Once again, financial markets are agonizing over the US economic growth outlook. A weak third quarter GDP report, paced by an ongoing housing recession, and in conjunction with tentative signs of further softness in October, has all the trappings of yet another soft patch. Time and again, a Teflon-like US economy has bounced back smartly from these periodic downshifts. Is another such bounce in the offing, or is this slowdown for real — the beginning of the end for a five-year expansion?
True to our culture, the Morgan Stanley Economics team doesn’t take this debate lightly. Both points of view are well represented in our internal discussions and our published work. Steve Roach and Dick Berner, friends for more than thirty years and whose offices share a common wall, don’t share much else in common these days insofar as the macro prognosis is concerned. But they both thought it would be an opportune moment to thrash out their differences in the exchange that follows:
Does the US housing downturn have further to go?
Roach: The housing downturn is a very big deal for the US economy. The way I see it, there are three macro impacts to consider: a contraction in construction activity; collateral damage on industries such as furniture, appliances, real estate brokers, and mortgage finance; and negative consumer wealth effects. So far, we have seen only the early stages of the first impact — a downturn in homebuilding activity. While residential construction activity fell at a 14% average annual rate in the two middle quarters of 2006, as a share of GDP it has only reversed 27% of the record run-up that occurred over the past decade.
Sure, housing starts bounced back a bit in September after three consecutive monthly declines — hardly an unusual trend-break for any statistical gauge. But given the magnitude of the building boom and the associated surge in home prices, in conjunction with a still huge overhang of unsold homes, isn’t it a bit premature to conclude that the worst is over for the housing recession?
Berner: It may come as a shock to you, Steve, but I agree, it is a big deal and I do think that the housing downturn does have a long way to go. The housing recession took more than a percentage point off growth in the summer, and we’re on track to see a loss of 0.8 percentage points in the current quarter. Moreover, sales likely have 10-15% more to decline, and the inventory overhang of unsold homes that you note means that the direct housing drag probably won’t end until late next year. That downturn clearly creates the potential for collateral weakness in the areas that you enumerated. Indeed, some of the softness in manufacturing activity is directly traceable to housing; output in the appliances, furniture and carpeting grouping in industrial production fell at a 2.3% annual rate in the three months ended in September.
But we’ve taken that into account in our forecasts. I take your points about the housing downturn seriously, but I think you are seriously underestimating the potential for a two-tier economy — housing in recession, the rest of the economy doing much better — to outperform your bearish expectations. The just-released October labor market tally echoes those themes — construction and manufacturing employment declined collectively by 60,000 whereas service producing jobs jumped by 152, 000.
Could we see a repeat of the 2001 downturn?
Roach: Well, I’m certainly not a compartmentalist — I’m more of a spillover kind of guy. So let me get to the real punch line of this story — the potential impacts of yet another post-bubble shakeout on the asset-dependent American consumer. This, of course, isn’t the first time we have had to confront a problem like this. Six and a half years ago, after the bursting the equity bubble, the American consumer pulled back — 1.5% average annualized growth in the first three quarters of 2001 — and the US economy slipped into, yes, a mild triple-dip recession. I fear a similar outcome this time as well. In my humble opinion, consumer spending and saving is even more asset-dependent today than it was when the equity bubble burst. After all, the income-based personal saving rate was over 2.5 percentage points higher in early 2000 than it is at present.
Berner: As long as we’re revisiting history, let’s get it right, not rewrite it: The mild downturn of 2001 — on which you and I were shoulder-to-shoulder in forecasting — was the product of the bursting of a capital-spending-cum-hiring bubble in Corporate America. We spent the first three years of this expansion cleaning up those excesses. With those extremes well behind us, and labor markets firm, the income-generating capacity of the economy is actually improving, not weakening.
Will American consumers cut back on spending?
Thus, I think that the real question is whether consumers will have enough wherewithal both to maintain moderate spending gains and rebuild saving. Where we most strongly disagree, however, is on the housing wealth-consumer spending link. You side with those who think it’s all about Mortgage Equity Withdrawal — that even a deceleration in housing wealth and thus declining MEW will cripple consumers. Unless it’s different this time, my view is that the wealth-consumption connection is no more than one-fifth or even one-tenth as big as feared.
Roach: How can you possibly say that, Dick? The wealth-driven spending culture of the American consumer is far more important than you are implying. In the 10 years ending 2005, average growth in real consumption (3.7%) has exceeded that of real disposable income (3.2%) by 0.5 percentage point per year. With the personal saving rate now in negative territory for the first time since 1933, with debt burdens at all-time highs, and with the first of some 77 million baby boomers staring at retirement in about three years, I suspect that rational consumers will now shift away from asset-driven saving back to income-based saving strategies. That suggests that consumer spending growth should fall short of the pace of underlying income generation — an abrupt about-face from the pattern of the past decade and eerily reminiscent of the retrenchment that occurred in the recession of 2000-01.
Berner: Let’s try to put some balance into this. As important as wealth effects have become in recent years, don’t lose sight of the income side of the equation, where I continue to be quite constructive. In particular, the October labor market canvass also shows healthy gains in hours worked and earnings, pointing to at least another month of solid gains in wage income.
Roach: Let me be the first to agree with your important point — “it’s all about income.” The problem, as I see it, is that labor income, the mainstay of consumer purchasing power, has been — and is likely to continue to be — woefully inadequate to sustain the type of upbeat consumption prognosis you envision. Yes, the real compensation comparisons have improved this year, as you have continually stressed, but that is largely due to upward revisions in stock options and bonus payments in January and February — a far cry from the pickup in organic wage income generation that you have argued would be forthcoming from a firmer labor market. With globalization holding back both employment growth and real wages, I continue to believe that there are powerful structural headwinds crimping labor income generation in the current climate. Over the broad course of this 58-month expansion, private sector compensation has increased by only about 16% in real terms, well short of the 23% average gains over comparable phases of the past four long-cycle expansions. Moreover, with the homebuilding sector now moving into recession, a cyclical shortfall of labor income should be increasingly evident in the months ahead. If it’s all about income, and the asset effects are fading, the case for a consumer retrenchment looks increasingly solid to me.
Berner: With all due respect, I disagree. True, the stock-option and bonus bunching in the first quarter may have boosted compensation as we measure it. But we have also learned where all the income came from, first in strong withheld and Social Security and Medicare tax receipts and then in the massive likely upward revision to nonfarm payrolls and hours over the year ended in March 2006, which will be officially reported next February. And while globalization is a secular force that probably has dampened inflation and pay gains, right now a powerful cyclical global growth dynamic may be working in the other direction.
Moreover, while I’m a fan of looking at cyclical comparisons with the average postwar experience, in the current expansion I attribute the cyclical experience of hours and employment more to domestic excesses than to globalization; as a result, such comparisons are simply less valid than normally. But I’ll be the first to wave the white flag if job and wage growth seriously falter in coming months. The good news, at least for now, is that certainly was not the message of the October jobs report.
What will happen in the event of another shock?
Roach: OK, I will wait with baited breath for another one of those lyrical revisions from your friends with the green eyeshades. But until that revelation, let’s focus on the here and now. As you have duly noted Dick, something else very important is going on — rapidly falling energy prices. You have calculated that this is the functional equivalent of a $100 billion-plus tax cut for the American consumer — more than enough to offset negative wealth effects from the bursting of the housing bubble and cyclical hits to income generation stemming from a pullback in building activity. I would argue that context is key here.
As I stressed above, in the absence of asset-based saving generation, there is good reason to believe that rational consumers now need to shift back to income-based saving strategies. In the three earlier oil shocks, the personal saving rate averaged about 8% — this time the number is basically “zero.” The saving cushion that was available during those earlier shocks came in very handy in fueling consumption rebounds once oil prices started to fall again. There is no such saving cushion today — other than that which was once embedded in overvalued homes. With that source of saving now sharply on the wane, why wouldn’t we expect the American consumer to save a much higher portion of the energy-related windfall than in the past?
Berner: You are absolutely right, and if consumers retrench because some shock makes them save more, I will be wrong. But three factors make me doubt that the shock will come from housing. First, the deceleration in prices nationwide is still likely to be more gradual than you believe. Second, I believe the influence of wealth on consumption is far smaller than you think. And third, both past experience and careful empirical work show that consumers adjust their lifestyles far more gradually than you think to a change in wealth.
But Steve, you’ve gotten bullish on Germany and Europe generally, and there’s no sign elsewhere in the world — except perhaps in Japan — that growth is falling short of expectations. While complete global decoupling may be a fallacy, as you recently argued, isn’t it likely that global rebalancing could occur through stronger growth abroad, which would boost US exports and provide something of an offset to housing-related hits on domestic demand?
Roach: Fair point — both Germany and Japan definitely look better to me these days. And as someone who has long focused on the imperatives of global rebalancing, it is great news to see the world’s second and third largest economies on the mend. But in both cases, the improvements have been focused on the corporate side of the ledger — led by impressive performance in productivity but without any meaningful follow-through from domestic private consumption. For US exporters to benefit from improvements in Japan and Germany, those economies need to deliver more in the way of internal demand. So far, that remains more of a hope than reality — raising serious questions about the notion of a seamless handover from the American consumer to consumers elsewhere in the world.
Roach and Berner: So where do we leave you, dear reader — other than confused and frustrated? There are two main bones of contention between us: Roach worries much more about the post-housing wealth effect and Berner is banking more on energy-augmented income support. Where we both agree is that a sharp upsurge in personal saving could derail the soft landing the markets seem to be banking on. Roach is clearly in the growth recession camp and worries that another shock at any point in the next 6-9 months would spell outright recession for an increasingly vulnerable US economy. Berner stresses resilience and soft landing. The market implications from these contrasting scenarios couldn’t be more different. Steve is in canned milk and bonds, while Dick still likes riskier assets.
How to choose? Keep your eye on the American consumer. A disappointing holiday selling season could turn a pause into a more serious problem, triggering the cumulative forces of outright recession. An inflation surprise could also be decisive. If prices accelerate significantly further, requiring a more aggressive Fed and triggering a dramatic backup in yields — read 100 bp or more — ironically, Steve could also end up being right. In contrast, the moderate further cyclical inflation pressures Dick expects could underwrite a more benign outcome. In any case, an important test is undoubtedly close at hand.
By Stephen Roach and Dick Berner, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum