World financial markets continue to feel as if they are balanced on the head of a pin. What’s particularly interesting are increasingly frequent swings from one scare to another.
Just a few weeks ago, it was the inflation scare – triggered by a fractional overshoot in America’s core CPI in April. Now it’s the growth scare – brought on by a weaker-than-expected increase in US nonfarm payrolls in May. The combination of these shifts points to one of the most worrisome scenarios of all – the dreaded stagflation scare. How likely is such a possibility?
The stagflation spectre: US growth is set to slow
While I am sympathetic to the ‘stag’ part of such an outcome, I am not on board with the ‘flation’ piece. My personal risk assessment is highly asymmetric: I see growth risks dominated by vulnerability in the US economy, whereas I continue to believe that the inflation outcome will be driven more by global forces.
My concerns over growth are consistent with a baseline macro framework of global rebalancing – that an unbalanced world remains overly dependent on the over-extended American consumer. My relatively sanguine prognosis for inflation stems from what I continue to believe are the persistently powerful disinflationary headwinds imparted by globalization.
My assessment of global growth prospects remains largely unaltered from the view I expressed a couple of months ago – namely, that the broad-based surge in first period of 2006 will likely represent the high-water mark for the next couple of years. According to our latest estimates, world GDP growth accelerated to a 5.0% sequential annual rate in 1Q06 (as expressed in IMF-based purchasing power parity metrics) – a sharp bounceback from the more subdued 4.4% pace in 4Q05. Our latest global forecast calls for a slowing to a 4.3% average annual pace over the remaining three quarters of 2006 – the slowest run-rate since 2003 – and a further moderation to 3.8% global growth in 2007.
The US appears to be leading the way in driving the current global downshift. Our most up-to-date estimates call for more than a halving in real GDP growth between the first and second quarters of this year – slowing from 5.3% in 1Q06 to an estimated 2.4% increase in 2Q06.
In and of itself, that deceleration is enough to account for all the slowing in global growth we are expecting in the current quarter.
Our Japan team also concedes that the Japanese economy has now entered a bit of a ‘soft patch;’ the 1.9% annualized sequential increase in 1Q06 came in slightly below our expectations and represents a distinct downshift from the 4.0% pace of the previous four quarters.
In Europe, incoming survey data also point to a slowdown – but one that is scheduled to arrive a bit later than in the US and Japan; our Euro team currently puts 3Q06 GDP growth at about a 2% sequential annualized rate – a marked deceleration from the 3.5% annualized pace they estimate for the current period.
The stagflation spectre: the US consumer is the weakest link
The American consumer is now a prime candidate for the weakest link in the global growth chain. The income side of the equation remains decidedly subpar. Despite a falling unemployment rate, labour income generation has suffered from chronic and, more recently, downwardly-revised weakness, as America has lurched from a jobless to an increasingly ‘wageless’ recovery.
By our calculations, over the first 53 months of the current cyclical upturn, the cumulative increase in private sector compensation amounted to only about 14% in real terms – fully $365 billion below the trajectory implied by a more normal expansion. The weak employment report for May points to a further deterioration of this comparison in the 54th month of this recovery.
The impetus from wealth creation also looks increasingly shaky as the housing sector now starts to roll over. The latest release of the OFHEO report on US house price appreciation certainly surprised me, with the y-o-y increase in the nationwide index holding at 12.5% through 1Q06 – the seventh quarter in a row of double-digit increases. Gains in some 53 metropolitan areas were still running at 20% or higher in the 12 months ending March 2006.
In my view, these comparisons have nowhere to go but down. With inventories of unsold homes now rising sharply, I fully expect house-price appreciation to be in the low single-digit zone a year from now. That, together with upward pressures on refinancing rates, should put downward pressure on equity extraction from residential property – undermining growth in what had been the fastest-growing source of discretionary purchasing power for US households over the past several years.
It’s not just the risks to US income generation and wealth creation that concern me. Household debt burdens are rising and the personal saving rate has fallen back into negative territory once again. At the same time, sharply rising energy prices are putting a squeeze on over-extended US consumers when they can least afford it.
By way of comparison, the personal saving rate averaged about 8% in the three prior energy shocks of the past – providing consumers with a cushion to defend their lifestyles in the face of the functional equivalent of a major tax hike. In today’s negative saving rate climate, there is a notable absence of any such cushion.
I’ll admit to a serious credibility problem with this aspect of my macro view. The main critique on my dour prognosis for the US consumer is that it has been wrong for the past three years. The consensus is betting that will continue to be the case going forward – drawing security from the time-honored proposition that it never pays to bet against the American consumer.
This year, however, that bet may well pay off – the stars are in the worst alignment for the US consumption outlook that I have seen in years. And if the American consumer finally fades as I suspect, the rest of a US-centric world could be quick to follow. Externally-dependent Asia, together with the rest of the NAFTA bloc (ie Canada and Mexico), are most at risk in that regard. The American consumer holds the key to the ‘stag’ piece of the stagflation scare. In my view, that aspect of the scare needs to be taken seriously.
The stagflation spectre: inflation may not materialise
I do not feel the same about the inflation piece of this threat. Yes, America’s CPI-based price metrics are now listing to the upside – pushing core inflation slightly out of its recent comfort zone. But this recent updrift may be more statistical than real.
At work is mainly an upsurge in the largest piece of the CPI – the so-called owner’s equivalent rent (OER) of primary residences. This construct, which attempts to measure the price of the service homeowners derive from living in their humble abodes, accounts for fully 30% of the total core CPI and has now risen 0.4% for two months in a row.
Excluding this component, the core inflation rate would have held relatively steady at 0.2% per month over the March-April period. It seems especially absurd to me to ground an inflation scare in what is surely the most fictitious component of the CPI – a construct that is impacted not only by statistical quirks (i.e., when utility costs fall, the OER goes up) but by a highly imperfect process of sampling rents on ‘equivalent’ units in order to come up with the imputed price of the consumed service of shelter. And yet if there was one ‘smoking gun’ to the dramatic risk reduction trade of the past several weeks, it was the release of the April CPI on May 17.
The bear case for accelerating inflation is, at this point, too much of an exercise in statistical extrapolation for my liking. It is driven by those stressing that the year-over-year increases in the core CPI are likely to continue drifting higher over the next few months as some of the weak-inflation months in early 2005 drop out of the calculation.
Even so, the analytics of the case for accelerating inflation are largely an outgrowth of timeworn ‘closed economy’ models that take their cue from mounting pressures on domestic labor and product markets. With the US unemployment rate having now fallen to 4.6% in May and the manufacturing capacity utilization rate up to 80.8% in April, many have argued that those pressures are now at an inflationary flashpoint.
In taking that point of view, however, they are overlooking growing evidence in support of the notion that the structural pressures of globalization are now imparting very swift headwinds, which largely offset the cyclical pressures of the inflationary process (see, for example, BIS research by Claudio Borio and Andrew Filardo, ‘Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation,’ March 2006).
In such ‘open economy’ models of inflation, the linkages between core inflation, labour costs, currencies and import prices have all broken down. Bottom line: the sharp slowing of wage inflation reported for May to a 0.1% increase goes a long way in putting the more worrisome 0.6% increase in April in better perspective.
The stagflation spectre: Iran could be the trigger
Fears over stagflation are the last thing bruised financial markets need. Yet with the inflation scare of a few weeks ago now being followed in short order by a growth scare, the possibility of a stagflation scare can hardly be dismissed out of hand.
While I think such fears will ultimately prove to be overblown – mainly because of my still-constructive prognosis for inflation – I certainly concede that the weight of evidence may render a different verdict over the next few months.
Moreover, new threatening statements from Iran’s Ayatollah Khamenei on the issue of Middle East oil security seem to borrow a page right out of the stagflationary saga of the late 1970s.
In this climate, events could well overtake analytics – drawing my newfound optimism on the more benign strain of global rebalancing into serious question. That gives me hope that a stagflation scare may end up being an excellent buying opportunity for all but the riskiest of financial assets.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum