Stephen Roach: "Pitfalls in a Post Bubble World"

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… 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.

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  1. foesskewered

    The fact that the decline in the pound has gone much the way foreseeable 6 months ago, am pretty sure, particularly with Roach’s view on the dollar for the mo0nths till 09, that the funds are purely doing a round robin shifting of funds. It’s the updated version of the 3 cups game, except the aim is to avoid losing marbles whilst shifting them around the 3 cups on the table. In current circumstances, they (fund managers) still have to produce some kind of returns and in lieu of some smart strategy , shifting money around is better than twiddling thumbs!

    ok, that’s just a dumb guess, anyone with better ideas?

  2. Anonymous

    thanks for posting roach’s astute analysis of the overall situation…. i didn’t have time to link to and read the whole paper; hence this question:

    Does Roach mention the role/responsibility of executives in financial and nonfinancial firms who have promoted for years and years this consumer and debt driven situation? Or, does he leave responsibility to the politicians and consumers themselves?

  3. JP

    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.

    I would love to see his reasoning for this, and I would bet that there’s still one (or more) i-banks that will go down in the future.

  4. gregory

    rather late with his analysis, mr. roach, don’t you think? since when has hindsight been called cutting-edge analysis?

    you guys pat each other’s backs regularly?

  5. Anonymous

    Where was he when all this going on??? Oh, that’s right, he was at the heart of the financial community that was slicing and dicing these same mortgages bought by foolish home owners, then leveraging them 30 times (some say 60 to 80 times) and selling them to the Asians, whom he is now advising. Nowhere does he mention the massive fraud perpetrated by the financials that led the public into believing that they would make money by using their savings to invest in assets that would continue to rise in price. Nowhere does he mention that is was the financials who foolishly overextended themselves and are now bringing down the economy around our collective heads. When the banks live way beyond their means, they simply have made bad business decisions and need to be bailed out. When the general public does it, they are fools living beyond their means and need to be wiped out. No wonder he has such a good grip on the situation. He helped create it.

  6. Dean

    Good assessment by Roach. At this point we must recognize two distinct commodity groups:

    Hard commodities. headed for a correction

    Soft commodities and precious metals most likely to perform inversely.

  7. B. Rosenberg

    it must be hard to really look at GDP figures in this light. How does the gov differentiate consumer spending versus savings in light of asset based vs. income based savings. If I buy a house does that go in to savings? This kind of purchase may not necessarily be one or the other, though its measurement surely has serious implications on the distribution of GDP. The drop in Investment Spending though has taken a hit, and I’ve seen very little discussion about this as an indicator of recessionary times.

  8. doc holiday

    MEW this:

    Reading the Entrails

    Breaking Open the Piggy Bank: The US Home as ATM

    From 2004 to 2006, Americans took almost $700 billion per annum of net equity out of their homes through borrowing and spent as much as 50% of it on consumables. The most highly regarded study on mortgage equity withdrawals (MEW) is “Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences,” by Prof. James Kennedy and none other than Alan Greenspan (Federal Reserve Board FEDS working paper No. 2005-41); Kennedy has been updating his numbers on an ongoing basis, as set forth in the graph below.

    Also: The Rise of A New Asset Class

    Without MEW, we would have had 2 years, 2001 and 2002, with negative GDP growth. We’re not going to go get those levels of mortgage equity withdrawals today – not in this environment. We’re still seeing some cash-out borrowing, but it’s getting more and more difficult; as home values drop, there are going to be fewer and fewer people pulling less and less money out of the “home ATMs.” As Paul McCulley says, your home ATM is starting to spit out negative twenty-dollar bills

  9. Stevie b.

    I am a big Roach fan and rued the day
    he stopped regular commentary. Whilst Naked Capitalism goes a very long way towards filling the void, I hope you will continue to keep us aware of Roach’s views on the now rarer occasions that they are updated.

  10. Anonymous

    On Wall Street: Painful lessons in the meaning of the term ‘credit crunch fef344…00779fd18c.html
    At the very least, borrowing from the central bank was still below prevailing and elevated money market rates. Both Citi and AIG sold long-term bonds this week at levels way above Treasury yields.

    The message from all these signals is that the squeeze on banks is not going away anytime soon.

    Compounding the pain are settlements over auction rate securities with the office of the New York attorney-general.

    As investors and companies are finally allowed to sell what they thought were cash-type holdings – but which since February have been turned into insolvent long-term debt by the credit crunch – banks are left clogging up their balance sheets with yet more debt.

    The link between falling home prices and the ensuing pain for bank, consumer and corporate balance sheets is tightening the credit tap. It is a squeeze pushing vulnerable consumers and companies towards the realm of bankruptcy.

  11. Anonymous

    For those who wish to read the full report, go to “”

    But use Internet Explorer, as Mozilla does not work.

  12. doc holiday


    Here is some background on what I think he is connecting to with that comment:

    This index is one of the purest leading indicators of economic activity. It measures the demand to move raw materials and precursors to production.

    Also: One in two fund managers feels world about to enter recession

    The slowdown in the world economy has been reflected in the tumbling price of oil. In the US, oil demand fell by an average of 800,000 barrels per day compared to the same period last year. That was the biggest volume decline in 26 years. The Baltic Dry Index, which measures the cost of shipping raw materials and is thus often used as an indicator of commodity demand, offers further testimony to the sell-off in commodities in general. It’s fallen by 37 per cent since its May peak.

    Despite the SP’s relative out-performance, American recession worries refuse to go away. Inflation this week hit an annual rate of 5.6 per cent, its highest level since 1991. Retail sales fell by 0.1 per cent in July, the weakest figures since February and with 87 per cent of the tax rebate stimulus package now delivered, few analysts expect a pick-up in spending.

    Stephen Stanley, an analyst with RBS Greenwich Capital, says that the “toxic combination” of tightening credit, a weak housing market and the fact the fiscal stimulus is “essentially done” will likely trigger the first “consumer recession” since 1990-1991.

  13. ndk

    Roach has long preached the dangers of international trade flows and leverage, including making badly wrong predictions (as he’s always fessed up to in the past) about how things will end. It always made complete logical sense, which is why I suspect he thinks too much to invest or trade well. He departed as chief economist about a year and a half ago, for whatever reason, to head up Asia for MS. I miss his writings too.

    In your search for villains — which I fully endorse, as I’m furious too — I think Roach is as unlikely a choice as Shiller or Baker.

    I have no clue which direction the chaotic capital flows will go next. I do know that they will go there without me, as I keep hiding in what I consider safe assets even after this latest set of exploding trades(defensive conglomerates, PM’s, short-term treasuries, industrial metals, and energy) for the foreseeable future. The monetary and fiscal intervention domestic and international of the last 25 years, which has grown ever more intense, is poisonous to rational asset allocation and a well-functioning economy. It could go on much longer, but I’m not going to be playing in the game.

  14. Anonymous

    The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster by Nouriel Roubini February 5, 2008

    Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges ofinvestors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks. Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy.

  15. mal

    Steve Roach to his credit was early in opining that reliance on debt induced asset-based income would cause problems and that the lack of real income growth and lowered savings was not sustainable. He however was never good at market timing or investment suggestions.

    What he missed and Doug Noland got right was the nature of the leveraged credit bubble and the perverse role of the Fed, GSEs and Wall Street securitization.

    What no one is really focusing on however is the role of Wall Street executives and their compensation, the privatization of profits and socialization of losses and the accounting shenanigans that allowed these executives to be paid billions in bonuses. From the Clinton era onwards the “too big to fail” notion was in place. However, the regulators in cahoots with the Wall Street elites allowed even more concentration and enabled rapid growth in questionable assets on balance sheets and earnings on income statements that now will be restated. But…. no one is calling for the bonuses paid on fraudulent financial performance to be returned and executives charged with misleading investors as they were cheerleading and promoting gains in their stock options.

    Where is the grand jury investigating Wall Street CEOs and the Chairmen of the Fed, SEC and other regulators? What did they know and when? What did they disclose and not disclose? What regulatory filings were knowingly incorrect? Were public investors knowingly defrauded by insiders? What is extent of criminality?

  16. Anonymous


    Stock repurchase/buybacks have a way of actually diluting common shareholders, i.e, shareholders use treasury stocks to buy overvalued common shares and then this new capital suddenly ends up as compensation in the form of option grant dilution, versus increased dividends. If you do your DD, I think you will find that dividends are very unwelcome nuisances to option holders! Furthermore, as yields are going down and dividends being cut, it is ironic that compensation is alive and well for the insiders.

  17. john

    There will be no investigations of the nobility until the peasants are unhappy enough to “demand” one. Of course, by “demand”, I mean that the politicians “sense” an “unhappiness” amongst the peasantry which must be rectified with a few scapegoats. After all, why would politicians willingly “investigate” members of their own social class; without some compelling reason, anyway. There aren’t enough unhappy peasants yet, their credit-cards are still working.

  18. JP

    Doc- Thanks for the reply. I should have been more specific though: While I agree that a greater slowdown is in the works, I find it hard to swallow that “share prices [of banks] now seem to be discounting something close to such an outcome.”

    Share prices of banks are still delusional imho, and I am curious why Roach thinks otherwise.

  19. Gregor

    Tell me what Steve Roach is asserting will happen, and I will tell you what’s not going to happen. I’ve been following Roach for a decade. His wrong-way macro calls have never failed. His record is nearly perfect. (for those of you who disagree, I would remind that Roach has often admitted that his calls are terrible, and consistently terrible). His problem is that he is simply unable to get outside the bubble of the consensus view. He just can’t do it. It’s like someone who can’t swim, or can’t cook. Just not going to happen.

    When Roach says it, you can be sure whatever the idea is–is now well entrenched, and is the consensus.

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