FYI | Oct 23 2007
By Chris Shaw
In what would not be a surprise to regular readers of his work Stephen Roach, chairman of Morgan Stanley Asia, has taken a bearish view on the outlook for the global economy given the recent bursting of the US property market bubble.
But it isn’t the sub-prime issue that is the major factor in Roach’s view, as he sees this as simply the tip of a much larger iceberg. Rather, it is the potential impact of the housing collapse on the ability of the US consumer to continue spending that has him most concerned.
Figures back up his view the bursting of the housing bubble will hurt the economy more than the dotcom bust at the end of last decade, as consumption now represents 72% of US GDP, a five-fold increase since 2000.
It is this consumption by the US consumer that has driven the demand side of global growth in recent years, Roach noting real consumption growth for the global economy has averaged 4% since 1996, with US consumption expenditure now standing at more than US$9.6 trillion or around 19% of global GDP.
The two drivers of consumption growth are income and wealth, but it certainly hasn’t been higher income driving US consumers in recent years. Roach points out over the last 69 months US private sector compensation as a measure of income has risen only 17% in inflation adjusted terms, an outcome well short of the 28% average increase in previous business cycle expansions.
This means the consumption boom has been financed largely by wealth and here the consumer has turned to rising residential real estate prices, increasing the net extraction from residential property from 3% of disposable personal income in 2001 to 9% by 2005.
That was fine while property prices were rising but this is no longer the case, meaning consumers are being squeezed at both the income and wealth end of the equation. For Roach this means one conclusion – a reduction in demand. Again the economic data back up such a view, as the US is experiencing a slowdown in job creation and the current supply overhang in the property market means there is scope for house prices to actually fall through 2008 and 2009 in his view.
There has been a quick flow through into net equity extraction as Roach notes this has now fallen to 5.5% compared to its high of 9% just two years ago. In other words, the US consumer is slowing down and for Roach this means the chance of the US economy entering a recession is rising.
Sadly for the rest of the world, he expects any US recession to impact on the global growth outlook as he is not a buyer of the theory the rest of the world’s economy is de-coupling from the US.
Indeed, Roach argues de-coupling is based on a fundamental contradiction in that it assumes greater globalisation, which makes cross-border linkages even more important. The counter argument is there are as yet no signs of a slowing in the global economy, but Roach contends this is because to date the US slowdown has been contained in the housing sector. As it spreads to other sectors of the economy it will begin to have a greater impact on the global economic outlook and recent earnings warnings from companies such as Caterpillar suggest this may in fact be starting to come into effect.
He also doesn’t agree with the argument Asia will be immune from any slowdown given it is less reliant on the US economy, arguing growth in the Asian region continues to be export-led while internal private consumption, the sector that would have to grow if de-coupling were to take over, has fallen from 67% to 50% since 1980.
For further evidence he points out a full 21% of China’s exports go to the US, while proposing the acceleration of intra-regional trade is in reality the development of what he classes as a pan-Asian supply chain based around China and focussed on sourcing new end-market demand for US consumers.
While Asia will be hurt if the US enters a recession Roach notes the impact won’t be felt evenly throughout the region. Least impacted is likely to be China, as while a US slowdown will also slows its growth it is only likely to come back to something in the order of 8%, or roughly inline with the slowdown the Chinese government has been trying to bring about anyway.
More serious will be the impact on growth in countries such as Japan where the economy has less domestic growth to support it in the face of a slowing of its export activities, while South Korea and Taiwan should also feel some impact.
As world growth slows Roach expects the US dollar to continue to weaken, something he suggests won’t come to an end until the US addresses its savings imbalance. He also sees potential for the current anti-China political sentiment in the US to weigh on the currency as the imposition of any sanctions would make the Chinese less keen to invest in the US, so worsening the current trade balance.
The problem for the US would then also become one of dealing with inflation, as a weaker US dollar would increase the price of imported goods and this would create additional inflationary pressures in the economy.
In terms of what outcome appears to be most likely Roach estimates global growth could come back to around 3.5% from the current rate of closer to 5%. This would bring growth back to its average since the 1970s, but still represents a slowdown of as much as 25% from recent highs.
This, Roach suggests, would be enough to bring corporate earnings under pressure globally, which doesn’t auger well for share prices given what he describes as earnings optimism still built into global equity prices. Conversely this should be good news for sovereign bonds as an earnings slowdown would likely deliver structural relief on the inflation front.
The other outcome Roach wants is a greater understanding by central bankers of what challenges globalisation presents, as the localised focus of central bank policymakers has in large part helped the global economy reach the current point. What is required in his view is a far broader perspective in terms of policy setting, something he hopes to see sooner rather than later.
