In response to a major reworking of our energy price assumptions, we are making our first meaningful cuts to the global growth prognosis in quite some time. This downward revision is not an event-driven response to the devastation of Hurricane Katrina, although we have tried to factor in some of the short-term dislocations of this wrenching natural disaster. Instead, our forecast cuts are largely a reflection of a 40% increase in our baseline crude oil price trajectory for 2006 from $45 to $64.
Reflecting the concomitant impacts of sharply higher energy product prices, we are paring our forecast of world GDP growth in 2006 by 0.4 percentage points from 4.1% to 3.7%. For 2005, our forecast adjustments are minor – we have shaved our estimate of world growth from 4.1% to 4.0%. Our downwardly revised growth forecast for 2006 depicts a global economy that is essentially reverting to its longer-term trend growth rate after three years of above-trend increases averaging around 4.3%.
With the global recession threshold commonly perceived to be 2.5%, we expect any deceleration in global growth to stop well short of full-blown recession. However, we concede that there could well be a “growth scare” over the next six months, with industrial-world GDP growth breaking below the 2.75% barrier during that period. That underscores a near-term vulnerability that could have meaningful consequences for financial markets. Equities could sag and bonds could rally further, as fixed income markets raise the odds of aggressive monetary easing by the world’s major central banks.
In my view, the near-term risks to our new global forecast remain very much on the downside. In large part, that risk assessment reflects the lingering imbalances of a US-centric global economy. Ironically our forecast cuts are most heavily concentrated in the US – a downward revision in 2005 to 3.5% (from 3.8%) and an even sharper cut in 2006 to 3.3% (from 4.0%).
Given the lack of autonomous domestic demand support elsewhere in this unbalanced world, externally-led economies – especially those in Asia – should be most vulnerable to a US-centric forecast adjustment. Yet we have modeled in only minor cuts to the region’s growth prognosis. We are leaving GDP growth in Asia ex-Japan for 2005 unchanged at 6.7% and cutting regional growth for 2006 to 5.5% (from 5.8%).
This could be too optimistic. I continue to stress that sharply higher energy prices could well hit Asia with a potentially powerful “double whammy” – an outgrowth of the region’s high energy intensity as well as its heavy dependence on the US.
China risks bear special mention. Despite my pessimism on the global economy, I have long been a China optimist. Yet I have to concede that China could be especially vulnerable in an energy-shocked climate. The energy intensity of Chinese GDP is double the global norm, and there is no other major economy in the world as highly levered to the over-extended American consumer.
Moreover, if China falters, Asia’s China-centric supply chain could be quick to follow – transmitting repercussions to Taiwan, Korea, Hong Kong, Malaysia, Singapore, and possibly even Japan. Asia ex-Japan is the world’s largest and fastest-growing region. By IMF purchasing-power parity weights, it accounts for fully 28% of world GDP – meaning that every one percentage point deceleration in pan-regional growth would have a direct effect of lowering global GDP growth by 0.3 percentage point.
In our newly revised global growth forecast, we see growth in Asia ex-Japan slowing by 1.2 percentage points in 2006 – enough to reduce world GDP growth by 0.4 percentage point. For an energy-intensive, US-dependent region, I wouldn’t be surprised to see a global impact that could end up being double that amount.
Elsewhere in the world, we have also made relatively modest cuts to our growth outlook – cuts that in all cases stop short of those we are making to our US outlook. That’s true of Europe, Japan, and even Latin America.
In each of these cases, our resident economists have taken into account our upwardly-revised energy price assumptions. But what concerns me as a global economist is the relationship between cuts in the US outlook and those we have made to other major economies in the world.
Either I’ve got the US-centric character of the global economy wrong or the cross-border spillovers are likely to be larger than our new forecast now reflects. In my opinion, America’s gaping current account deficit – together with large surpluses in Japan, Asia ex-Japan, and parts of Europe – provide prima facie evidence of an unbalanced world that is deriving excess support from the US.
Unless the rest of the world suddenly discovers new sources of support – either from other export markets or from its own internal demand – to the extent we are paring our US growth outlook, I would expect the rest of this unbalanced world to be hit just as hard, if not harder, than the US.
Japan, with its nascent recovery, could be an exception. But the rest of Asia and Europe are still lacking in self-sustaining resilience. Moreover, Latin America’s NAFTA-related ties to the US leave that region more vulnerable than our fractional downward revision to the regional growth forecast suggests (a cut from 3.8% to 3.7% in 2006). In my opinion, any benefits to Mexico as a major oil producer should be more than offset by tight NAFTA-dependent linkages to US consumption.
Once again, the endgame probably hinges importantly on the American consumer. Reflecting our higher energy price assumptions, Dick Berner has pared the 2006 US consumption growth forecast from 3.4% to 2.8%. Moreover, this forecast also allows for the trajectory of real consumption growth to slip below 2%, on average, in the final quarter of 2005 and the first period of 2006.
While these are significant downward adjustments, Katrina-related aftershocks raise the possibility that they may not be large enough. The last thing a saving-short, overly-indebted American consumer needs is an energy shock just before the peak heating oil and holiday buying season. I have argued previously that the asset-dependent US consumer is far more vulnerable on a fundamental basis going into this oil shock than was the case in earlier energy-related disruptions. I made that point prior to the Katrina-related disruption of some 15-20% of US energy production. Now that a full-blown supply shock is at hand – one that could last for at least a few months – those vulnerabilities may well be borne out in the form of a much sharper-than-expected cutback in discretionary US consumption. For the rest of a US-centric world, that would only compound the problem.
Up until now, the global economy has been extraordinarily resilient in the face of sharply rising energy prices. Growth alerts have been sounded repeatedly as oil prices pierced once-worrisome thresholds at $40, $50, and $60. Yet with those alerts having turned out to be false alarms, an understandable sense of complacency has set in to financial markets. The energy shock of 2005 is widely viewed as a far less disruptive blow to the world economy than were the shocks of the 1970s and early 1990s.
That complacency is less evident in global bond markets, where the possibilities of downside growth risks and a pause in monetary tightening are now being discounted into the price structure of some fixed income instruments. But equity markets, in large part, remain very much in denial; few seem concerned about downside earnings risks in developed-world markets in an energy-shocked climate, and there is even less worry about spillover effects into emerging markets in the event of a US-led shortfall in global growth. If the American consumer doesn’t flinch, that complacency may well be justified. But to the extent that resilience is finally challenged in a post-Katrina climate, the downside risks to the rest of a US-centric global economy can hardly be minimized.
At the same time, it is important not to lose sight of the cyclical implications of our global forecast revisions. As the world tips to the downside in response to the energy shock of 2005, the stage may well be set for a solid rebound in 2007. Our new energy price assumptions allow for significant demand-driven relief to oil prices over the course of 2006-07 – returning to the low $40 range by the end of that period.
That would amount to a price drop of about 27% for crude oil and considerably larger than that for refined products in 2007 – the functional equivalent of approximately a $550 billion tax cut for the oil-consuming world that would equate to about 1.2% of global GDP. While there would be a related shortfall in energy-related revenues for the oil-producing world, given relative spending and saving propensities – oil-consuming nations spending far more than producers – the world economy as a whole should be a net beneficiary of the coming decline in energy prices.
For the time being, however, that’s getting too far ahead of the increasingly significant downside risks associated with the more immediate impacts of sharply higher energy prices. But this is one dark cloud that does have a silver lining.
The oil price call has been a fool’s game for the macro forecaster in recent years. I have no idea where energy prices are headed over the intermediate and longer term. The bookshelves are filled with very compelling tomes on the demise of Saudi oil. In that respect, this oil shock is no different from those of the past – all of which ended with doomsday forecasts of permanently higher oil prices.
Yet there can be no getting around the mean-reverting history of oil prices over the past 30 years. To the extent the near-term growth hit sows the seeds for a subsequent cyclical decline in oil prices, even an unbalanced world will survive this energy shock. In the meantime, this first-cut revision to our baseline global forecast underscores the downside risks that still loom in the weeks and months ahead.
By Stephen Roach, Morgan Stanley economist as published on the Global Economic Forum