The turn of the calendar year is always a convenient time for taking stock – looking back on the year just ended and pondering what that passage of time portends for the future. The temptation is to wipe the slate clean and come up with a fresh look at the macro puzzle. Yet barring shocks, economies and markets don’t operate in such a discontinuous fashion – they are heavily influenced by trends of the recent past. Notwithstanding the inertia of such an autoregressive world, I have long believed that we macro practitioners periodically need to look inside ourselves and re-examine what worked and what didn’t. In the mark-to-market spirit of personal growth, I present the Lessons of 2006.
Global rebalancing: important consequences
Global rebalancing. This has been my personal crusade for the better part of the past five years. In its simplest form, the rebalancing thesis maintains that ever-widening disparities between the world’s surplus and deficit savers are not a recipe for sustainable global growth. With America’s current account deficit averaging well in excess of $800 billion in each of the last two years, the US absorbed nearly 70% of the rest of the world’s surplus saving – an external financing burden that, by the end of 2006, required about $3.5 billion of foreign capital inflows each business day. In the end, the rebalancing imperatives of such an unbalanced world require nothing short of a fundamental realignment in the mix of global saving – namely, an increase in long-deficient US saving and a decline of excess saving elsewhere, especially in Asia and the Middle East.
Absent such a shift in the mix of global saving, the rebalancing thesis argues that there should be important consequences for the terms on which the deficit economy conducts its external financing. In the case of the US, that would imply a decline in the foreign exchange value of the dollar and a widening of the real interest rate premium on dollar-denominated assets. Yet there can be no mistaking the lack of such concessions in 2006. While the dollar sagged a bit and real rates inched higher as the year came to an end, these moves were well short of the more extreme adjustments implied by the rebalancing framework. Such an outcome points to one of two possible explanations: Either other factors came into play or the theory is simply wrong. My vote is with the former, driven both by the persistent excesses of the global liquidity cycle as well as by the policy-induced dollar buying of Asian and Middle Eastern central banks. As long as those forces remain in play, I certainly concede that the financial market implications of the rebalancing thesis could continue to be tempered as a result.
I think it is critical, however, to make the distinction between the problem – ever-mounting global imbalances – and the consequences of the problem – its saving, currency, and real interest rate implications. I am not of the view that a problem should be dismissed because its consequences have failed to fully materialize. Moreover, I now draw greater comfort from an international community that takes the threat of global imbalances seriously – as evidenced by coordinated statements from G-7 finance ministers and the IMF last spring. At the same time, as noted below, I also recognize the need to rethink the financial market repercussions of a problem whose implications could well continue to materialize later rather than sooner.
Global trade: a milestone of globalisation
Last year was a critical milestone on the globalization front. Courtesy of an accelerated pace of cross-border integration, global trade exceeded 30% of world GDP in 2006 for the first time ever. Nor was last year an aberration. Over the 1998 to 2006 interval, the growth in global trade accounted for fully 42% of the cumulative increase in world output (as measured in US dollars at market exchange rates). This trade-intensive global growth dynamic was not without important macro consequences.
The rapidly expanding supply of goods and services from the low-cost developing world was the functional equivalent of a major disinflationary headwind in the developed world. Even in the face of rapidly rising energy prices, our estimates put CPI-based inflation in the industrial world at just 2.4% in 2006 – identical to the energy-elevated outcome in 2005 but little changed on a “core” basis in either of those years. Given the narrowing of slack in labor and product markets in most large industrial economies, the persistence of low inflation underscores an increasingly important global offset to the more traditional domestic pressures that have long shaped underlying inflation in the developed world.
Meanwhile, the ever-powerful global labor arbitrage continued to exert downward pressure on both job creation and real wages in most major economies of the developed world – sufficient to push the labor compensation share of national income down to a record low of 53.7% in the major industrial countries in 2006. This raises serious questions about the so-called “win-win” results of globalization. While there has been a big win for low-wage workers in the developing world, it is exceedingly difficult to find signs of the second win for high-wage workers in the developed world.
Global politics: Western pro-labour shift
Largely because of the global labor arbitrage, the interplay between economics and politics took an important twist in 2006. A persistence of relatively stagnant real wages in the rich countries of the developed world had important implications for political outcomes in the United States, France, Germany, Italy, Spain, Japan, and possibly Australia. Partly in response, the political pendulum swung to the left with potentially significant pro-labor implications. The ascendancy of the pro-labor left threatens to shift the global political debate from the collective concerns of globalization to the nation-specific self-interests of “localization.”
That would imply mounting risks of trade frictions and protectionism – as well as a potential regulatory and legislative assault on disparities in the global income distribution. This could well pose an especially serious challenge to the mix of overall income in the developed world – tilting the reward structure back toward labor through a reslicing of the global income pie away from record shares currently going to corporate earnings and the owners of capital.
Fallout from the US housing bubble
As was the case with the equity bubble six years ago, another major asset bubble burst in 2006 – this time, America’s monstrous property bubble. Just as the demise of the equity bubble led to a mild, triple-dip recession in 2000-01, I fear the risks of a similar outcome in 2007 have been dismissed all too quickly. First of all, the correction in the housing sector has only just begun; for example, just 15% of the outsize run-up of US residential construction employment over the past five years has been unwound. Second, overly-indebted, saving-short American consumers have been using increasingly over-valued homes to support excess consumption; as that option is now foreclosed in a softer house price climate, consumer demand should come under ever-greater pressure. Third, as the outlook for housing and consumption gets drawn into question, capital spending plans – long highly sensitive to expectations of end-market demand — could well be tempered; two consecutive monthly declines in core capital goods orders in October and November 2006 hint that such an adjustment may now be under way. As was the case in the post-equity-bubble climate of six years ago, there is a broad consensus of opinion that any damage from the bursting of the latest asset bubble can be contained to the US home-building sector. To me, that’s a classic example of a lesson unlearned.
A challenge to the commodity super-cycle
The super-cycle view of commodity markets met a stern challenge in 2006. Oil prices fell by more than 25% from their mid-July peaks, natural gas prices dropped by more than 30%, and late in the year there were signs of a softening in economically-sensitive base metal prices such as copper. The super-cycle theory is premised mainly on a very credible case of shortages on the supply side of major commodity markets, where there has been a notable lack of investment in new extractive and processing capacity for well over 20 years. With globalization promising new sources of demand from large commodity-intensive economies such as China and India, the mismatch between constrained supply and increasingly vigorous demand encourage the apostles of the super-cycle to endorse a conclusion of ever-lofty commodity price expectations. Missing, in my view, is an appreciation of potential cycles on the demand side of commodity markets.
The US housing shakeout is a case in point – a downturn that is likely to provide a major drag on demand for many building-sensitive industrial materials. But the real cycle on the demand side is likely to be made in China – an economy that makes up only about 5% of world GDP (at market exchange rates) but accounted for fully 50% of the cumulative increase in the global consumption of oil and base metals over the past three years. Driven by a conscious effort to cool off an over-heated investment sector, in conjunction with a US-induced slowing of exports, China is likely to face slower growth in the year ahead. That could be a decisive demand-driven blow to the supply-dominated case for the super-cycle view of commodity markets.
Global economy: lessons learned in 2006
It’s all too easy to become fixated on any one of these lessons. The financial market outcome reflects the interplay between all these developments. As I put the package together, the lessons of 2006 did a reasonably good job of explaining the major developments in the markets last year. Bonds did better than expected, in part because globalization played an important role in containing core inflation in the face of both a major energy shock as well as diminished slack in the industrial world. Equities turned in a good year as an ever-powerful global labor arbitrage continued to squeeze worker compensation and boost earnings. And orderly adjustments were the rule in currency markets, as the stewards of globalization finally turned their attention to the need for containing the dreaded dollar-crisis scenario.
But do the lessons of 2006 hold the key for 2007? If it were only that easy. While undoubtedly there are some important hints that can be gleaned from last year’s experience, there is also a critical catch: Significantly, I continue to expect a two-engine global slowdown – driven by a post-housing bubble shakeout in the US and a cooling-off of Chinese investment. While I am not in the global hard landing camp, I would not be surprised if global growth fell one percentage point short of the 4.9% average pace of the past four years. In such a context of slower growth, I worry increasingly about a new and important wrinkle in the political equation – driven by an ascendant Left that pushes the pendulum of power away from capital and back toward labor.
My biggest concern is the complacency that continues to shape the outlook for ever-frothy risky assets – namely, high-yield corporate debt, structured credit products, emerging market securities, and yes, even commodities. This, in my opinion, is the next bubble. But as was the case with equities and housing, experience tells us that the extremes in asset markets always persist for longer than we think – especially in an era of excess liquidity. That was certainly an important lesson in 2006, but it may be tougher for the bubble in risky assets to persist for another year. This underscores the trickiest aspect of any market call – the near impossibility of predicting that point in time when an asset bubble bursts. That’s a lesson for all years.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum