Global economic growth: have we avoided a downturn?

It seems markets have quickly tired of the slowdown play - asset markets have enjoyed a resurgence on the back of cheaper crude. But is the lower price of oil all it's cracked up to be? asks Stephen Roach.

Financial markets have quickly tired of the slowdown play, and the reacceleration bet is being priced back into asset markets. Equities love it, bonds have sagged a bit, the so-called spread markets (i.e., emerging markets and corporate credit) are thrilled, and commodities are re-energized - no pun intended. It's as if a $46 trillion global economy turned on a dime. I've learned never to say never, but I suspect this flip-flop will be short-lived. Relative to the consensus mindset, I continue to believe that there is a much greater chance that global growth will surprise on the downside in 2007 rather than on the upside.

Three developments have altered the cyclical growth outlook - sharply falling oil prices, Fedspeak, and the ever-present China factor. The energy story gets top billing. Spot oil prices are down nearly 25% from their mid-July highs and prices of refined petroleum products have tumbled even more. In the US - whose consumers have long been the major engine of global demand - this is being billed as a veritable bonanza. With wholesale gasoline prices plunging by some 75 cents per gallon and natural gas and home heating oil quotes also moving appreciably lower, Dick Berner has calculated that there could be an energy-related windfall of some $120-130 billion in discretionary income. It's the functional equivalent of a major tax break heading into the all-important holiday shopping season - another stroke of luck for the fabled American consumer.

Will falling oil prices boost economic growth?

I have no idea where oil prices are headed, but I would offer a couple of observations before you crack out the champagne. First, soaring oil prices did absolutely no damage on the upside to either the American consumer or the global economy. Nominal oil prices essentially doubled from 2003 to 2005, while real consumption growth in the United States accelerated from 2.7% over the 2001-03 period to 3.7% over the 2004-05 interval; meanwhile, world economic growth averaged 4.9% over the past four years - the strongest burst of global growth since the early 1970s. The ex post rationale for this seemingly paradoxical outcome is that it matters whether surging oil prices are an outgrowth of supply or demand. In the past couple of years, the price spikes are now viewed as an endogenous implication of robust demand - so, of course, they didn't hurt. Now, however, the hope is that falling oil prices will boost economic growth because the decline is coming from improved conditions on the supply side of the energy equation. In other words, the oil price has changed stripes - what didn't hurt will now help.

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This pro-growth explanation could be wrong on two counts: First, I don't think that the factors behind the recent oil price decline have been black and white; improved supply expectations may have helped but I suspect that reduced demand expectations were also at work - a perfectly normal by-product of the slowdown bet. Nor do I think it is entirely accurate to calculate the windfall from last summer's peak energy prices - a spike that rational consumers tend to look through in their ongoing budgeting decisions.

Are Americans saving or spending?

Second, there is the saving response to the so-called energy-related tax cut. The oil price windfall is not the only thing going on here. The hissing sound you hear is that of the bursting of the US property bubble - drawing into serious question the wisdom of asset-based saving strategies that have taken America by storm over the past decade. Absent the housing bubble, rational consumers focusing on life-cycle saving objectives - especially those 77 million baby-boomers that will be starting to face retirement in the next few years - should begin to shift back to income-based saving strategies. And with the income-based personal saving rate in negative territory for the first time since 1933, the urgency of that shift in a post-housing bubble climate cannot be minimized.

That's especially the case in light of the juxtaposition between saving and oil prices. In the three oil shocks of the past, the personal saving rate averaged 8% - leaving consumers not only an ample cushion to withstand the blow of higher energy prices but also the wherewithal to step up and start spending when oil prices went the other way. At a zero or negative saving rate, no such cushion exists. This suggests that there is a much greater chance US consumers will save an energy-related tax cut rather than spend it. In short, I'm still a believer in the notion that - lower oil prices or not - the bursting of the housing bubble is likely to take a meaningful toll on the seemingly unflappable American consumer.

The Fed has also been an important factor influencing the growth debate. The recent spin of Fedspeak appears to have been aimed at reining in the excesses of the bond market. Two weeks ago, fixed income markets were looking for three rate cuts in 2007 - today, the verdict calls for about half as many moves. Ever mindful of its inflation target - explicit or not - the US central bank is sending a signal that it is prepared to err on the side of being firm rather than accommodative in setting monetary policy. Meanwhile, the Fed's latest "beige book" - a tabulation of anecdotal reports of economic conditions around the US - dashed hopes of those who were looking for a swift deterioration in the real economy. A bounceback in consumer confidence and those ever-amazing upward revisions to employment - despite a major shortfall of job creation in September - also fueled hopes of the reaccelerationists. Ironically, our US team cut its "tracking estimate" of third quarter GDP growth below the 2% threshold for the first time. Sure, the contrarian might depict this cut as the final capitulation of the slowdown play. If, on the other hand, it's only a hint of what lies ahead, an increasingly aggressive Fed-easing bet hardly seems unreasonable.

Will China's growth continue so rapidly?

And then there's China - everyone's favorite growth story. While the monthly production and investment numbers ticked to the downside in August, and the September reports are just starting to trickle in, there's no conclusive confirmation of the long-awaited China slowdown. For what it's worth, my own hunch is that the mid-2006 Chinese growth spike - 11.3% for GDP in the second quarter and 19.5% for the y-o-y industrial output comparison in June - will represent the high-water mark for this cycle. A year from now, I think Chinese economic growth will have decelerated into the 8% range for GDP and 12-13% for industrial output. This is tantamount to a shift from white- to red-hot growth - hardly symptomatic of weakness but nevertheless a meaningful deceleration with actionable implications for commodity markets and China's major Asian suppliers.

The whispers in Beijing are consistent with such an outcome. The resurfacing of Ma Kai, China's head central planner, who has been unexpectedly silent over the past several months, suggests that a new round of administrative edicts could be in the offing - the most effective means for controlling investment funding and construction in this blended economy. Similarly, the recent arrest of Chen Liangyu, politburo member and the Secretary of the Shanghai Communist Party, underscores Beijing's push for more centralized control over this long-fragmented economy. The Chinese leadership very much understands the imperatives of cooling off - both for investment and exports. The alternatives of excess capacity and deflation from a runaway investment boom and/or a protectionist backlash from open-ended export growth are simply unacceptable. I have never been in the China hard-landing camp, but I have long been of the view that a slowdown is crucial to the sustainable growth objectives of the Chinese leadership. This is the year when I expect Beijing to deliver.

What about the other major economies?

In my simple two-engine view of the world, downshifts of the American consumer on the demand side of the equation and the Chinese producer on the supply side are a recipe for a meaningful deceleration in world economic growth. Yes, there are many other moving parts to the world economy. And with talk of revival in Japan and Germany in the air, there are hopes that the world's second and third largest economies could spark a global decoupling that would allow the world economy to keep growing while barely skipping a beat. While I am sympathetic to the German revival story (see my 15 September dispatch, The New Wirtschaftswunder?), I hardly think that's enough to fill the void.

Until the broader world economy establishes a solid base of internal demand - especially private consumption - it will have a hard time withstanding the impacts of a slowing in the US and China. That's true of Europe, where an encouraging - but still relatively modest - cyclical upturn remains vulnerable to a meaningful payback in 2007 on the back of a sharp increase in German VAT taxes, a meaningful shift to fiscal restrain in Italy, and the lagged impacts of a stronger euro and ECB tightening. It's also likely to be the case in Asia, whose export-led economies (including Japan) remain very much a levered play on both the American consumer and the Chinese producer. And it's true of America's tightly linked NAFTA partners - Canada and Mexico - who will hardly be spared in the event of a US slowdown. A similar fate also awaits commodity producers in Russia, Australia, and New Zealand if they have to cope with the reverberations of a downshift in commodity-intensive China.

In today's fast-paced world, market participants quickly tire of focusing on much of anything. The slowdown play was nice while it lasted, but it now feels so yesterday. Stubborn as always, I'm wary of such a quick about-face. I still believe the bursting of the housing bubble is a very big deal for the American consumer and all those export-led economies around the world that are so dependent on US buying power. And I remain equally convinced that China is about to get serious in its cooling-off campaign - triggering a downshift with significant repercussions for its Asian suppliers of manufactured components as well as for the global commodity complex that has fed China's seemingly insatiable demand for raw materials. Without the overdrive of the American consumer and the Chinese producer, the newfound reacceleration bet could be setting the markets up for yet another flip-flop.

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum