this raises the distinct possibility that the boom of 2004 was nothing more than a one-off growth spike that fails to get traction in spurring a sustainable, synchronous upturn in the global economy. Our baseline forecast is not terribly far away from depicting just such a possibility. Our current estimates call for a 3.9% increase in world GDP growth in 2005 — a downshift of 0.7 percentage point from the 4.6% increase expected in 2004 and only 0.3 percentage point above the post-1970 longer-term trend of 3.6%. World financial markets are now in the process of digesting the ramifications of just such a downshift. Equity markets have been hit by a peaking of earnings revisions, and fixed income markets have now all but dismissed the possibility of an aggressive monetary tightening cycle. For the broad consensus of investors, complacency has now given way to a more balanced assessment of risks. The shift in sentiment, however, has stopped short of the ultimate capitulation to fear — that sense of panic, which ultimately sets the stage for major market moves.
I wouldn’t rule out just such a possibility over the next several months. As I see the world, the risks remain decidedly on the downside of our own forecast as well as that of the broad consensus of investors. There are three important reasons to worry about a global relapse, in my view: First, the powerful global policy stimulus that pushed the world to the upside in 2004 will not be in play in 2005. Outsize fiscal deficits in the US, Europe, and Japan are unlikely to widen further, and monetary policy is now in the process of moving away from the lower bound of the nominal interest constraint. Second, much of this year’s global growth surge was concentrated in durables goods — motor vehicles, housing-related outlays, and capital equipment. By definition, these are long-lived items that are purchased infrequently. To the extent that such spending gets distorted to the upside, it typically borrows from future demand. There are signs that just such a blow-out has occurred — especially in the US; durables consumption rose at a 23% annual rate in the two middle quarters of 2003; capital spending is being artificially stimulated by tax cuts that expire at the end of this year; and the homebuilding sector appears to be in the final stages of its boom, especially as interest rates now start to rise. Consequently, there is good reason to believe that the US durable goods impetus is likely to be short-lived.
The third potential source of a global relapse is one that has long disturbed me the most — the continued and worrisome build-up of global imbalances. It’s on this count that complacency remains very much intact. Views are widespread in policy and investor circles that the world has learned to live with a permanent state of disequilibrium in national saving balances. Yet another new paradigm is perceived to be at work, this one driven by globalization and the concomitant integration of world financial markets. We are urged not to look at America’s massive current account deficit, but more at its capital account surplus as a demonstration of the world’s insatiable demand for dollar-denominated assets. Never mind that such external demand for dollars is no longer coming from private investors but mainly from Asian central banks that wish to keep their currencies cheap and their exports competitive. Never mind that such tactics also subsidize US interest rates, thereby providing the sustenance for debt-intensive wealth extraction from asset markets — a key factor that keeps America on an excess consumption path. Needless to say, these conclusions are very much at odds with a more sanguine consensus. After all, since imbalances haven’t mattered yet, goes the logic, the odds are they won’t matter for the foreseeable future either.
Anything, of course, is possible in this Brave New World. But my guess is that is that this boom will be short-lived — likely followed by the payback that invariably comes when demand is artificially pulled forward. To the extent that this resurgence reflected the impact of unusual policy stimulus, then it is about to be starved of its fuel. To the extent that this resurgence was skewed to the upside by durable goods, then a pause is likely as consumers and businesses digest their recent excessive purchases of long-lived goods. And to the extent that the US-centric strain of the latest growth resurgence has exacerbated the imbalances of an already seriously unbalanced global economy, then the imperatives of rebalancing can only mount.
It is always possible, of course, that the world squeaks by without having to endure the pain of any payback. For that to occur, in my view, a US-centric world would have to weaned from the life-support measures of policy stimulus, asset-market-induced wealth effects, and an open-ended appetite for debt. A sustained pick-up in job creation — and the income generation that would spark — is both a necessary and sufficient condition for such a renewal to occur. That condition has not been satisfied, in my view. Even though US hiring has picked up over the past four months I have my doubts that such an organic, internal growth dynamic is about ready to kick in. As I see it, the quality of job creation has remained so low that the case for a spontaneous regeneration of earned labor income growth remains a real stretch (see my July 9 dispatch, “America’s Job-Quality Trap”).
Yes, financial markets have lost some of the complacency evident earlier this year. But by no means has there been a capitulation to the type of fear that often spawns major investment opportunities. Yet as I see the fundamentals, the case for just such a shift in the markets remains compelling, in my view. Macro is at its best in defining a framework of adjustment. Macro is at its worst in identifying that point in time when critical turning points occur. As I continue to see it, the current global upturn has all the trappings of the boom that begets the bust. For a world economy beset with record imbalances and supported by artificial policy stimulus, I continue to worry that the payback is coming sooner rather than later.
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