naked capitalism

Reader Saboor was kind enough to send me an August 1 report by Stephen Roach, former chief economist of Morgan Stanley, now chairman of its Asian operations. It’s noteworthy in two respects. First, although Roach remains a long-term dollar bear, he made a well timed call that it was oversold, due for a rally, and could stay at higher levels into early 2009 before it resumes its slide. He also argued that inflation will moderate, which has suddenly become conventional wisdom.

Second, by the standards of bears (and Roach is a constitutional bear), his forecast is in some ways surprisingly moderate, but a close reading suggests that he sees almost all the risks to be on the downside.

He starts by arguing that the root of our collective mess is sustained US overconsumption:

No economy can live beyond its means in perpetuity. Yet….the US thought it was different. America’s current account deficit surged from 1.5% of GDP in 1995 to 6% in 2006. At its peak annualized deficit of $844 billion in the third quarter of 2006, the US required $3.4 billion of capital inflows from abroad each business day in order to fund a massive shortfall of domestic saving….

At the root of the problem was America’s audacious shift from income- to asset-based saving. The US consumer led the charge, with trend growth in real consumer demand hitting 3.5% per annum in real terms over the 14-year interval, 1994
to 2007 – the greatest buying binge over such a protracted period for any economy in modern history. Never mind a seemingly chronic shortfall of income generation, with real disposable personal income growth averaging just 3.2% over the same period. American consumers no longer felt they had to save the old-fashioned way – they drew down incomebased saving rates to zero for the first time since the Great Depression. And why not? After all, they had uncovered the alchemy of a new asset-based saving strategy – first out of equities in the latter half of the 1990s and then out of housing in the first half of the current decade…..

That enabled income-short American consumers not only to squander income-based saving but also to push consumption up to a record 72% of real GDP in 2007….And, of course, they went on a record debt binge to pull it off. Household sector indebtedness surged to 133% of disposable personal income by year-end 2007 – up over 40 percentage points from debt loads of 90% prevailing just a decade earlier. It was the height of folly. Yet the longer it lasted, the more it became deeply ingrained in the American psyche. And now it is finally over.

Roach discusses at some length the role of developing economies. They happily accommodated this situation, since US overconsumption produced export-led growth that was much faster than if they had sought to build up their own consumer markets as well as pursuing foreign opportunities. Roach concludes:

The global boom of 2002 to mid-2007 was an outgrowth of the powerful cross-border linkages of globalization. No region of the world benefited more from this connectedness than export-led Asia. That has been especially the case in the region’s high-flying developing economies, dominated by China. Decoupling – the supposed untethering of developing economies from the developed world – is antithetical to the linkages that have become central to the powerful globalization trends of the past five years.

He presents a useful paradigm (click to enlarge) :

He deems the first order effects, which consist largely of the hits to the financial system, to be roughly 65% complete. Readers will know that this blogger thinks that is a tad optimistic (we seem to be roughly halfway through the housing price decline, and sources suggest that while banks have made good progress in marking down subprime, they are behind on Alt-As, option ARM, and arguably on LBO loans too). But he makes up for it with the rest of his discussion:

The second stage reflects the impacts of the credit and housing implosions on the real side of the US economy.
As noted above, the main event in this phase of the adjustment is the likely capitulation of the over-extended, saving-short, overly-indebted US consumer. For nearly a decade and a half, real consumption growth averaged close to 4% per year. As consumers now move to rebuild income-based saving and prune debt burdens, a multi-year downshift in consumer demand is now likely. Over the next two to three years, I expect trend consumption growth rate to be cut in half to around 2%. There will be quarters when consumer spending falls short of that bogey and the US economy lapses into a recessionary state. There will undoubtedly also be quarters when consumption growth is faster than the 2% norm and it will appear that a recovery is under way. Such rebounds, unfortunately, should prove short-lived for post-bubble American consumers. This aspect of the macro-adjustment scenario has only just begun. As a result, Phase II is only about 20% complete, in my view.

Consumers have done such a good job (if you can call it that) of continuing to spend despite weakening of the real economy and tightening of credit (like banks cutting home equity credit lines) of continuing to consume that many economists appear to assume that retail spending won’t take much of a hit. I’ve been surprised at the continued optimism I’ve heard on this front.

Back to Roach:

The third stage is a global phase – underscored by the linkages between the US consumer and the rest of the world. As also noted above, those linkages are only now just beginning to play out. Ordering and cross-border shipping lags suggest that this phase of the adjustment will take a good deal of time to unfold. Early impacts are already evident in China and Japan – largely on the basis of US-led export adjustments. With ripple effects now only beginning to show up in Europe, these cross-border impacts should gather in force over the months and quarters to come. That suggests to me that Phase III is only about 10% complete.

In short, this macro crisis is far from over….

A voracious appetite for economic growth lies at the heart of the boom that has now gone bust. An income-short US economy rejected a slower pace of domestic demand. It turned, instead, to an asset- and debt-financed growth binge that had little to do with the time-honored underpinnings of income generation forthcoming from current production. For the developing world, rapid growth was a powerful antidote to a legacy of wrenching poverty.

Note again his discussion was considerably longer, but let’s proceed to the most interesting part, the prognosis:

Four key conclusions…

With equity markets now in bear-market territory in most parts of the world, it is tempting to conclude that the worst is over. I am suspicious of that prognosis…..it is important to make the distinction between financials and nonfinancials. The former have certainly been beaten down. While the adjustments of Phases II and III as outlined above will undoubtedly put more cyclical pressures on the earnings of financial institutions, share prices now seem to be discounting something close to such an outcome. That is not the case for nonfinancials, however. For example, consensus earnings expectations for the nonfinancials component of the S&P 500 are still centered on prospects of close to 25% earnings growth over 2007-08. As US economic growth falters, however, I fully expect earnings risks to tip to the downside for nonfinancials – underscoring the distinct possibility of yet another important downleg in global equity markets. The equity bear market is likely to shift from financials to nonfinancials.

For bonds, the prognosis centers on the interplay between inflation and growth risks – and the implications such a tradeoff has for the policy stance of central banks. As inflation fears have mounted recently, yields on sovereign government bonds have risen as market participants have started to discount a return to more aggressive monetary policy stances of major central banks. In a faltering growth climate, however, I suspect cyclical inflation fears will end up being overblown and monetary authorities will turn skittish out of fear of overkill. Over the near term, that leads me to conclude that major bond markets could rally somewhat on the heels of a rethinking of the aggressive central bank tightening scenario.

Over the medium term – namely, looking through the cycle – I concede that the jury is still out on stagflation risks, especially in inflation-prone developing economies. The bond market prognosis is more uncertain over that time horizon.

For currencies, the dollar remains center stage. I have been a dollar bear for over six years for one reason – America’s massive current account deficit. While the US external shortfall has been reduced somewhat over the past year and a half – largely for cyclical reasons – at 5% of GDP, it is still far too large. And so I remain fundamentally bearish on the dollar. At the same time, it appears that the dollar has overshot on the downside over the past 10 months on the fear that subprime is mainly a US problem. As the global repercussions of the macro crisis spread as outlined above, I believe that investors will rethink the belief that they can seek refuge in euro- and yen-denominated assets. As a result, I could envision the dollar actually stabilizing or possibly even rallying into yearend 2008 before resuming its decline in 2009 due to America’s still outsized current account deficit.

The commodity market outlook is especially topical these days. A year from now, I believe that economically sensitive commodity prices – oil, base metals, and other industrial materials – will be a good deal lower than they are today. Soft commodities – mainly agricultural products – as well as precious metals could well be the exception to that outcome. Two reasons underpin the case for a correction in economically-sensitive hard commodities – a marked deceleration in global growth leading to a related improvement in the supply-demand imbalance, as well as a pullback in commodity buying by return-seeking financial investors. This latter impetus to the commodity bubble cannot be underestimated, in my opinion. I am not sympathetic to the view that hedge funds and other speculators have driven commodity markets to excess. At work, instead, are mainly long-only, real money institutional investors such as global pension funds – all of whom have been advised by their consultants to increase their asset allocations into commodities as an asset class. Such herding behavior of institutional investors invariably turns out to be wrong. I expect that to be the case this time as well – although I would be the first to concede that my own record in calling the end of this commodity bubble has been nothing short of terrible over the past three years.

Doug Noland, by contrast, gives the hot-money players a central role in the commodity unwind (scroll to the end of the post for his weekly commentary).

So far, this isn’t too extreme a view. But Roach gets more forceful when he turns to policy responses. A key section:

Undisciplined risk taking has been a central element of this crisis. By tempering the consequences of the bursting of the risk bubble, the authorities are shielding irresponsible risk takers and thereby enabling a “moral hazard” that has become increasingly ingrained in today’s financial culture. At the same time, a Federal Reserve that continues to ignore the perils of asset bubbles in the setting of monetary policy is equally guilty of reckless endangerment to the financial markets and to an increasingly asset-dependent US economy.

In short, Washington has responded to this financial crisis with a politically-driven, reactive approach. Policy initiatives have been framed more by the circumstances of the moment than by a strategic assessment of what it truly takes to put the US economy back on a more sustainable path. By perpetuating excess consumption, low saving, unrealistic goals of home ownership, and moral hazards in financial markets, this patchwork approach has the biggest flaw of all – it does little to change bad behavior. Far from heeding the tough lessons of an economy in crisis, Washington is doing little to break the daisy chain of excesses that got America into this mess in the first place….

Financial and economic crises often define some of history’s greatest turning points. They can be the ultimate in painful
learning experiences. But there can be no escaping the urgent imperatives of learning these lessons and addressing the systemic risks that have given rise to the crisis. Such heavy lifting rarely sits well with the body politic. A path of least resistance is invariably selected that leads to more of a reactive response – the quick fix that tempers immediate dislocations but does little to tackle deep-rooted systemic problems. That’s the risk today. And if that’s where the Authorities end up, a globalized world will have squandered a critical opportunity to put its house in order. That would be the ultimate tragedy. If this crisis demonstrates anything, it’s that it only gets tougher and tougher to pick up the pieces in a post-bubble world.

In other words, the results are likely to be worse than what Roach now foresees.