Tuesday, December 06, 2005

ROACH looks to 2006

The annual year-end forecasting ritual has begun. For us, it is always sparked by the extension of our forecast horizon to another year -- in this case, our first official glimpse at 2007. We also take an in-depth look at our calls for the year nearly completed (2005) as well as for the 12 months lurking just ahead (2006). It is as close to soul searching as the heartless macro prognosticator ever gets.
Time and experience -- there is a difference -- has taught me not to take the point estimates of our global forecast-extension exercise too seriously. We do our best as a tightly knit group of seasoned forecasters to capture the rhythm of the global business cycle. We agonize over policy assumptions -- monetary and fiscal -- currencies, oil prices, inflation, yield curves, and, yes, even global imbalances as we put the pieces of the global macro outlook together. But in the end, the outcome of this exercise typically suffers from the classic drawbacks of groupthink. The offsetting inputs from our far-flung network of economists around the world often tend to produce a rather boring outcome -- something close to a trendline forecast for the world economy.
Our latest year-end global forecast exercise is no exception. Our first cut at 2007 calls for a 3.8% increase in world GDP growth -- down slightly from an upwardly revised 4.1% increase for 2006 (versus our previous estimate of 3.8%). On the surface, these are pretty impressive numbers for the world economy -- slightly above trend (an average of 3.7% world GDP growth since 1970) and well above the global recession threshold (2.5%). If this forecast comes to pass, it would mark five consecutive years of above-trend growth for the world economy -- the longest stretch of global vigor since the late 1980s. With global inflation expected to remain well contained over this time horizon -- we are forecasting industrial world CPI increases averaging just 2.0% over 2006-07 --- our global baseline is starting to take on the ever-seductive characteristics of Rosy Scenario, that voluptuous handmaiden of yesteryear.
In looking at the major regions of the world, our baseline forecast conveys the impression of “steady as she goes” through 2007. Within the developed world, a slowing in European growth is most pronounced (downshifting from 2.2% in 2006 to 1.8% in 2007), whereas we have penciled in more modest downshifts to trend-like outcomes in the US (from 3.8% in 2006 to 3.5% in 2007) and Japan (from 2.5% in 2006 to 2.3% in 2007). In the developing world, the biggest shift is an upgrade to our 2006 Chinese growth forecast from 6.7% to 7.8%; while this would still represent a significant downshift from average gains of 9.5% over the 2003-05 period, it is certainly not as draconian a slowdown as we had been expecting. Our first cut at 2007 calls for a further moderation in Chinese economic growth to 7.5%. We also look for growth in India to slow somewhat to an average of 6.6% over the 2006-07 interval -- impressive gains by most standards but down from the heady 7%-plus pace of 2003-04 and the 8% annualized increase just recorded in late 2005. Elsewhere in the developing world -- Asia, Latin America, and Emerging Europe -- we see growth in 2006-07 averaging close to the above-trend 2005 pace.
The pitfalls of groupthink have long taught me to focus on the risks to our baseline view of the world. That’s especially the case when we peer into our scratched and cracked crystal balls and stretch the forecast horizon out for another year. Baselines are an important aspect of any macro debate -- be it for an individual economy, a region, or the world as a whole. But, in my view, the baseline should only be viewed as a starting point. Over the course of any year, the unexpected always happens -- namely, oil shocks, natural disasters, wars, or financial market disturbances. Our baseline is the benchmark by which we then measure the impacts of these all-too-frequent “exogenous” disturbances. This is where the rubber meets the road for the macro analyst -- not in discerning the precision of a baseline but in trying to capture the risk factors that are most likely to jar economies off this trend-like path. In that spirit, I present the five risks that I believe will be especially critical in shaping the global macro climate in the year ahead:
Global rebalancing. You’re tired of hearing about this, and I’m equally tired of writing about it. But, in my view, this remains the key risk for a still unbalanced world -- an overarching framework that unifies many of the other risks enumerated below. It is an outgrowth of the excesses of the world’s two main growth engines -- the American consumer on the demand side and the Chinese producer on the supply side. It also reflects the persistence of subpar growth in the rest of the developed world and lack of autonomous support from internal demand in the export-led developing world. And it reflects the increasingly precarious asymmetrical distribution of the world’s external imbalances -- a record US current-account gap that accounts for 70% of the world’s total external deficits juxtaposed against a far more broadly diffused distribution of surpluses. Global imbalances have, of course, been building for years, and the longer they continue to fester without major financial market consequences, the greater the conviction this state of disequilibrium is sustainable. However, with America’s current account deficit likely to widen further over the next year while at the same time the three largest surpluses -- Japan, Germany, and China -- start to shrink, I believe the presumption of sustainability will be drawn into serious question in 2006.
Chinaslowdown. After years of skepticism, the world now treats China as a perma-growth story, capable of sustaining 9%-plus GDP growth in perpetuity. We were wrong on the China slowdown story in 2005 and, as noted above, have responded to this forecast error by raising our growth forecast for 2006. However, based on intelligence gathered during a recent trip to Beijing, I now believe that Chinese bank lending will slow sharply in 2006, as the transition from a policy-directed to a commercial banking system reins in the excesses of open-ended credit growth. Publicly-listed banks, along with those that are about to go public, are now focusing on profitability and shareholder value, unwilling to tolerate a new round of NPLs that a perpetuation of policy lending might otherwise imply. The result is likely to be a surprisingly sharp slowdown in bank-funded fixed asset investment -- a welcome development for an unbalanced Chinese economy that is in danger of letting its investment boom turn into a breeding ground for excess capacity and deflation (see my 2 December dispatch, “China Slowdown -- Early Not Wrong”). Given China’s outsize claim on global resource demand, such an investment slowdown could also lead to surprising drops in oil and other industrial commodity prices.
American consumer. The American consumer has been the mainstay of a decade of US-centric global growth. Like impressions of the all-powerful Chinese producer, most believe that US consumption is now impervious to external shocks. I think that perception will be challenged in 2006. Lacking in normal support from labor income generation, the saving-short, overly-indebted, asset-dependent American consumer could well be squeezed by the twin pressures of a post-bubble housing market and higher energy costs. Contrary to widespread perception, US consumers are now in the process of cutting back discretionary spending in response to the energy shock of 2005; growth in real consumption is tracking an anemic 1.5% pace in 4Q05, down from the nearly 4% trend of the past decade. Moreover, not only should the Fed tightening cycle take its toll on house price inflation -- the sustenance of the Asset Economy -- but it should spur an increase in debt service obligations based on the profusion of floating rate loans that were taken out at below-market “teaser rates” over the last several years. In my view, the days of open-ended US consumption are drawing to a close -- sooner rather than later.
The dollar. A year ago, the dollar bears were strutting. Now it’s the new-paradigm dollar bulls who are exuding confidence (see, for example, Alan Greenspan’s 2 December speech, “International Imbalances”). However, with the Federal Reserve signaling that the end of its tightening cycle is now open to debate, I expect the interest rate differential theme to fade in importance as a driver of currencies. Foreign exchange markets should shift their attention back to an old theme as well as to a new one -- the former being America’s record and still-widening current account deficit and the latter being Japan’s economic recovery. If the Japan story is for real -- and I suspect it is -- there are powerful fundamental reasons why the yen should begin to appreciate. With Japan having the world’s largest current account surplus, that possibility is even more likely. I also look for a rethinking of the “China factor” in currency markets. With the exception of the US dollar, the RMB has appreciated against most major currencies this year. Nor do I expect the Chinese to up the ante on the “symbiosis trade” by raising their overweight in dollar-denominated assets. For China, this is a recipe for excess liquidity creation (brought about by the partial sterilization of Treasury purchases), mounting bilateral trade tensions with the US, and a huge fiscal hit in the event of dollar depreciation. Finally, I am highly suspicious of the consensus view that the dollar will continue to be bailed out by petro-dollar recycling from the Middle East (see my 28 November dispatch, “The Case of the Missing Petro-Dollars”). While a surging dollar could well be supported by a powerful momentum trade for a while longer, my advice is to watch out for a reversal in early 2006.
Central bank credibility. Central banks turned out to be great inflation fighters. Their record is far more tainted in managing the approach toward the hallowed ground of price stability. The Bank of Japan lost the battle against deflation and could well have a surprisingly difficult time in extricating itself from the anti-deflationary policy stance that remains in effect today. The Federal Reserve narrowly escaped the deflationary aftershocks of one asset bubble, but will it be so lucky when the housing bubble pops? As the newest central banker in the world, Ben Bernanke will be lacking support from the confidence factor that Alan Greenspan has long enjoyed -- potentially a serious problem in a US current account adjustment. Transitions to new Fed chairmen have not gone well in the past (see my 7 October dispatch, “Transition Curse”). Is there a compelling reason to believe it will be different this time? And then there’s the case of the ECB -- beginning a process of policy normalization when the Euroland economy remains shaky, at best. I suspect central bank credibility will meet a stern test in 2006 -- typically a tough development for financial markets.
In the end, good macro is not about honing the precision of the baseline forecast. It is more about a risk assessment of unexpected developments on the tails of the probability distribution. As I look to 2006-07, I see the downside risks outweighing those on the upside by a factor of two to one. Specifically, I think there is a much greater chance that world GDP growth could slip back into the 2.5% to 3.0% danger zone rather than cruise at or above our nearly 4% projection. As 2005 draws to a close, ever frothy financial markets are in the process of discounting an increasingly sweet macro scenario that bears a striking resemblance to our baseline view of the world. If my risk assessment is correct, financial markets could be in for a rude awakening.

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