Two-Engine Slowdown (Stephen S. Roach)

  By Stephen S. Roach -- Morgan Stanley Global Economic Forum

  Nov. 20, 2006 -- NEW YORK -- The U.S. and Chinese economies are slowing sharply as 2006 comes to an end.  Inasmuch as these two engines have accounted for about two-thirds of the cumulative increase in world GDP over the past five years, this two-engine slowdown can hardly be taken lightly.  In my view, it poses major downside risks to the global soft-landing call embedded in liquidity-driven financial markets.

  Decelerating production momentum is evident in both economies.  After peaking at a 19.5 percent comparison in June 2006, year-over-year growth in Chinese industrial output growth has slowed to 14.7 percent over the subsequent four months; such a deceleration is every bit as severe as that which occurred in China’s last cooling off campaign of 2004.  Meanwhile, U.S. production growth is also downshifting; the year-over-year increase in factory sector production moved down sharply from 6.2 percent in September to 4.1 percent in October 2006.  That’s actually a faster one-month deceleration in the year-over-year growth rate in U.S. manufacturing output than that which was recorded at any point during the last recession of 2000-01.

  In the United States, downshifts in the housing and consumer sectors are leading the way.  Led by former Fed Chairman Alan Greenspan, the consensus had pounced on what we now know to have been a statistical blip in the September housing starts data and erroneously concluded that the worst was over for the housing recession.  Not only did the 15 percent plunge in October starts dispel this misimpression -- with newly initiated residential construction activity falling to more than a six-year low -- but it underscores how much further this housing recession has to go before it hits bottom.  A couple of numbers say it all: Through the third quarter of this year, residential construction expenditures have unwound only 27 percent of the boom that occurred since early 2001, while employment in the residential construction sector has reversed a mere 12 percent of the hiring surge that occurred over the same period.  In other words, the macro impacts of this housing recession have been puny so far.

  I don’t know if housing starts have hit bottom or not.  But the critical point to keep in mind is that these data only represent the first phase of the commitment to a building project; their sharp weakness, in conjunction with still elevated levels of unsold homes around the nation, underscores the empty pipeline that builders will be staring at once they complete projects still under construction.  That implies there’s plenty more to come on the downside of this housing recession -- both in terms of the actual construction expenditures that drive GDP as well as the employment and income generation of this sector that has been so important in supporting overall consumer demand.

  Taking its cue from housing, the asset-dependent American consumer has followed suit.  Retail sales have now fallen for two months in a row -- resulting in a 1.8 percentage point deceleration in the year-over-year growth rate in this series from 6.3 percent in August to 4.5 percent in October.  The October comparison is now the weakest in over two years and is literally less than half the 9.4 percent growth rate evident in January of this year.  Not by coincidence, Wal-Mart, America’s dominant retailer, recently issued its weakest monthly sales report since December 2000 -- +0.5 percent y-o-y on a same-store basis in October 2006, with “flat” guidance for November.  What I find truly fascinating is that most still cling to the now-discredited notion that U.S. consumers will just keep on spending; this argument further claims that since they haven’t flinched yet, they are unlikely to do so in the months ahead.  As I spun around the world last week, I found this view to be the most deeply entrenched pillar of consensus thinking.  Yet this premise is not only completely at odds with the weak retail sales of the past two months, but it also ducks a similar impression conveyed by the broader data on personal consumption expenditures.  According to our latest estimates, growth in real consumer spending slowed to a 2.5 percent average annual rate in the final three quarters of 2006 -- a significant shortfall from the 3.7 percent ten-year growth trend.  If that’s not a flinch, I don’t know what one is.

  There’s far more to this story than a data debate.  Consensus thinking had not contemplated the possibility of a pullback of U.S. consumption in the face of sharply falling energy prices -- a nearly 30% reduction of oil prices that was supposed to provide consumers with the functional equivalent of a $100 billion tax cut.  This surprise has occurred, in my view, because something else very important is going on -- namely, a bursting of the housing bubble that has long fueled asset-dependent U.S. consumer spending.  With personal saving rates in negative territory for the first time since 1933 and asset-driven saving strategies challenged by the sharp and swift implosion in the housing market, rational consumers now need to switch back to income-driven saving strategies.  That means, contrary to consensus expectations, a much larger portion of the energy price windfall is likely to be saved rather than spent.

  The China slowdown is of an entirely different ilk -- at least, so far.  It is largely an outgrowth of a government-directed “cooling off” campaign.  At work is a marked downshift in the fixed investment sector, with monthly growth rates in the urban piece of investment spending falling to a 16.8 percent comparison in October -- a dramatic shortfall from the 28 percent gains of 2005 and the first none months of 2006.  This is, by far, the largest sector of the Chinese economy: Fixed asset investment was more than 40 percent of Chinese GDP in 2005 -- larger than private consumption (38 percent) and exports (34 percent).  From a pure arithmetic point of view, such a downshift in China’s dominant sector has to have major implications for aggregate trends in GDP and overall industrial output.  The latest numbers on industrial output lend credence to this view.

The Chinese economy is hardly collapsing.  But its central planners have made a conscious decision to rein in the excesses of the investment sector by imposing a series of administrative controls on a number of overheated sectors.  Last month, Ma Kai, Chairman of the National Development and Reform Commission and China’s lead central planner, complained that these administrative measures haven’t been nearly as effective as he had hoped.  He noted that through September, fully 50 percent of the new investments in coking have violated the government’s recently announced edicts on overheated projects, while non-compliance ratios were as high as 42 percent in coal, 35 percent in cement, 26 percent in electricity, and 22 percent in textiles.  The NDRC now appears to be redoubling its efforts at enforcing these administrative edicts, while at the same time the Beijing leadership is moving to consolidate political control through the arrest of Chen Liangyu, former head of the Shanghai Communist Party.  The word appears to have finally gotten through: Policy-directed investment is now slowing, with important implications for the growth in the overall Chinese economy.

  Yet there is still an important missing piece to the China slowdown that could fall into place in the months ahead -- a weakness in export demand brought about by a softening in China’s largest export market, the American consumer.  Chinese exports were still surging at a 29.6 percent y-o-y rate in October while the export-oriented piece of industrial output was running at a 22.2 percent y-o-y comparison last month.  The downshift of US consumption apparently has not had much of an impact so far on the all-powerful Chinese export machine -- at least not yet; growth in China’s exports to the United States inched down to 22 percent y-o-y in October following a 26 percent comparison in September.  Clearly, in light of the rapidly changing dynamic of US consumer demand noted above, downside risks to the great Chinese export machine are building.

  The export dynamic is a critical aspect of the Chinese macro conundrum.  It is the lightening rod in the US protectionist debate and is also key in driving the massive build-up of China’s trade surplus and foreign exchange reserves.  China knows full well that it cannot sustain 30 percent growth in exports for economic reasons, to say nothing of financial market and political considerations.  But it is clearly wary of leaning too hard on this key sector.  On Nov. 1, the Chinese raised export taxes on several commodities -- namely, alumina, copper, coal, and steel.  But these actions appear to have been more symbolic than real.  If U.S. consumer demand continues to falter as I suspect, the Chinese do not want to have erred on the side of compounding the problem through the use of domestic policies that might reinforce an externally-driven adjustment.  The same reasoning applies to the currency issue and to China’s reluctance to be too aggressive in pushing for RMB appreciation.  One way or another, however, I am convinced that Chinese export demand will slow appreciably over the course of the next 12 months. 

  As I put this all together, I continue to believe that global growth will fall well short of consensus expectations in 2007.  The IMF’s forecast of another year of 4.9 percent world GDP growth in 2007 -- identical to the trends of the past four years and the strongest surge in global activity since the early 1970s -- is very much in line with what I hear from the broad consensus of investors I meet with around the world.  Implicit in this view is that nothing can stop the American consumer or the Chinese producer -- conclusions that are both being drawn into sharp question in the final months of 2006.  With slowdowns in the United States and China likely to have a meaningful impact on two-thirds of the global growth dynamic, the burden of proof for the case for global resilience has shifted to the decoupling crowd.  The sharp -2.8 percent annualized decline in Japanese consumption in the third quarter of CY06, together with recent disappointing trade date from Taiwan and Korea, do not exactly bode well for the decoupling case.

  There’s one word that permeates virtually every discussion I have with investors around the world -- liquidity.  It’s literally the only thing they want to talk about.  In the view of most fund managers, liquidity remains more than ample to support ever-frothy markets -- irrespective of the outcome for the global economy.  I continue to suspect that this disconnect between the global growth and liquidity cycles will be resolved one way or another in 2007.  For my money, the risks of the “global fizzle” are being taken far too lightly.

LINK: Morgan Stanley

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