The great global growth debate
The global growth debate could well prove decisive for financial markets in 2006. An increasingly vigorous acceleration in world economic activity has been evident in the early months of this year.
The global growth debate could well prove decisive for financial markets in 2006. An increasingly synchronous and vigorous acceleration in world economic activity has been evident in the early months of this year. With the markets now discounting the likely persistence of this synchronous boom, it pays to ponder whether the global growth story might swing the other way.
There can be no mistaking a decisive acceleration of the world economy in early 2006. A quarterly global GDP proxy maintained by Morgan Stanley's global economics team now points to a 3.4% gain in industrial world GDP in 1Q06 -- fully 70% faster than the anemic 2.0% pace recorded in 4Q05 (all figures expressed as annualized sequential quarterly increases). Within the developed world, the acceleration was particularly evident in the US, where the Katrina- and energy-related shortfall in the final period of last year (1.7%) appears to have been followed by a 4.1% rebound in the quarter just ended. I should note, however, that this latest calculation of 1Q06 real GDP growth in the US is not nearly as vigorous as we had once thought would be the case; just six weeks ago, our peak "tracking" estimate for the first period -- a calculation we continually update on the basis of incoming data -- stood at a far more robust 5.9%. We have since marked down our 1Q06 estimates for growth in personal consumption, business capital spending, and foreign trade. Looking through the volatility, our latest take on the underlying pace of aggregate US economic activity works out to an average of nearly 3% over the past two quarters. While that's not bad for an expansion now in its fifth year, it does represent a bit of a downshift from the headier 3.8% average gains of 2004-05.
In Europe, the degree of acceleration is equally impressive - although the absolute growth rates continue to fall well short of those evident in the US. Following an anemic 1% annualized gain in the euro zone for 4Q05, our latest estimates point to an acceleration to 2.8% in 1Q06. Our euro team makes this calculation largely on the basis of incoming business surveys - all of which, other than for Belgium, have looked very upbeat in recent months.
Particularly impressive was a sharp increase in German business sentiment in March as measured by the all-important Ifo survey. This rebound has now spread beyond manufacturing into the long-dormant retail and construction sectors .
Taken literally, the latest European business surveys underscore upside risks to our upwardly revised growth estimates for 1Q06; they also hint at the possibility of a spillover of the newfound vigor into the spring quarter.
In Japan -- quite possibly the world's most exciting economic recovery story -- the quarterly volatility has worked the other way. That shouldn't be so surprising after an outsize 5.4% annualized spike in real GDP growth recorded in 4Q05. On the basis of incoming data, our estimates suggest the economy slowed to a more sustainable 2.9% clip in 1Q06 -- still a very impressive gain for an economy that had been mired in a 1% growth slump for well over a decade. While the latest data flow has been a bit on the soft side -- especially the February industrial production report -- our Japan team continues to believe that newfound vigor in the world's second-largest economy remains intact. For reasons that are hard to fathom, Japanese government statisticians have never done a great job in smoothing out the quarterly volatility of their GDP statistics.
Nevertheless, if our estimates are correct, the Japanese economy expanded at an average annual rate in excess of 4% in the two quarters ending 1Q06 -- making Japan the most rapidly growing economy in the industrial world over that period. It's been a long, long time since any of us have been able to say that!
According to the Bank of Japan's just-released Tankan survey, business confidence for manufacturers slipped fractionally in the three months ending March; while that is hardly a major reversal, it did come as something of a surprise and underscores the Japan downshift call. Our forecast calls for Japanese GDP growth to slow a bit further to slightly more than 2.5% over the next three quarters -- far short of the heady pace of the past two quarters but still faster than the Japanese economy's longer-term growth potential.
In the developing world, quarterly data on economic activity are highly unreliable. But in tracking the ongoing pace of the global economy, we ask our teams in Asia, Latin America, and Eastern and Central Europe to take a stab at estimating sequential quarterly growth patterns in their respective regions, as well. Our latest take from this exercise points to a bit of a slowing in 1Q06 (5.3% for sequential annualized growth in developing world real GDP) relative to exceptionally vigorous gains evident in 4Q05 (7.4%). I would not place much weight on the quarter-to-quarter volatility but would, instead, underscore the average 6.5% increase over that two-quarter period -- more than twice the pace we estimate for the industrial world (2.7%) over that same interval. With the developing world accounting for 45% of world GDP, as measured by the IMF's purchasing power parity metrics, this ongoing vigor can hardly be taken lightly.
There's always a risk from a round-up of high-frequency data that we make too much out of the latest trend. Financial markets, and even policy makers, have tended to do just that in recent years. Time horizons have shortened as the momentum play has taken center stage in the debate. Periodic growth scares, as well as equally frequent boom alerts, are all too frequent by-products of this ever-myopic culture. On the basis of the latest spin of the numbers, the verdict is very much on the boom side of the global growth call. And financial markets have certainly taken their cue from this important conclusion -- especially bond markets.
The recent back-up in long-dated sovereign yields is an important case in point. In the US, for example, the increase in 10-year Treasury yields toward the all-important 5% threshold -- a level that hasn't been seen in nearly two years -- is almost exclusively traceable to a surge in the real interest rate component. As measured in the TIPS market, real yields are close to a three-year high - suggesting that the bond market could well be close to "maxing out" on its perceptions of growth risks. The inflationary premium, by contrast, has changed very little over the same period. This decomposition of recent trends in the bond market speaks far more to a growth-induced acceleration on the demand side of the US and global economy than it does to the inflationary consequences of such an outcome. The connection between financial markets and the growth implications of the latest spin of the incoming data flow has never seemed tighter.
Yet as night follows day, the global growth story has its own inevitable ebbs and flows. Based on our quarterly global growth proxy, our baseline forecast implies that industrial world GDP growth in 1Q06 probably hit its high-watermark for at least the next couple of years. Over the two middle quarters of this year, we see growth slowing by about 0.5 percentage point to a 2.9% average annual pace. If we're right, that means financial markets will need to start factoring in at least a modest deceleration.
The risk, in my view, is that any such slowing could be far more pronounced than our current baseline implies. Three considerations lead me to that conclusion - the first being a post-housing-bubble capitulation of the over-extended American consumer. Our latest tracking estimate puts 1Q06 real consumption growth at 5.1% - the strongest gain in ten quarters but obviously a bounceback from the anemic 0.9% gain in 4Q05. As the housing bubble continues to deflate and equity extraction from property fades, I continue to believe that income-constrained American consumers will prune discretionary spending - putting the risks to overall consumption growth on the downside of the 3% average pace recorded over these two quarters.
China could well be a second source of deceleration over the course of this year, as the government makes a downpayment on its avowed rebalancing away from exports and fixed investment toward private consumption. Rising protectionist risks could well provide a third source of deceleration -- operating not just through the seemingly all-powerful Chinese export dynamic but also through the currency and interest rate implications of a US current account adjustment.
Financial markets are currently dismissing downside growth risks leaning the other way -- betting more on the upside of the global momentum play or, at worst, believing that any deceleration in the pace of world activity is likely to be minimal. That's certainly the message to take from the recent sharp back-up in real interest rates, as well as the latest surge in metals prices -- precious and industrials, alike. Central banks have reinforced this pro-growth cyclical play by sending signals that they remain very focused on the traditional closed-economy linkage between rapid growth and inflation. In my view, that leaves markets increasingly exposed on the other flank to the possibility of a downside growth surprise.
If those risks play out, bonds could rally and equities could sag on growth concerns.The biggest risk, however, is that it doesn't take all that much to
turn the global liquidity cycle. For their part, the world's major central banks are all on the tightening side of the monetary equation for the first time in 15 years. The Federal Reserve has already gone a long way down the road toward policy neutrality, and there are those who argue that it may already have entered the restrictive zone. Nor should we underestimate the potential impacts of the sea change in Japanese monetary policy now under way -- the shift away from quantitative easing that has already commenced and a possibly sooner-than-expected ending of the Bank of Japan's zero-interest-rate policy this summer. If the turn in the global liquidity cycle reinforces a downshift in global growth, financial markets could be especially vulnerable.
Recent action in some of the more exotic corners of the markets may well be providing a hint of how that vulnerability might spread. An unwinding of carry trades in Iceland and New Zealand, corrections
in Middle Eastern equity markets, and very recent pullbacks in commodity-linked currencies (i.e., Canada and Australia) could well be canaries in a much bigger coal mine. Even the big equity markets in the US, Europe, and Japan have looked a bit toppy in recent days as yields on long-dated US Treasuries close in on the 5% threshold.
The global economy has just come off a very hot and increasingly synchronous burst of growth. Momentum-driven financial markets are betting this trend will continue. However, there is good reason to suspect that the ever-fickle pendulum of global growth is now about to swing the other way. If that turns out to be the case, increasingly myopic markets could reverse course in a flash.
By Stephen Roach, global economistat Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum