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The Big Slowdown
Interview With Nancy Lazar, Co-founder, International Strategy & Investment Group
By SANDRA WARD
A DAY WITHOUT INTERNATIONAL STRATEGY & investment Group's global economic analysis is a day without access to some of the most current and informed thinking about where the world and its money are headed. Fans especially appreciate the turn-on-a-dime investment calls, in which co-founders Nancy Lazar and Ed Hyman adjust their views to reflect the latest developments in monetary policy, the most recent findings of ISI's proprietary industry surveys and up-to-the-minute business trends from Sydney to Seoul to Stockholm to Seattle. Indeed, in the past few weeks they have changed their forecast for the fed-funds rate and reassessed their view on the outlook for housing. But it still adds up to a forecast for a major slowdown around the globe. Let Lazar explain.
Barron's: Is the bad news outweighing the good news these days?
Lazar: Global growth is certainly slowing. But I think the slowdown in the economy is good news because there were some inflationary pressures starting to build up in the system. We saw it in the data and we were hearing it anecdotally from companies. So to use the cliché, this is the pause that refreshes and it increases the odds that we have a prolonged expansion.
What is your outlook for growth this year?
Growth is definitely going to slow and will be noticeable. You had 3% in the second quarter, but that will decelerate in the third quarter to about 2.5% and maybe even 2% by the fourth quarter and the first half of 2006.
The ISI seer thinks there's a good chance inflation is peaking and will be low for quite some time.
Will we be spared a recession?
I don't think we have the ingredients for a recession. There was an inflation scare that is fading pretty quickly -- not disappearing but fading pretty quickly. The slowdown in the economy further increases the odds that inflation probably slows a little bit. Tom Gallagher, our head of policy research in Washington, has the Fed stopping at 3.75%, given its hawkish bias towards inflation and because growth has been OK. Also, the Fed is very focused lately on housing and housing prices and might tighten a touch more than they would otherwise to reduce the froth in that market. The key ingredient for why there probably won't be a recession is that wage inflation has remained tame. Prior to previous recessions, there's been a clear acceleration in inflation and wage inflation and the Fed has had to really slam on the brakes. Another characteristic of a mid-cycle slowdown is that bonds and fed funds converge. The bond market figures out before the Fed decides to change rates that the economy is slowing. Obviously, the yield curve has flattened as bond yields have come down. The same thing happened in 1985 and 1995. By the summer of 1995, bond yields and fed funds were at equilibrium and the Fed was finished tightening. We are forecasting fed funds and bond yields to converge at roughly 3.8%, similar to what occurred in 1995.
Yet a lot of people assume a flattening of the yield curve is enough to push us into recession.
The flattening of the yield curve is going to increase the odds you get a slowdown. Also, there's been a very sharp slowdown in money supply, which suggests the Fed is tighter than the 3% fed funds suggest. Historically, it is the change in the fed-funds rate that drives the change in money supply and not the level. The Fed was easing very aggressively in 2001 and 2002 and the fed-funds rate plunged 500 basis points [five percentage points]. Now it's up 200 basis points, and that has corresponded perfectly with a very sharp slowdown in money supply to basically zero. It is the combination of all these forces, from oil to money supply to the yield curve, that are indeed contributing to this slowdown.
There has been a lot of comparison to 1995 in the ISI reports.
In the 1980s and 'Nineties you had very long expansions. But within both, there were roughly three cycles. The first cycle I'd call the strong advance, in which the economy finally comes out of recession and accelerates enough so there is some inflation concern and the Fed tightens. That happened in 1984, that happened 1994 and that happened in 2004. Then, in both the previous two decades and maybe again now, in part as a result of that tightening, the economy slowed. It slowed in 1985, it slowed in 1995. In both of those periods, the Fed then eased and the economy reaccelerated. Today, there is a comparison not only to the '95 period but also maybe to the '85 period, where the economy slows because of central-bank tightening and higher oil prices. We are moving into the mid-cycle slowdown.
What sets this period apart?
In both '85 and '95, the stock market absolutely had a very strong run. In the 1985 period it was more of a step function, where the market rallied and then went sideways for several months then made another significant rally and then went sideways again. By the time the mid-cycle slowdown was over, there was still a very significant rally in 1985. In 1995, it was just a steady climb in the stock market for roughly a year straight. This stock market is not behaving like 1995 so far. It has similar characteristics to 1985, because the market rallied last fall and then went sideways and rallied again this spring before going sideways. It is still early in the mid-cycle slowdown and, I think, on a historical basis there should be a decent rally in the market, though maybe not as much as occurred in 1985, when the markets rallied about 40%. We are not expecting that, but we do think the market can rally roughly 15% from its spring low of April 20.
Are you still concerned about a looming financial crisis?
Yes. At this stage of a business cycle there has always been a financial crisis. By that I mean roughly one year after the Fed has started to tighten, there's been a financial crisis. Put differently, as you go into a mid-cycle slowdown, there's always been a financial crisis. We've had a little taste of strains in the system with the General Motors and Ford debt downgrades of several weeks ago. As of now, they seem to have faded. I still think we are going to end up with a very clear financial crisis. I don't know if it is going to be problems at GM and Ford resurfacing, or some other part of the economy or another country. But historically, the combination of higher interest rates and a slowdown in the economy puts a lot of pressure on the weak links.
What about home-equity loans? They've soared to levels never seen before. Could that be a problem area?
There are many categories, and home-equity lending, to the extent it was growing roughly 45% for several years in a row, is a candidate. But quite frankly, with our forecast for growth to slow, inflation to slow and the Fed to be done tightening sooner rather than later, interest rates are likely to be lower than anyone would have expected at this stage of a business cycle. That could actually further cushion or maybe even support home-equity loans and make it even a bigger problem. Whenever interest rates do start rising again, it could be a real crisis. However, home-equity lending could become an issue today if employment in certain parts of the country were to weaken. We are less bullish on housing than we had been given the Fed's attempts at cooling some of the speculation and risky mortgage lending that's occurred in the real-estate market. Housing could weaken as a result and contribute to the economic slowdown.
The Big Slowdown -- Part II
What's your outlook on capital spending?
We are going to have a full-blown economic slowdown, from consumer spending to capital spending. That's in part related to a slowdown in corporate profit growth. S&P 500 operating earnings, year-over-year, could move down toward zero by the fourth quarter. If companies start to see that kind of pressure on their profits, they'll cut back on spending or certainly slow spending growth, including capital spending. The Business Roundtable and Duke University business-confidence measures have started to weaken. That to me is confirmation we are probably starting to see the slowdown in profits and suggests a slowdown in employment and capex.
What about the global scene?
This is a full-blown, synchronized global slowdown, and actually some parts of the world will probably be weaker than the United States.
The emerging markets, too?
It is very true for the emerging markets. The main culprit there is energy. Energy prices are up around the world, and historically prior to every domestic and global slowdown we've always had an increase in energy prices. The case and evidence for slower growth outside of the United States is even more powerful than it is inside the United States. There is so much weak foreign economic news from the developed economies, Europe and the U.K. in particular, and from the developing economies. We've exported a lot of our manufacturing activity to these developing economies, and as we slow, they slow.
Any areas bucking the trend? What about the commodity-producing countries?
Australia has a double-edged sword. On the one hand, as a commodity producer it's doing OK, but on the other hand, their housing is slowing. That said, to the extent this is a global slowdown, historically during every global slowdown you have had some pressure taken off of commodity prices if not actually a decline in commodity prices, and so we would expect some softness in commodity prices because this is indeed a global slowdown. I would expect China to remain pretty strong, but gee, even they could experience somewhat of a slowdown because of their huge export market. If we are slowing and Japan is slowing and Germany is slowing, there is a chance China might slow some, and maybe that's what this recent decline we've seen in the Baltic Freight Index is indicating. In addition, the purchasing managers' index for China has also faded some recently.
Table: The Coming Pause2
What does all this mean for the dollar?
I'm not a big dollar forecaster. We look at the dollar technically, and technically it has made a nice move to the upside. Whether or not it continues is another story. The dollar is relative to everything else. To the extent there is a pretty clear slowdown from Europe to Japan, maybe the dollar can hold its own, and technically it has had some nice support.
Will foreign interest in U.S. bonds continue?
That's had some impact on our bond market. But, as you know, bond yields around the world have declined dramatically. The real main driver for lower bond yields, globally along with the U.S., is that inflation is going to stay low. Even [Federal Reserve] Chairman Greenspan retracted his "conundrum" remark and said the financial market's focus on low inflation is encouraging bond yields around the world to move lower. So foreign-central-bank buying of bonds could be a factor, but the driving force is a slowdown in global growth and low inflation. Core inflation has peaked at less than 2%. That's pretty encouraging, and the Fed is going to make sure it doesn't get out of control.
What is the long-term trend for inflation? Is it time to be more concerned about deflationary forces?
One step at a time. I can't even convince people that inflation is peaking. If we get another couple of months of inflation news like we saw in April, increasingly there will be a view that because of the slowdown, because of the competition, because of China, because of technology, because of the slowdown in money supply, there is a good shot that inflation has peaked and should indeed slow as long as we are in this mid-cycle slowdown phase. Beyond that, I would think that even secularly we are going to remain in a pretty low inflationary environment.
Why are you having such a hard time convincing people inflation has peaked?
Commodity prices are hooking back up. If China stays strong, won't commodity prices stay strong? Some of the data still aren't convincing people, particularly the unit-labor-cost data and the compensation-per-hour data are very strong, and that worries some. I've noticed labor costs and compensation have accelerated. But if you go back and study previous mid-cycle slowdowns, particularly in the 1985 and '95 periods, even though unit labor costs accelerated, inflation slowed because the economy slowed.
Where are we headed with oil?
That's our integrated-oil strategist's focus. Mike Rothman believes, in part because of the global slowdown, that oil prices should move lower -- say, toward roughly $45, by the end of the year. But that's a pretty hard story to peddle with oil moving back up toward $60.
I was surprised to read in one of your reports that productivity declined quarter-over-quarter.
So was I. It does look as if second-quarter productivity could actually decline slightly, and it is an unusual event. I don't think it's a prolonged phenomenon, but it is going to put some pressure on corporate profit margins. I suspect as a result you are going to see a very clear slowdown in employment. There is still a debate on whether or not the May employment reading reflects a beginning of a major slowdown in employment. And I would say that May employment numbers probably understated job growth just as April numbers probably overstated job growth. We probably need to look at a two-month average. But before it is over, there will be a very clear slowdown in employment, in part because of the pressure on productivity and therefore profit margins.
But has employment really ever picked up to the extent you would have expected in a recovery?
Absolutely not. There is plenty of slack in the system. This employment cycle is anemic relative to the 1994-95 employment cycle and that was a jobless recovery. That is another key reason why I think inflation stays low; there is still plenty of labor-market slack in the system.
Because of gains from technology?
That's part of it, but I think it also has to do with health-care costs. There seem to be three key drivers for employment growth. Two of them are real GDP and the GDP price deflator, or a company's ability to sell a product at a certain price. But the third variable seems to be health benefits, or benefits in general. And benefit inflation has been too strong. Put differently, despite improvement in GDP, employment growth has been restrained given the strength in benefits. Companies are just saying no. One of the most positive things that could happen for the long-term employment cycle would be a very clear slowdown in benefit inflation. Maybe it is starting. We saw the Employment Cost Index in the first quarter, and it was encouraging. If that were to continue it would be very helpful to long-term employment growth. We have not had a bad recovery from a GDP standpoint through 2002-2004, so I'm not convinced we need strong employment growth. But we need solid employment growth, and I suspect that resurfaces again after this mid-cycle slowdown.
Where do you expect interest rates will end up?
Ten-year Treasury yields move down to 3.60 and the Fed should be done at roughly 3.75. The Fed will tighten probably at the June, August and September meetings, bringing the fed-funds rate to 3.75%. But by then it should be clear we're in a mid-cycle slowdown.
So are you bullish on bonds here?
I would be bullish on bonds. First, the economy slows. Second, there's lower inflation. In addition, there is still an awful lot of bears on the bond market, and from a contrarian standpoint, that makes bonds a fair bet. It is not just in the U.S., but globally there have been tremendous rallies. Long rates in China are down to about 3½%. In Germany, they are down to about 3.20. At 4% in the U.S., we're not low compared to the rest of the world, and maybe we're a little on the high side.
Thanks, Nancy.
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