July 13, 2002

Steven Roach Preaches Doom and Gloom

Morgan Stanley's Stephen Roach--one of the best we have at current analysis of the state of the business cycle--explains why he is so much more pessimistic about the future of the American economy than the typical forecaster. In brief, he sees the parallels between the U.S. today and Japan a decade ago as much stronger than the typical forecaster does (or than I do).


Morgan Stanley Global Economic Forum

...most view the US macro outlook through the lens of a traditional business cycle framework. That's not unlike the approach that remains in favor back home. I guess I'm on a different planet. I continue to see the US macro through the lens of a popped asset bubble. As a result, the macro I practice these days couldn't be more dissimilar from that embraced by the broad consensus of investors, businesspeople, and policy makers. For me, the past several years have been like peeling away the layers of an onion. Once the equity bubble popped, the steady progression of subsequent events has fallen into place in a fairly logical and predictable fashion. Nasdaq, of course, was the first to go -- and, sadly, is still going. It's currently off 73% from its March 2000 high. The information technology bubble was next to fall in line, with nominal IT hardware expenditures plunging 26% over the four quarters of 2001. The linkage between the Nasdaq and IT bubbles is crystal clear in my mind. As Nasdaq soared toward 5000, Corporate America -- especially the so-called Old Economy companies -- was keen to reinvent itself as a collection of e-based New Economy companies. It was a surefire recipe for stodgy US businesses to receive a zippy Nasdaq-like re-rating. The B2B and B2C frenzies provided the cover, and the IT-induced spending binge was on with a vengeance. The Y2K mania was the icing on this cake. The IT cycle went to excess and the rest is history.

Not much argument on this point. However, most of the financial market participants I meet with don't want to take the post-bubble shakeout beyond the ensuing IT carnage. Implicit in this line of reasoning is the belief that any damage from the asset bubble was confined to that relatively narrow portion of the economy that got carried away with a legitimate technological revolution. After all, even at its peak in late 2000, nominal IT accounted for only about 5% of America's GDP. Why indict the remaining 95% of the US economy? Here's where the rubber meets the road for my stylized depiction of macro. As I see it, the bubble went far enough -- for long enough -- to have permeated most other facets of economic activity in the United States. Not only did it entice Corporate America to go on to binge out on IT spending, but it also lulled consumers into the mistaken belief that a surging equity market had become a new and permanent source of saving. It's hardly a coincidence, in my view, that a pre-bubble personal saving rate of 6.6% in late 1994 plunged to 0.5% in March 2000.

Global: A Different Lens

Stephen Roach (from Sydney)


Context is everything in the macro research business. As I travel the world, I still find that most view the US macro outlook through the lens of a traditional business cycle framework. Thatís not unlike the approach that remains in favor back home. I guess Iím on a different planet. I continue to see the US macro through the lens of a popped asset bubble. As a result, the macro I practice these days couldnít be more dissimilar from that embraced by the broad consensus of investors, businesspeople, and policy makers.

For me, the past several years have been like peeling away the layers of an onion. Once the equity bubble popped, the steady progression of subsequent events has fallen into place in a fairly logical and predictable fashion. Nasdaq, of course, was the first to go -- and, sadly, is still going. Itís currently off 73% from its March 2000 high. The information technology bubble was next to fall in line, with nominal IT hardware expenditures plunging 26% over the four quarters of 2001. The linkage between the Nasdaq and IT bubbles is crystal clear in my mind. As Nasdaq soared toward 5000, Corporate America -- especially the so-called Old Economy companies -- was keen to reinvent itself as a collection of e-based New Economy companies. It was a surefire recipe for stodgy US businesses to receive a zippy Nasdaq-like re-rating. The B2B and B2C frenzies provided the cover, and the IT-induced spending binge was on with a vengeance. The Y2K mania was the icing on this cake. The IT cycle went to excess and the rest is history.

Not much argument on this point. However, most of the financial market participants I meet with donít want to take the post-bubble shakeout beyond the ensuing IT carnage. Implicit in this line of reasoning is the belief that any damage from the asset bubble was confined to that relatively narrow portion of the economy that got carried away with a legitimate technological revolution. After all, even at its peak in late 2000, nominal IT accounted for only about 5% of Americaís GDP. Why indict the remaining 95% of the US economy?

Hereís where the rubber meets the road for my stylized depiction of macro. As I see it, the bubble went far enough -- for long enough -- to have permeated most other facets of economic activity in the United States. Not only did it entice Corporate America to go on to binge out on IT spending, but it also lulled consumers into the mistaken belief that a surging equity market had become a new and permanent source of saving. Itís hardly a coincidence, in my view, that a pre-bubble personal saving rate of 6.6% in late 1994 plunged to 0.5% in March 2000. Consumers were more than willing to extract new sources of purchasing power from what they perceived to be ever-appreciating equity assets. Unlike businesses, consumers have remained in denial -- keeping many of the dreams of the bubble still alive. Thatís because asset-driven saving strategies have gotten a new lease on life in this post-Nasdaq-bubble climate. Property market appreciation has taken over where Nasdaq left off, and consumers have continued down the merry road of extracting incremental purchasing power from yet another bubble -- their homes.

Sadly, it doesnít stop there. The US economy has taken on most of the other classic characteristics of a post-bubble era. The debt-deflation syndrome is especially worrisome in that regard. Private sector debt loads remain at record highs to this day -- for consumers and businesses alike. Even debt service burdens are at records for American households -- especially shocking in a climate when market interest rates are at 40-year lows. The excesses of the debt cycle are always the transmission mechanism for the extremes of wealth-related impacts on real economic activity -- they are the principal means by which new sources of purchasing power are extracted from frothy asset markets. Moreover, to the extent that asset bubbles promote an uneconomic expansion on the supply side of the real economy, the popping of that bubble unleashes a powerful deflationary impulse. The capital spending binge of the late 1990s is classic in that regard. So, too, is the message from the broadest measure of the US inflation rate -- an anemic 0.5% average increase in the GDP chain-weighted price index in the two quarters ending in 1Q02. America is now teetering closer to the brink of outright deflation that any point in the past 48 years.

All this sets the stage for what could be several more years of a post-bubble shakeout. The excesses of the debt cycle are a breeding ground for systemic risks in the financial system -- and for the financial accident that always seeks to arise out of this climate (see my 10 July dispatch "The Risk of Financial Accidents" and my 8 July dispatch, "The Drumbeat of Systemic Risk"). In addition, the debt cycle lies at the heart of Americaís current-account financing conundrum. Lacking in domestic saving, the United States has had to tap foreign saving pools to finance excessive spending at home. The result has been a record-setting balance-of-payments deficit and the related overhang of a dollar bubble. As seen from that perspective, the recent popping of the dollar bubble makes perfect sense -- itís just the latest layer of the onion to get peeled off.

This admittedly stylized depiction of Americaís post-bubble macro climate provides some important hints as to what lies ahead. Two other bubbles still seem likely to be popped -- the property bubble and Americaís consumption bubble. Itís only a matter of when -- not if -- in my view. As always, supply-demand imbalances hold the key to the property market. New homebuilding supply has been coming on stream with considerable vigor in the past couple of years. Thatís the message from the surprising strength of housing starts. Unfortunately, itís occurred at precisely the same time that demand underpinnings are being weakened by rising unemployment. As I see it, the housing cycle is much closer to the end than to the beginning.

Yet the American consumer remains steeped in denial. Before this post-bubble shakeout is over, I believe that denial will crack. Saving-short and overly indebted, consumers have thus far ignored the perils of rising unemployment and the related downward pressures on wage income generation. That, in my view, will change if the jobless rate continues to rise, as I suspect it will in a climate of ongoing corporate cost cutting. Lacking in asset-based incremental purchasing power, consumers will have no choice other than to relearn the art of saving from their paychecks. The ticking of the demographic clock can only put greater pressure on the coming shift in the preference for saving. The aging generation of baby-boomers adds a new urgency to retirement planning. The secular shift from defined-benefit to defined-contribution pension regimes only heightens that urgency. The consumer bubble will probably be the last bubble to pop. But I remain convinced that any post-bubble adjustment in the US economy will remain incomplete until this layer of the onion is peeled as well.

Finally, there are critical cultural, social, and political implications of any post-bubble shakeout. Americaís corporate governance shock -- and the regulatory backlash it is triggering -- are at the top of my list in that regard. The greed and hubris of the late 1990s was classic in distorting the values of the American system. Again, that should not be so surprising. Bubbles do that -- in fact, every one Iíve ever studied leads to precisely this same point of warped values and socio-cultural excesses. The good news is that our system is coping with these very excesses today. The bad news is that my macro lens tells me there are still several more layers to this onion to be peeled. As I said, it all depends on context.

Posted by DeLong at July 13, 2002 01:20 PM

Comments

Roach doesn't marshall any evidence here for what he says.

This unfortunately doesn't mean he is wrong.

My own take on the UK, at least, is that property prices continue to rise at +20% p.a., while stock markets fall and the financial services sector (almost 10% of GDP) is showing significant signs of stress. Rental flats in Central London now yield c. 3% net, which against government bond yields of c. 5% is surely not sustainable.

Consumption has grown faster than income in the UK for at least the past 5 years: consumer borrowings have risen commensurately. Historically, this has always led to a currency crisis, but because of the problems of the Euro and the strength of the dollar, this has not been the case this time. The strong pound has held down inflation, which has stayed the Bank of England's hand.

In the late 1980s, the UK was in a similar position of rising housing prices and increasing consumer debt. Once the Bank of England raised interest rates (to a peak of 15%), the housing market began a crash which led to drops of c. 40%. In addition, personal savings ratios doubled.

My sense is the UK is unquestionably still living through the consequences of its own bubble, driven in part by the global telecom-IT boom and the rising stock market, but also by its own singular factors (rising government spending, shortage of new housing land leading to higher prices and hence higher consumption).

Whether the UK will repeat the severe recession of the early 1990s? I certainly hope not, but in the UK at least, we can say that all the evidence of Roach's continuing asset bubble is in place.

See www.valuingwallstreet.com for Andrew Smither's case for the overvalued S&P.

Posted by: John on July 14, 2002 11:19 AM

I've seen the past recession as the result of a massive drop in capital spending. IT can be lumped into this. Yet somehow, consumers kept spending so the result was a mild recession. Now, I haven't looked at the numbers, but if capital spending is picking up, then we might not have to worry about prolonged stagnation.

Posted by: Sean Hackbarth on July 14, 2002 10:00 PM

An increase in business investment, even if large, is unlikely to offset the full impact of a fall in consumer spending (because the latter is c. 60% ? of GDP, and the former c. 15%).

In addition, business investment tends to respond to demand, so if the demand is not there, then the investment will not follow.

The external side might help the US greatly: the dollar is now at parity with the Euro, and I expect it to fall to 0.8-0.9 euro/ dollar. This will be very good news for US exporters (those steel mills we keep weeping for also Boeing) and (perhaps more importantly) for US manufacturers producing for domestic markets in competition against foreigners.

The difficulty is this will also unleash deflationary forces, particularly in Europe (where growth is now almost entirely the result of exports), but also in Mexico (peso too strong) and Asia (Japan must be sweating it). As the US' trading partners are suffering from their own domestic structural problems, strong currencies will really hurt.

To avert a global slowdown, the central banks of Europe and Asia will need to pursue some (for them) quite radical monetary loosening. To date, as the torrid experience with the Bank of Japan shows, they are most unwilling to do so.

Where does it all end up? I see the US having a protracted period of slower growth, as consumers seek to rebuild their savings ratios to historic levels (from minus 1-2 % to plus 3-4%), as US companies digest the impact of their huge investment binge of the late 90s (so, for example, not hiring more workers, but simply producing with fewer), and the US external deficit slowly corrects itself. Because of the 'reverse J curve' effect, the US external balance will get *worse* before it gets better: ie the value effect (dollar imports go up because the US pays more for them) will offset the substitution effect (switching to domestic sources which are now more competitive) in the short run.

Short term, there won't even be light at the end of the tunnel, until the Iraq invasion is done and dusted. For reasons of weather and logistics (you have to attack October-March in the desert and it takes 6 months to move 300,000 men and their supplies into position), I don't expect that before March 2003.

The policy response of European and Asian central banks and governments is key: if they maintain their tight stances, then the world economy could be sluggish for a long time.

Posted by: John on July 16, 2002 03:08 AM

Roach, the most perceptive analyst out there, is right yet again: the U.S. is following in the footsteps of Japan. A bubble is a bubble, it creates severe misallocation of resources into nonproductive investments, and that matters. It's not somethat an interest cut is going to fix (how pray does that get us back the wasted resources?). It's not just the American consumer in denial, but most economists and economic analysts.

Posted by: Andrew Boucher on July 26, 2002 01:23 PM

i am looking foward to adopt a guinea pig in mid town manhattan please e-mail me for information on my topic

Posted by: alfredo on September 2, 2002 06:57 AM

It takes significantly less time than six months to move 300,000 troops

Posted by: emil kaneti on October 16, 2002 08:05 PM
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