Secrets of Consumption Dynamics
Sept 05, 2006
Serhan Cevik (London) and Katerina Kalcheva (London)
Consumer spending holds the key to post-volatility growth performance. The global volatility shock may be easing away, as investors develop a better understanding of the road ahead, but its economic consequences, especially in developing countries, are not easy to dismiss. In the case of Turkey, for example, the lira’s sharp depreciation and more restrictive financial conditions have already resulted in a slowdown in economic activity. The crucial point for equity as well as fixed-income investors is the intensity and duration of the slowdown, which of course depend on a variety of factors, and the feedback mechanism between these multiple forces. This is why we need to look deeper into economic and financial figures to assess the effects on aggregate domestic demand. Since private consumption is the largest component of total spending in the economy and therefore has a significant influence over the business cycle, it is an appropriate starting point for our project on post-volatility growth performance. In this first instalment, we analyse real private consumption expenditures with an error-correction model based on explanatory variables like disposable income, net financial assets, bank lending to the household sector and currency volatility. But before trying to identify the sensitivity of consumer spending to shocks and open a window into the future, let’s start with where the Turkish economy is coming from.
Macroeconomic normalisation paved the way for higher growth across the board. Real gross domestic product increased by more than 35%, on a cumulative basis, in the last 17 quarters following the deep recession in 2001. In our view, prudent fiscal policies, structural reforms and an independent monetary policy focusing exclusively on achieving price stability have contributed to macroeconomic normalisation and led to across-the-board income growth. As a result, despite the challenges of structural adjustment in the labour market, we have witnessed a sustained increase in consumer spending, driven by pent-up demand and improving financial conditions. Real private consumption grew by 32.8%, rising marginally from 63% of GDP in 2002 to 64.9% last year. Although the current level is still below the average of 68.4% of GDP in the 1987-2000 period, its strong growth momentum and composition skewed towards durable goods certainly raise the risk of a financial shock causing a vicious circle, whereby slower consumer spending forces companies to cut jobs, prompting private consumption to slow even more. Indeed, with financial tremors and heightened uncertainty, the consumer confidence index has already fallen to the lowest level, posting a year-on-year drop of 7.0% in June and 10.7% in July and consequently leading to a sudden drop in domestic sales. However, as our results show, this is still a cautionary response (especially in discretionary household spending) and an outright recession remains highly unlikely. The error-correction model helps us to better understand the behaviour of the Turkish consumer. Economic theory suggests that real private consumption expenditures can be modelled as a function of real disposable income, real wealth and other explanatory variables capturing income uncertainty and intertemporal substitution effects. In the Turkish context, our analysis reveals that consumers base their consumption decisions on disposable income, net financial assets and the cost and availability of credit. Unfortunately, we could not include the real capital stock of houses and apartments in our model, due to missing reliable time-series data, and use financial assets as a proxy for the total stock of household wealth. We also include exchange-rate volatility to capture the effect of uncertainty on consumer spending. Our single equation error-correction model for the behaviour of the Turkish consumer is successful in distinguishing long-run from short-run dynamics and thereby helps us to develop a better understanding of the main determinants of private consumption. After identifying a stable long-run relationship between the variables, we estimate the long-run elasticities relative to consumer spending, which have significant coefficients with the expected signs. Disposable income is the most important determinant of consumer spending in the long run. The steady-state elasticity of private consumption to disposable income is about 0.90, which implies that a 1% increase in disposable income would lead to a 0.9% rise in consumption expenditures. On the other hand, a similar increase in net financial assets and consumer loans boosts household spending by just 0.08% and 0.04%, respectively, in the long run. In other words, disposable income is the main determinant of private consumption expenditures over an extended period. Such excessive income sensitivity is not a surprising result, since numerous economic crises in the past contributed to a mental inertia influencing consumption behaviour in Turkey. Likewise, a low — but positive and significant — elasticity of consumption to net financial assets simply suggests that the accumulated financial wealth (at least in the recorded system) is too small and unequally distributed across the society to influence aggregate spending at this stage. Nevertheless, our results indicate that macroeconomic normalisation — bringing an improvement in credit conditions — can indeed boost private consumption in the short run and will likely have a greater effect in the future. Consumers adjust 48% of their current spending to the disequilibrium in the previous period. The short-run model is specified with the difference of log consumption as the dependent variable and lagged differences of consumption, contemporaneous differences in disposable income, currency volatility and the lagged difference of real interest rates as explanatory variables. The results show that consumers adjust 48% of their expenditures in the current period to the disequilibrium in the previous period — a relatively high speed of adjustment to the long-run relationship. The lagged value of private consumption has a significant positive impact, leading to a 0.28% increase in consumption expenditures in the next quarter. However, once again, current disposable income has an overwhelming influence on consumption dynamics, increasing consumer spending by 0.67% within one quarter. On the other hand, exchange-rate volatility has a negative effect on consumption expenditures, as expected. Our results also show that an increase in real interest rates prompts consumers to save more, which is consistent with the data highlighting a tendency in the household sector to accumulate buffer-stock savings in times of high volatility and heightened uncertainty. However, as we witnessed in the last four years, consumers switch from a precautionary saving mood to higher consumption once income uncertainty diminishes. Moreover, capital gains on buffer-stock savings also have a positive effect on consumption expenditures. All in all, our main findings are as follows: · Disposable income, capturing both wage and employment growth, is the key determinant of consumer spending. · The long-run consumption elasticity to real disposable income in Turkey is comparable to those in European countries. · Low but positive elasticity of consumer spending to net financial assets suggests that although a small portion of income is invested in financial assets, rising asset prices still boost consumption. · An increase in bank lending to the household sector has a smaller immediate effect on consumption, albeit becoming more important, especially for spending on durable goods. · Exchange-rate volatility, a proxy measure of the degree of uncertainty in the economy, has a negative effect on private consumption. The volatility of consumption growth is relative to the volatility of output growth. The volatility of consumption growth, measured by its standard deviation, is 5.3%, compared to 3.0% for output growth. In other words, consumer spending is more sensitive to transitory shocks and exhibits greater volatility. Even though consumption variability has moderated in recent years, heightened uncertainty could still change spending dynamics in quantitative as well as qualitative terms. The most important reason is the sensitivity of discretionary spending on durable goods to changes in interest rates and consumer sentiment. Since households increasingly rely on bank credit to finance the purchase of durable goods, financial conditions play a crucial role in determining the level of durable goods consumption. For example, lower interest rates and greater financial intermediation helped boosting spending on durable goods by 94.9%, on a cumulative basis, from 15% of total private consumption to 22% in the past four-and-a-half years. Impressive, but it also makes household spending vulnerable to even temporary shocks. Indeed, most of the consumption volatility is a result of higher volatility in durable goods consumption — 25.1% versus 6.7% for the total consumer spending in the 1987-2006 period. This means that the recent volatility shock will have adverse effects on private consumption of durable (and, to a lesser extent, semi-durable) goods. However, although consumers may increase precautionary savings and postpone the purchase of big-ticket items in the short run, currency volatility and restrictive financial conditions are unlikely to damage the underlying positive trend in the economy, in our view. New linkages between the financial sector and the real economy are based on strong foundations. Bank lending to the household sector has recorded strong growth in the post-crisis period, attributable to both demand and supply-side factors. Thanks to the marked decline in the cost of borrowing and balance-sheet improvements in the banking sector, consumer loans (including credit card advances) surged from 4.6% of bank deposits in the first quarter of 2002 to 20.1% at the end of last year and 24.3% so far this year. Even though external sources of financing provide a greater propensity to spend — especially on durable and semi-durable goods — financial liabilities of the Turkish household sector, increasing from 2.3% of GDP in 2002 to 9.3% last year, are still very low compared to the average of 49% of GDP in Europe. In other words, the average consumer in Turkey remains underleveraged and is likely to have a secular tendency to borrow more going forward. And supply-side developments will keep providing a supportive setting for greater financial intermediation. With fiscal consolidation, the banking sector will hold a declining amount of public-sector debt and expand loans to the private sector. Of course, the crowding-in trajectory will not be as steep as it was in the last couple of years, and the rise in household debt, from 4.7% of disposable income in 2002 to 20.6% last year, should curb credit demand in the short run. Structural changes in the labour market bring a new dynamism to the economy. The unemployment rate improved from 9.2% in the second quarter of 2005 to 8.8% this year, but, more importantly, the composition of employment is changing for the better. As the share of agricultural employment declined from 34.9% in 2002 to 28.4%, the Turkish economy has created a growing number of paid non-farm employment opportunities. In our view, these structural gains will raise income growth and improve access to the consumer credit market. However, despite the new dynamism, the near future is still full of challenges for the Turkish consumer. First, real wages lagging behind the rise in productivity lowered the labour share of national income from 30.7% of GDP in 1999 to 26.6% last year. Second, real disposable income growth slowed from an average of 5.1% a year in the 2002-2004 period to 2% last year. Third, the household sector’s debt-servicing burden increased from 1.7% of disposable income in 2002 to 4.1% in 2005. And last but not the least, the rise in energy prices and rents has outpaced the average inflation rate and nominal wage growth. As a result, discretionary income growth — the amount consumers have after paying unavoidable expenses such as taxes, rents and household bills — is not strong enough to maintain the pace of consumption in the past couple of years. The consumer-led slowdown is unlikely to turn into a hard landing or recession. Our analysis shows that private consumption will slow broadly in proportion to the slowdown in real disposable income growth. This is, we believe, a beneficial and expected development, especially after private consumption outpaced the increase in disposable income for four consecutive years. Furthermore, with monetary tightening and more restrictive lending conditions, credit expansion will become less aggressive, restraining consumer spending on durable goods. However, we expect neither an income contraction nor a credit crunch. Indeed, we remain fairly optimistic about Turkey’s macroeconomic performance and income generation over the medium term. As long as public finances remain on a sustainable path, the banking sector will continue replacing government securities with lending to the private sector. Accordingly, our baseline projections see consumer spending hold up over the coming year, albeit realising a downside risk from the lagged effects of weak disposable income growth on private consumption.
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2Q06 Growth in-Line, but Weak Politics to Hurt 2H06
Sept 05, 2006
Deyi Tan (Singapore)
2Q06 growth in line with expectations. 2Q GDP rose 4.9% YoY, following an upwardly revised 6.1% in 1Q06. Domestic demand continued to contract on the back of weaker private investment and destocking. However, external balance lent strong support as global demand remained healthy amid weak imports from slow domestic demand and high base effects. Resolution to political problem taking longer than expected. Elections are likely to be pushed back by a month to November, with the new government being formed by December. More importantly, approval of the FY2007 (Oct-06 to Sept-07) budget is now expected to be delayed until 2Q07 according to officials. Revising 2006 and 2007 growth estimates. We are revising downwards our 2006 GDP forecast from 4.9% to 4.5% to take into account the impact on private investment from the political quagmire since the April 2 snap elections. We are also concomitantly revising downwards our 2007 GDP forecast from 5.2% to 4.5% as public investment is likely to be delayed until 2Q07, at least from the delay in Budget approval. Maintaining the view of growth recovering in 1H07. Although slower than estimated earlier, we are still expecting a recovery in GDP growth in 1H07. We believe that an improvement in macro sentiment in 1H07 will support a moderate pick-up in private fixed investment. 2Q06 GDP growth came in at 4.9% YoY, in line with our expectations for 5.0% YoY. 1Q06 growth was revised upward to 6.1% YoY from 6.0%, bringing 1H06 growth to 5.5% YoY (versus +5.0% in 2H05). Private consumption: In 2Q06, private consumption slowed down to 3.7% YoY from 4.1% YoY as households realized the impact on their household balance sheet of higher oil prices and interest rates. Specifically, we see households slowing down their purchases in discretionary items such as automobiles, restaurant services and other personal services, while still maintaining purchases of non-discretionary items such as food and beverages. Public consumption: Public consumption expanded 3.4% YoY after contracting 0.9% YoY in 1Q06. Three key one-off reasons that caused the 1Q06 growth have normalized in 2Q06. First, the base effect has turned easy. Second, the one-off accounting adjustment related to spending on health policy for the poor is not affecting 2Q numbers. Third, the budget funding that constrained 1Q spending growth is not an issue in 2Q. With a fresh round of treasury income collections coming in through 2Q, expenditure has recovered. Fixed investment: The impasse following the April 2 snap elections and their subsequent invalidation has led to a marked deceleration in private fixed investment (+3.6% YoY versus +7.2% YoY in 1Q06) as corporates likely hold off investment decisions until political uncertainty clears up. Specifically, private equipment uptake has been scaled back (+3.9% YoY versus +8.5% YoY in 1Q06) even though construction plans were maintained at 2.5% YoY (versus +2.8% YoY in 1Q06). The impact on inventory stock, which would be the first to be adjusted in any up or down cycle, remained evident. Inventory stock, which usually peaks in March and took a hit in 1Q, continued to decline in 2Q, shaving 5.7%-pts off headline growth. On the other hand, public fixed investment stayed at 5.0% YoY (versus +4.7% in 1Q06). Public construction grew at 9.3% (versus +5.6% in 1Q06) but public equipment contracted 2.0% (versus +2.8% YoY in 1Q06), off the blistering double-digit expansion in 1H05. Indeed, we do not expect public investment in FY2006 to be adversely affected by the political stalemate. Public investment due to be disbursed this year would already have been approved by previous budgets and would not be hampered by the caretaker government. External balance: The external balance lent support to overall growth, contributing a strong +7.4%-pts (versus +8.1%-pts in 1Q06). Specifically, exports of goods and services rose 9.2% YoY (versus +13.5% YoY in 1Q) but imports of goods and services contracted 2.2% after almost flat growth in 1Q. Political uncertainty to stunt 2H06 growth; expect no relief from Bank of ThailandGoing forward, we expect growth to decelerate into 2H06. The external environment is likely to soften. Domestic demand should weaken due to political uncertainty further hindering investment decisions as the private corporate sector holds back its decisions. Also, while the tightening cycle has already peaked out at 5.0%, it is premature to expect the Bank of Thailand (BOT) to provide relief in the near term. Although inflation, which we believe is a lagging indicator, has also peaked out, the BOT is likely to be cautious, in our view. We believe that the BOT probably perceives the growth slowdown to be a one-to-two quarter issue for which the monetary policy need not react. As a result, we are adjusting downwards our 2006 forecast from 4.9% to 4.5% to take into account what has panned out on the private investment front since the invalidation of the snap elections. Indeed, our new forecasts imply 2H06 growth dipping to 3.5%. Revising 2007 GDP forecast due to political quagmireReflecting the delay in elections, we are also revising our 2007 GDP forecast for Thailand from 5.2% to 4.5% to factor in the impact on public investment from the political quagmire (Note: Our previous estimate was on the assumption that a new government would be formed after the April 2 elections and the FY2007 Budget was not delayed). While our growth forecasts still assume a recovery from the bottom of 3.5% in 2H06, it is now much lower than estimated earlier. We believe that the main impact from the political crisis will be felt in the delay of the approval of the FY2007 (Oct-06 to Sept 07) budget, which could take until 2Q07, at least according to government officials. In the absence of a full-fledged government, current expenditure such as civil servants’ salaries and debt repayments can continue to be disbursed. However, new development expenditure commitments will have to be deferred. As per the government’s original plan, Bht427.5 billion of mega infrastructure projects (mega projects being those that are more than Bht1 billion in value) had been slated for 2007. The start of these projects would be delayed until at least 3Q07, given that projects will have to go through the bidding process before investment can actually start. However, to offset the effect from this, the government has plans to utilise Bht134 billion from carry-over budgets in the past three years as capex expenditure. (The quantum of this carry-over budget is equivalent to 10% of total expenditure in FY2005.) To hasten disbursements, line ministries have been urged to expedite investments in 1HFY2007. At the same time, the Ministry of Finance is also looking at the possibility of accelerating investment from state-owned enterprises, though it does not know the extent of such investment at this point. We believe that these contingency plans will slightly offset the impact from a capex expenditure vacuum in 1H07. The real recovery in public investment spending will happen only towards the second half of 2007. Nonetheless, with the elections likely behind us in early 2007, our base forecast assumes an improvement in the domestic sentiment supporting a gradual recovery in private investment from 1H07 onwards. Election timeline and political risks
We believe that the new Election Commissioners are likely to be appointed by end-September. The ECs will most likely delay the elections to end-November and the new government could be formed by end-December. Who will be the political maestro going forward remains unknown. However, we believe that the more critical factor for the economy in the short term is the smooth formation of a new majority government. To that end, we expect the Thai Rak Thai (TRT) party to still garner a majority of the votes, albeit with a lesser margin. A new government, regardless of who will be the Prime Minister, should pave the way for a smooth approval of the FY2007 Budget without delays or significant changes to some of the mega project plans. While our base case outlook assumes that the new government will be formed by December 2006, from a medium-term perspective, some unresolved issues could have a bearing on our forecasts: 1) Who will be the next Prime Minister should Mr. Thaksin step down, now that Deputy PM Somkid seems to have indicated his intention not to stand for election; 2) the possibility of constitutional reforms and another fresh round of elections following that; and 3) the likelihood of Mr Thaksin returning as PM and reaction of the opposition to such a move.
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July Exports Accelerated
Sept 05, 2006
Deyi Tan (Singapore)
Quick comment. Exports expanded an accelerated 16.0% YoY (versus +10.5% in June and +9.8% in 2Q). However, imports rose a slower 10.2% YoY in July (versus +11.4% in June and +11.5% in 2Q06). The 3MMA, which better captures the trend, shows export momentum moving up to 13.2% from 9.5% in June while imports slowed to 11.1% from 11.5%. Consequently, July trade balance rose to RM9.1 billion (versus RM8.2 billion in June). Key trends in export segments. The exports acceleration was evident in most segments. In particular, electrical and electronic products expanded 8.9% YoY (versus +7.1% in June) and contributed 4.5%-pts to headline. Commodities such as refined petroleum products, palm oil and liquefied natural gas also saw a YoY jump to 66.9% (versus +22.8%), 31.6% (versus -8.7%) and 10.9% (versus +2.5%), respectively, in July versus June. Chemicals and chemicals products rose 23.5% YoY (versus +21.2% in June). In terms of market destinations, exports to the US, Japan and Hong Kong remained weak at -0.7%, -1.1% and -7.4%, respectively, YoY (versus +6.1%, -1.9% and -7.3% in June). Nonetheless, exports to the EU, China and within ASEAN accelerated to 25.6%, 64.2% and 22.5% YoY (versus +15.8%, +24.4% and +13.9%, respectively, in June). Import momentum mixed across categories. On the import front, consumer goods are still expanding at a healthy pace of 12.9% YoY (versus +13.8% in June). Intermediate imports accelerated to 7.9% YoY, contributing the most (5.7%-pts) to import headline growth. Lastly, capital goods imports contracted 1.5% YoY after rebounding to 23.4% YoY in June. While the breakdown is not yet available, we suspect that the contraction is on the back of weaker transport equipment imports, which are typically lumpy and had risen 233.4% in June.
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Another 50bp Cut
Sept 05, 2006
Deyi Tan (Singapore)
Quick comment. Bank Indonesia cut the benchmark rate by 50bp to 11.25% in its meeting today. This is the second consecutive 50bp rate cut following the one last month. The 50bp rate cut continues amid stable currency. Despite the 50bp rate cut last month, the steady currency is likely one reason why the central bank has chosen to make another 50bp cut. Stable portfolio inflows have likely been supporting the currency. The 30-day trailing sum in net foreign equity buying has increased and held stable ever since the net selling we saw in the middle of this year, though the 15-day trailing sum of net foreign equity buying, while positive, has been declining from a peak in the past couple of weeks or so. Moreover, with Fed Fund futures pricing in a 12% probability of another rate hike, it likely opened a window of opportunity for the central bank to be more aggressive in rate cuts. Falling inflation... The latest August inflation data also helped. August inflation continues to show a moderation trend to 14.9% YoY (versus +15.2% YoY in July). Specifically, the more marked deceleration was seen in the food segment, where prices rose 15.2% YoY, slower than the 15.8% seen in July. Core inflation however sustained at 9.7% YoY (versus +9.6% YoY in July). Nonetheless, we continue to expect inflation to dip into single-digit territory in October, with inflation possibly reaching between 6% and 7% by year-end. ..and tepid domestic demand. The need to stimulate domestic demand via monetary loosening remained. While the latest 2Q06 GDP showed acceleration, domestic demand in private consumption and fixed investment continued to remain weak. We expect 10.5% by year-end. With three more monetary policy meetings to go before year-end, we reiterate our expectation of policy rates to come down from the current 11.25% to 10.5% by year-end.
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Global Growth Paradox
Sept 05, 2006
Stephen S. Roach (New York)
The global labour arbitrage tilts returns to labour away from the high-wage industrial world toward the low-wage developing world. After fixating on an inflation scare over the past four months, financial markets have turned their attention back to the growth debate. And with good reason: Energy prices are now receding and a modest upside breakout to core wage and price pressures seems to have been contained. Meanwhile, cyclical risks are building on the downside of the global economy -- underscoring the risks of a surprising deceleration in world economic growth in 2007 after the strongest four-year run since the early 1970s. The inherent asymmetries of globalization and the persistent global imbalances they have spawned could exacerbate the downshift. The coming global slowdown is likely to be made in America. After a decade of leading the demand side of the global economy, consolidation is in the cards for the US consumer. The wealth dynamic imparted by a long frothy housing market is now beginning to recede. That will expose personal consumption to the tough fundamentals of stagnant real wages, subpar employment growth, record debt loads, and negative saving rates. The excesses of asset appreciation -- first equities, then property -- masked these persistent problems. As the housing bubble now bursts, over-extended US consumers have no place to hide. A decade of excess consumption -- with growth in real consumer demand exceeding growth in real disposable personal income by an average of 0.5 percentage point per year since 1995 -- is likely to be unwound. As I argued recently, this should have important implications for the rest of the world, which is lacking a consumption engine of its own (see my 28 August essay, “Another Post-Bubble Shakeout”). The key in all of this is a seemingly chronic shortfall of income generation in the developed world -- long the major driver of consumer demand. While there can be no mistaking the vigor of growth in world GDP over the past four years -- a 4.8% average increase on an IMF purchasing power-parity basis -- the benefits of this boom have not accrued to labor. This is illustrated by the downtrend in the real compensation share of national income for the “G-7 plus” -- the US, the Euro-zone, Japan, the United Kingdom, and Canada. By this metric, real compensation fell to 53.7% of gross national income for the G-7 plus in early 2006, fully 2.3 percentage points below peak rates hit in early 2002 just prior to the onset of the current upsurge in world economic growth. For the rich countries of the developed world, labor has been on the outside looking in during the strongest period of global growth in 35 years. That poses an obvious and important question -- a boom for whom? Two likely candidates come to mind -- returns to capital in the developed world (i.e., corporate profits) and rewards to labor in the developing world. Both possibilities are outgrowths of globalization -- the most powerful macro force at work today. Insofar as the developed world is concerned, it is all about the global labor arbitrage -- a development that has turned one of the key building blocks of traditional macro theory inside out. Economics tells us that workers are ultimately paid in accordance with their marginal productivity contribution. That has not been the case in the US, where productivity gains averaged 3.3% per annum over the 2002-05 interval -- more than double the anemic 1.4% trend in real hourly compensation over the same period. It’s one thing for labor income to be under pressure in slow-productivity economies like Europe and Japan. It’s another matter altogether for labor income shares to fall in a high-productivity-growth economy like the United States. Therein lies the paradox of global growth: The global labour arbitrage tilts returns to labour away from high-wage developing world. At the same time, globalization leads to intensified competitive pressures and a mega-productivity push in the high-cost developed world. This results in downward pressure on both real compensation and employment in the rich countries -- crimping labor income generation, the sustenance of consumer purchasing power. For a decade, the United States was able to sidestep this headwind by drawing heavily on the wealth creation of its asset-based economy. As the US housing bubble now bursts, that option has been effectively foreclosed. At a minimum, that means US consumption should return to its labor-income-based underpinnings. But it could be a good deal worse than that. If American consumers elect to rebuild long-depleted income-based saving balances, consumption growth might be pushed below income growth for a protracted period of time. There is an important footnote to this argument -- the contention by many that America’s labor income generating machine is now functioning quite normally again (see Dick Berner’s 21 February 2006 dispatch, “All About Income”). The argument is simple: Irrespective of global forces, real wages are viewed as finally responding to falling domestic unemployment. That, in conjunction, with improved employment growth, should result in a meaningful upturn in worker compensation -- by far, the largest component of personal income. Unfortunately, I don’t think the facts bear this one out. Yes, there was a stunning upward revision to wage income just announced by US Commerce Department statisticians; some $98 billion was added to private sector wages and salaries in the first half of 2006 -- although fully 85% of this revision was concentrated in just two months, January and February. But, even with the revision, after 56 months of the current economic recovery, inflation-adjusted private sector compensation -- wages, salaries, and fringe benefits -- are still tracking some $360 billion below comparable points in the average trajectory of the past four long-cycle expansions in the US. Moreover, based on the just-released August labor market survey, the combination of anemic wage gains, a declining workweek, and sluggish employment growth suggests that month 57 of this comparison is likely to be even weaker. Looking through the ebb and flow of monthly gyrations in the labor market, the case for a chronic shortfall of US labor income generation remains very much intact. That underscores one key element of the global growth paradox -- the uphill battle faced by consumers in the developed world. The headwinds of subpar labor income generation may fade from time to time or, as in the case of the US, be temporarily overcome by wealth effects from asset bubbles. But as long as globalization and the cross-border labor arbitrage remain intact, those are likely to be aberrations rather than the norm. The flip side of this development is the other beneficiary of the global labor arbitrage noted above -- labor in the low-wage developing world. On the surface, the rising real wages of these workers appears to be a very consumer-friendly outcome. Unfortunately, the developing economies benefiting the most from this shift, such as China, are lacking the institutions like social security, private pensions, unemployment insurance, and medical benefits that nurture consumer cultures. All this points up what could well be one of the greatest ironies of globalization -- a decidedly anti-consumption bias. Over time, this bias might dissipate as the cross-border labor arbitrage levels the global playing field of worker rewards and as the developing world makes progress in providing a safety net for insecure families. But these are long-term possibilities. That means for the foreseeable future, globalization is likely to remain highly asymmetrical -- offering more opportunity and support for producers rather than consumers. That raises one of the deepest questions of all -- the sustainability of world economic growth in a weak global consumption climate. For most of the last decade -- and especially over the past four years -- it has been a one-consumer world. But now as the over-extended American consumer weakens in a post-housing-bubble climate, the world growth dynamic could falter as a result. For that not to happen, the baton of global economic leadership has to be transferred quickly through the exquisitely well-timed handoff that many still seem to be counting on. For reasons I have long advocated, I don’t think another consumer is capable of stepping up and filling the void (see my 28 August essay cited above). Nor do I believe that another sector in the US economy, such as business capital spending, will take up the slack. Too much of the incremental capex decision is heavily conditioned on the expected state of end-market demand. A likely slowing of US consumption is a distinct negative in that regard. Financial markets are playing the growth debate as a standard cyclical risk-assessment exercise. I don’t think there is anything standard about the adjustments now under way. An unbalanced global economy is very much an outgrowth of an asymmetrical globalization. As the US-led demand side now weakens, downside adjustments to global growth expectations could be fast and furious. Bonds have rallied and equities have held their own in the belief that all this ends in a well-orchestrated soft landing. Yet lacking in consumption support, that optimistic endgame could be no more than wishful thinking. Moreover, in a slower growth climate, the squeeze on labor income can only raise the odds of a social and political backlash -- giving even greater reason to worry about the protectionist wildcard. If the American consumer now fades, as I suspect, the pitfalls of the global growth paradox could pose serious problems in 2007.
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Is This What A Soft Landing Feels Like?
Sept 05, 2006
Richard Berner and David Greenlaw (New York)
| 2005E | 2006E | 2007E | Real GDP | 3.2% | 3.6% | 3.0% | Inflation (CPI) | 3.4 | 3.5 | 2.1 | Unit Labor Costs | 2.0 | 4.7 | 3.6 | After-Tax “Economic” Profits | 5.5 | 16.8 | -1.0 | After-Tax “Book” Profits | 32.6 | 14.4 | -1.5 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates The US growth debate has moved back to center stage in financial markets. Equity investors fervently hope that the Fed has pulled off the perfect soft landing — in which growth and inflation will cool just enough to end Fed tightening but not so much that recession threatens earnings and credit quality. As evidence in support of these hopes, employment, income, and orders continue to grow, though at a slower pace, and consumer inflation has moderated. Bond investors, in contrast, hope for more weakness, verging on a harder landing. As confirmation, they cite the obvious recession in housing and its potential to infect the rest of the economy, and the long stagnation in real wages. In our view, the outcome may surprise both camps: Underneath a swift housing downturn is a still-resilient economy that refuses to “land” and still carries lingering inflation risks. At the outset, we need to come clean on one issue: We based our long-standing call for a second-half economic acceleration on the idea that growth would pick up from a soft second quarter. Now, however, we expect a muted acceleration, or simply continued sturdy growth, for two reasons. First, second-quarter growth was revised to nearly 3% — essentially the same as our expected third-quarter gain. In addition, we shaved second-half growth by 0.1% to 3.3% to reflect Detroit’s production cuts in both the third and fourth quarters. There’s still an acceleration in our outlook, but it is small. More important, it may seem optimistic. Small wonder: The housing downturn is accelerating, and it’s hard for many to imagine that such a sickening slide in a key cyclical part of the economy could occur without inflicting substantial collateral damage on the rest of the economy. That’s especially so today because it’s fashionable to ascribe to housing activity and housing wealth so much of the economy’s past strength. We’d agree that the plunge in housing activity does threaten collateral damage in home prices and job and income growth. Builder concessions on unsold new houses will pressure home prices generally, housing-related employment will contract, and there will be ripple effects from the decline in housing activity to housing-related spending. We don’t think housing activity is in for a soft landing; far from it. We’ve long expected a 25-30% annualized second-half decline in single-family construction, reflecting lack of pent-up demand, the slide in affordability, and the mismatch between 1-family housing demand and “production” or housing starts. Incoming data suggest that our current dour prognosis, which is in the bottom quintile of the Blue Chip survey, is on track. As we see it, however, five critical factors mean that the slide in housing activity is unlikely to produce broad-based economic weakness. First, while some coastal housing, second-home and condominium markets are overvalued, we still don’t buy the notion that even a simple majority of the 275 major US metro-area housing markets are in bubble territory. Investors should not think that home prices will slide in tandem with housing activity, because builders are slashing new housing supply to bring it into better alignment with demand. That fits our view that activity will contract but prices will “rust, not bust:” We expect that inflation-adjusted housing prices will decelerate from an estimated 6% rate in the second quarter of 2006 to zero over the next 9-12 months. Second, we think that the supposed influence of housing wealth on consumer spending is far smaller than do the pessimists who rely on the analysis of so-called mortgage equity withdrawal. Empirical studies suggest that at most a $1 decline in real housing wealth would trim spending by 11 cents (see “Housing Wealth and Consumer Spending” and “Housing, Mortgages and Consumption: Comparing Australia, the UK and the US,” Global Economic Forum, October 7, 2005 and March 2, 2006, respectively). Of course, that’s not negligible; we estimate that the flattening in real housing wealth in our outlook will pare roughly ½ percentage point from the growth in consumer outlays over the coming year. Third, we think fears of collateral damage from a decline in housing activity and decelerating home prices to the consumer in particular and the economy is general are overblown, because sturdy US income and overseas growth are potent offsets. Indeed, in virtually all empirical studies, income is at least five times more important for consumer spending than is housing wealth. And consumer income gains are rising. We’ve long maintained that official income statistics understated wage and salary income, based on analysis of proxies in other data and booming tax receipts. Now, significant upward revisions to wage income data are encouraging; indeed, they show a boom. Real wage and salary income rose by 4.3% in the year ended in July — a six-year high — and it came despite the energy-induced, 3.4% rise in consumer prices over the same period. To be sure, stepped-up stock option exercise activity and bonus payments probably boosted recent pay gains, and because those sources accrue mainly to upper-income households, the recipients will probably save some of these gains rather than spend them. On the plus side, while global growth may be cooling somewhat, we still think that it will result in a rise in net exports that will contribute to US output and job gains (see “Betting on Global Growth,” Global Economic Forum, August 14, 2006). Fourth, US financial conditions are still supportive of growth, despite the substantial rise in short-term interest rates over the past year. Longer-term and borrowing rates are still low, and vendors are offering zero-interest financing to nurture spending. The recent decline in real, long-term rates, the gains in stock prices, the decline in volatility and tightening in risk spreads, and ample credit availability have recently added slightly to financial stimulus. And a widespread squeeze on consumers from rising mortgage-rate resets won’t occur until next year and 2008. Finally, relief is coming for consumers on the energy front. Gasoline prices are plunging just in time to provide consumers with a needed dose of discretionary income, likely reversing all of the hit from higher prices in the spring. Retail regular unleaded gasoline quotes tumbled by 20 cents in the past three weeks to $2.89/gal., and wholesale gasoline prices have plunged 50 cents in the past month to a level consistent with $2.50/gal. If this latter plunge materializes, it would alone add some $78 billion to consumer purchasing power. A slide of half that magnitude could boost overall real growth by half a percentage point in the second half of 2006. Against that backdrop, it appears that the rapid pickup in inflation is over. Measured by the personal consumption price index (PCEPI), core inflation rose by 40 basis points to 2.4% in the past six months. But July’s tame increase of just 0.1% seems to rule out a repeat performance in the next six months. In our view, however, while the gains may be slower, inflation has yet to peak, much less recede. Inflation expectations remain elevated, with the latest University of Michigan canvass suggesting that 5-10 year expectations have again risen to 3.2%, a 10-year high. While industrial operating rates stalled in July and the unemployment rate has stopped declining, there may be less slack in the economy than previously thought (see “Is Potential Growth Downshifting?” Global Economic Forum, August 25, 2006). Finally, unit costs are accelerating, adding modestly to upside inflation risks. Measured by the CPI, core inflation is likely to peak at 3.1% early in 2007, while core PCEPI inflation may peak at about 2.7%. We think that there is a disconnect in financial markets that offers investment opportunities: There is too much growth pessimism in 10-year Treasury yields. Judging by the TIPS market, on-the-run, real risk-free yields along the maturity spectrum stand at about 2.25%, down about 40 bp from their peaks at the end of June. The market is priced for a steady Fed and an easing as soon as early 2007. Given our views on growth and inflation, neither of those seems likely. Stronger growth seems likely to boost both real yields and term premiums (see “Risks to the Bond Call,” Global Economic Forum, August 21, 2006). Likewise, we think the Fed will tighten once more and that it’s highly unlikely that officials will ease any time soon. If anything, they may hold rates steady in a manner reminscent of the “opportunistic disinflation” tactics of the 1990s to bring inflation down gradually over 2007. Thus, we think a 5-5.5% range for 10-year notes is more consistent with our scenario. We’re encouraged by the valuation work of our colleague Joachim Fels, putting the fair value for 10-year US yields in a similar range (see “Re-assessing the Bull Case for Bonds,” Global Economic Forum, September 1, 2006). While the growth trajectory that we envision may feel weak on Main St., it may matter more on Wall St. given the pessimism priced in to fixed-income markets. In contrast, despite slowing earnings, we think equities offer a better combination of risk and reward. As always, we’d be the first to acknowledge significant risks to the outlook. Supply shocks could still reverse the slide in energy quotes, bringing back a whiff of stagflation that would be bad for stocks and bonds. After all, the hurricane season is far from over, and new storms lurk. Pre-election US politics could add to market uncertainty, and Democratic victories could create concerns about eventual policy changes. And margin compression seems likely to reduce earnings growth below that of the economy next year.
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