The Davos Disconnect
January 30, 2007
By Stephen S. Roach | from Dubai
Note: This essay was published in the upcoming February 5, 2007 issue of Newsweek International.
This year's World Economic Forum was the most optimistic in years. Four years of booming global growth and surging financial markets put the attendees in a giddy mood. The Davos consensus was convinced that more of the same lies ahead in 2007. The optimism is understandable. After years of agonizing over the implications of terrorism, geopolitical instability, higher oil prices, and ever-mounting global imbalances, the world economy never even flinched. This resilience stands in sharp contrast with the vulnerability that many, including yours truly, have long feared. The Davos consensus was heartened by the equally euphoric state of financial markets. Particularly encouraging was the froth in what traditionally have been some of the riskiest of assets — emerging market debt and high-yield corporate credit. Sharply reduced volatility in major equity, bond and currency markets was the icing on the cake. Just as the markets were betting on a riskless world, those gathered at this year's World Economic Forum were prepared to do the same. Yet beneath the surface, there was an undercurrent of concern. Even the optimists admitted that many problems were festering — especially rising income inequalities, unfunded retirement obligations of aging developed nations, America's chronic saving shortfall, and increasingly contentious trade frictions. Therein lies the contradiction of Davos: In the end, a baseline forecast of a riskless world dismisses any complications that might arise from social, political and economic tensions. I suspect the resolution of this contradiction is likely to take the form of an important power shift in the global economy — a realignment that could add a good deal more risk into the equation than is the case at present. The reason: The pendulum of economic power is at unsustainable extremes in the developed world. For a broad collection of major industrial economies — the United States, the euro zone, Japan, Canada and the U.K. — the share of economic rewards going to labor stands at a historical low of less than 54% of national income — down from 56% in 2001. Meanwhile, the share going to corporate profits stands at a record high of nearly 16% — a striking increase from the 10% reading five years ago. This divergence is not sustainable. The angst of workers in the developed world has become a major source of tension. Yet with labor unions on the decline and with workers from China, India and the former Soviet Union representing a doubling of the global labor supply in the last 15 years, workers in the developed world don't have much of a leg to stand on. They have chosen, instead, to express their displeasure in the polling booth, with the result that the pendulum of political power is now swinging to the left in countries such as the United States, France, Germany, Spain, Italy, Japan, Australia and yes, even Switzerland. A shift in political orientation is likely to prompt an equally important pro-labor swing in the pendulum of economic power. With the Democrats now in control of both houses of the U.S. Congress, America is leading the way. Among the topics now on the table are increased minimum wages, higher taxes on the energy industry, and new scrutiny of executive compensation and excessive returns going to hedge funds and private equity firms. These are all early warning signs of a looming shift in America's reward structure, away from the excesses going to capital and back toward labor. The biggest risk is the rising threat of protectionism. Politicians throughout the developed world view trade liberalization increasingly as a serious threat to job and income security. That's especially the case in Washington, where Congress has connected America's record trade deficit with pressures on real wages and employment growth. With fully 29% of the U.S. trade deficit currently made in China, China bashing is going from bad to worse. This is a tough blow to the spirit of Davos. Nowhere has the "win-win" mantra of globalization garnered greater adulation than at the World Economic Forum. Yet the angst of labor in the developed world now draws this vision into serious question. Yes, workers in poor developing countries are winning big time, but in the more prosperous developed world, the win has gone more to the owners of capital rather than to the providers of labor. How this plays out worldwide is anyone's guess. But the point is that the risks of the great global power shift are rising at precisely the time when the Davos consensus and world financial markets are paying precious little attention to risk. Something has to give. My guess is it's the markets. The Davos disconnect has an ironic footnote. The pre-selected theme of this year's gathering was "The Shifting Power Equation." It's as if the Davos elite senses what's coming, but doesn't want to admit it. You might call that denial.
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Bloated Optimism
January 30, 2007
By Luis Arcentales | New York
Low inflation worldwide and expanding trade continue to underpin a world awash in liquidity, but are investors complacent about the risks? Rock-bottom country risk premiums and strong capital flows into emerging markets suggest a broad consensus of investor optimism on the near-term outlook for the global economy. Risks to this rosy view have been assigned very low probabilities; indeed, for the most part these risks have been relegated to the tails of the distribution of likely outcomes. Such broad optimism for the year ahead summarizes the general sentiment from Morgan Stanley’s macro team and our clients during our annual MacroVision seminar held in New York in mid-January. In Latin America, we have repeatedly argued that the recent abundance has placed policymakers at risk of complacency – they may be squandering the opportunity to introduce necessary reforms. Among the necessary changes are moves to make public spending more efficient, increase competition, raise productivity and put the region on a higher sustainable growth path (see “Latin America: Stability Brings Complacency” in Global Economic Forum, January 9, 2007). But policymakers are not the only ones who are at risk of complacency: we suspect investors are as well. Latin Americahas been one of the biggest beneficiaries of the recent flood of liquidity. We suspect that one of the drivers of the current abundance of liquidity is the confluence of increasing openness and lower inflation. World trade has expanded dramatically, growing, as a share of world GDP, from just under 22% in 1994 to nearly 30% in 2005, inducing tougher competition and higher productivity in world markets. At the same time world inflation has fallen, as has inflation in Latin America. And Latin America has enjoyed a large and positive terms-of-trade shock. In fact, the region is enjoying one of the best periods in its recent economic history. Investors seem to agree and have voted with their wallets: since mid-2004, the MSCI Latin America stock index has tripled in US dollar terms and sovereign spreads are at historically tight levels. Yet there are two interrelated issues that give us pause for thought when thinking about the region, namely liquidity and political risk. Indeed, while we share the optimism on the global economy in 2007, we think that investors are running the risk of complacency, given the speed and force with which political risks could arise should the liquidity cycle start to turn. First, while everyone agrees that the world is awash in liquidity, it is also clear that there is no consensus on what liquidity really is or how to measure it. What came out of our MacroVision workshops was that there are no good metrics to gauge liquidity, thus making a turn in the current liquidity cycle difficult to predict. Second, despite the confluence of positive external conditions, the region’s economies are riddled with political risk as governments continue to show interventionist tendencies in dealing with economic problems. While the problems differ from country to country, we are afraid that the consensus might be overestimating the power of market forces to trump political risk in the region. Argentina, for example, sports one of the highest rates of economic growth in the world and a government that is highly interventionist. The current government inherited an economy plagued by multiple distortions. One particularly acute problem is the energy sector, where household tariffs have been frozen at pre-devaluation levels. As a result, there has been little private investment in the sector. With GDP growth above 8%, the existing infrastructure for electricity generation risks getting overextended and potentially derailing the ongoing strong growth performance. Indeed, in December, Buenos Aires suffered several days of intermittent black-outs as hot weather led to elevated electricity demand to power air conditioners. The source of the problem turned out to be the distribution system of power lines that were not maintained since investment in the sector remains unprofitable. Rather than clearing the distortions to help solve the problems in the energy sector, the government has maintained the price controls. In fact, the government has added new price controls to fight inflationary pressures that arose late in 2005. In addition to price controls, recent government interventionism is seen in frequent changes to export tax rates, in part to address inflationary pressures stemming from a weak currency and rising commodity prices. Our central case for Argentina for the next two years is one of continued good growth without any major dislocations emerging from the many distortions plaguing the economy. And for investors willing to look past Argentina’s unsustainable policy mix, the returns have been impressive — whether we look at debt instruments, stocks or real estate. Investor bullishness seems predicated on the premise that authorities will, at some point, manage to resolve some of the emerging distortions seen in the economy today. However, if the MacroVision consensus on a benign global backdrop proves wrong, we are afraid that Argentine authorities might not be able to engineer a soft landing and give themselves the time needed to adjust prices and incentives. We suspect that currently such a scenario is absent from the outlook of too many Argentina watchers. And in Brazil, the darling of financial markets, the political risks in the event of a downturn are not negligible. The recent announcement of a growth acceleration package — a compilation of measures aimed to boost economic growth — has come on the heels of the government back-tracking on its commitment to invest in infrastructure through partnerships with private sector investors. The government had originally intended to implement a scheme under which private companies could build and operate roads in exchange for a guaranteed stream of revenue. A number of companies participated in an auction for the right to participate in the scheme but, at the last minute, the government pulled the plug and decided to strike out on its own. This is just one example of the regulatory uncertainty that is lurking just below the surface and that makes Brazil one of the least hospitable business environments in the region (see Macro and Micro Radars: 2H 2006, August 18, 2006). Moreover, we suspect that the growth acceleration program is no more than a symptom of reform fatigue on the part of the current administration, which, over the medium term, does little to improve Brazil’s mediocre economic growth record. As we had warned in the past, for Brazil staying the course is not good enough (see, for example, “Brazil: Abundance of Fiscal Challenges” in Global Economic Forum, March 27, 2006). The bullish consensus from our annual MacroVision workshop is likely music to the ears of Peru watchers. After all, few countries in Latin America would benefit so greatly from another year of ample global liquidity, a continuation of the commodity super-cycle and the seemingly unstoppable forces of globalization. Just by one metric, namely exposure to commodities, such optimism is easy to understand: last year commodity exports, which contributed nearly 85% of total export growth in Peru, represented nearly 20% of Peruvian GDP. The commodity bonanza, in turn, allowed Peru to post dual fiscal and current account surpluses while delivering a mix of persistently robust growth and muted inflation (see “Peru: Building Resilience” in Global Economic Forum, October 17, 2006). In a financial world where complacency appears to reign supreme, the market jitters sparked by the heated 2006 presidential election seem all but a distant memory. At the time, markets feared that the country could take a sharp policy turn to the left — following the patterns seen previously in Venezuela and Bolivia; however, the election ended up in the hands of the candidate favoured in the second round by markets. In November, the results of the local and regional elections — won mostly by independents — seemed to further strengthen the hand of the new administration by sharply reducing the risk of any meaningful, united opposition from the far left. Against this backdrop, it is not surprising that any risks that could derail Peru’s bullish story have all but evaporated from investors’ radar screens. Despite the supportive election outcomes, the political landscape is not without risks. Indeed, even as the fundamental improvement in the Peruvian economy is worthy of praise, we believe that the social and political stability needed for sustainable long-term growth will remain elusive as long as the benefits of Peru’s impressive growth fail to lift the living standards of nearly half the population still in poverty. Indeed, we suspect that the rapid emergence of radical voices in last year’s presidential race was a manifestation of this widespread poverty finding an outlet rather than a strong ideological support for the far left from those Peruvians who have not shared in the ongoing boom. While so far several actions by the new administration have reflected an understanding of the urgent need to ease Peru’s vast income disparities, the risk of social unrest — with important implications for governability — remains very much alive. Bottom line
Over the past few years, investors have become increasingly at risk of complacency as Latin America has enjoyed one of the best periods in its recent economic history due to a confluence of a large, positive terms-of-trade shock, low inflation and abundant liquidity. Prudent monetary and fiscal policies have helped put the current abundance to work in patching the many problems the region has accumulated over many years — such as fiscal imbalances or large stocks of external debt — and setting the foundations for long-term economic stability. However, better growth in the region is likely to require more than macro stability. And while we share the market’s optimism on the global economy in 2007, we think that investors are running the risk of complacency, given the strength with which political risks could surface should a sharp turn in the liquidity cycle occur.
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Stress testing the Economy (For a Good Reason)
January 30, 2007
By Vladimir Pillonca | London
Italy’s economy will be subject to a significant stress-test this year, as fiscal policy turns restrictive, short-term interest rates rise, and the effects of euro appreciation propagate across the economy. Will economic growth stall again in 2007, as it did in 2002-2005? And was this degree of fiscal tightening really necessary? For starters, this year the global external environment will be less supportive for Italian exporters. We forecast global GDP growth to slow to 4.3% this year, from 5.0% in 2006, which amounts to a noticeable deceleration. In the euro area, we forecast GDP growth to slow to 1.9% YoY this year from 2.7% YoY in 2006, which we judge to be around trend growth. Beyond slower global growth, the expected slowdown across the euro area reflects the lagged impact of higher interest rates, a strong euro and fiscal tightening in Germany and Italy. In Germany, one of Italy’s key export markets, we forecast GDP growth to slow from 2.7% YoY this year to 1.7% YoY in 2007, as the VAT hike comes into effect at the turn of the year (see Euroland Economics: Peeping Through 2007 Uncertainties into 2008, December 1, 2006). The fiscal shock will stress-test consumers We think the main downside risk to Italy’s economic performance this year stems from domestic fiscal policy, which will be restrictive by about €15 billion (about 1% of GDP). This amounts to a stress test of significant proportions, at a time when three other adverse factors are at play: 1) higher interest rates, 2) euro appreciation, and 3) slower growth in the euro area and globally (see Eric Chaney’s Enduring a Triple Whammy, July 26, 2006). Increased fiscal pressure, however, will not necessarily result in a recession, though Italy’s GDP growth is likely to slow noticeably in the first half of this year. The ultimate size of the impact of the fiscal shock on the economy will depend on how consumers and firms react. Consumers will have to decide how much to consume and how much to save, which will depend on how they expect the path of their incomes and interest rates to evolve. All these factors will determine how much the economy will grow. The evolution of expectations, in these uncertain times, will be crucial. This year’s fiscal tightening will be a tough test for the Italian economy, alongside Germany’s VAT hike, higher interest rates, a strong euro and slower external growth. Rational expectations could save the day As we have highlighted before, we expect consumers to be rational, to behave in a forward-looking way, and to look through the current phase of higher fiscal pressure as a temporary phenomenon, in anticipation of higher economic growth in 2008 and beyond. If consumers believe this phase of fiscal consolidation is temporary, they are likely to lower their savings ratio and stick to their usual consumption patterns, even as fiscal pressure rises and their incomes are squeezed. Besides, the expectation of higher future economic growth could strengthen if the structural reform effort gathers pace. Recent polls suggest a high degree of support for the liberalization programmed. Conversely, a loss of reform momentum could trigger a significant loss of confidence in the future path of the economy, leading to a rise in precautionary savings and a lower consumption growth. In synthesis, the longer-term expectation of the future stream of income will have a first order impact on consumption patterns (formalising this intuition helped Modigliani to get a Nobel Prize). In fact, most consumers do not typically allow their consumption to fluctuate as much as their (current) income, and instead smooth their consumption expenditure over their life cycle, and when their income falls temporarily. This forward-looking behaviour, and households’ willingness to smooth consumption over time, suggests to us that consumer spending could hold up relatively well this year, while the savings ratio falls slightly, after having risen in 2006. This relatively optimistic assessment also reflects the fact that this year the payroll tax wedge will be cut by five percentage points, insulating consumers’ take-home pay from income tax increases, which will mostly affect higher-earning individuals and holders of financial assets. We forecast consumption to hold up this year also because we expect the process of credit deepening to continue (Italy’s mortgage debt/GDP ratio has increased from 10% in 2000 to 17.2% by the end of 2005). However, the size of the fiscal shock and the joint impact of the three adverse factors cited above suggest downside risks to our central forecasts for consumption to grow by 1.3% YoY this year, as well as our central GDP growth projection of 1.1%. Fiscal surprises ahead Tax receipts exceeded expectations throughout last year, but the budget deficit could well breach the 5% mark in 2006 (as a share GDP) — the worst outturn recorded since 1996, and a further increase from the 4.1% recorded in 2005. This deterioration is largely the result of two large lump payments (the €13.4 billion ruling on VAT deductibility on corporate car fleets by the European Court of Justice and up to €30.0 billion related to the financing of the high-speed rail network), and admittedly, excluding one-offs, the budget deficit would have been closer to the 3% mark. But this ‘underlying’ hypothetical outcome would have been achieved largely thanks to the unsustainably strong economic growth recorded in 2006, rather than more lasting fundamental changes on the government expenditure side of the equation. Conclusions Despite risk of a recession, fiscal consolidation was necessary given the critical state of Italy’s public finances. While we think the amount of fiscal tightening should be enough to push the budget deficit down to 3.0% of GDP next year, it will not be enough to position Italy’s massive stock of debt on a lasting downward path. Instead, in the absence of policy change, only budget deficit numbers will improve, while the overall stock of debt will remain worryingly high. For this reason, fiscal policy is likely to remain tight beyond 2007. But all this is for a good cause. If the broader reform effort continues and effective measures to contain public expenditures are introduced, we can expect the Italian economy’s performance to improve in a lasting way over the coming years.
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The Petrodollar Connection
January 30, 2007
By Serhan Cevik | London
Low long-term interest rates are an indication of abundant global liquidity. Liquidity can be quantified in numerous ways, using either monetary aggregates or price metrics like real interest rates and credit spreads. Although financial innovation and globalization have made price metrics more effective, compared to money-based measures, in assessing ‘excess’ liquidity, the instrument of choice does not really change the verdict in today’s conditions. From whatever angle you look at the issue, global liquidity remains abundant, albeit expanding at a slower pace. Indeed, despite higher short-term interest rates in the US and Europe, real interest rates and credit spreads are still below their long-term averages, reflecting the abundance of global liquidity. Of course, this has dampened volatility and raised the level of risk tolerance in financial markets. But what is the source of liquidity? Even though accommodative monetary conditions in the post-2001 period increased global money supply, the extent and strength of the current liquidity cycle now depend on its interaction with the global commodity cycle and financial innovation, in our view. The recycling of petrodollars contributes to the global liquidity cycle. The commodity boom has enriched oil-producing countries in the Middle East and North Africa, with export revenues surging from US$251 billion in 2002 to about US$860 billion last year. As a result, the cumulative current account surplus of resource-rich economies in the region increased from 5.4% of GDP in 2002 to 25.5% last year. Given the limited degree of domestic absorption — especially after the collapse of local stock markets — the recycling of petrodollars has fuelled global liquidity at an accelerating speed. Oil-exporting countries increased their net foreign assets by 1.5% of global GDP a year in the first half of the decade and then 2.5% in 2005 and approximately 3.8% last year (see The Great Arabian Bubble, December 4, 2006). In our view, such an unprecedented accumulation of foreign assets has provided a massive liquidity injection into the global capital markets and contributed to the ‘conundrum’ of low long-term interest rates — even more than China’s reserve build-up. Furthermore, oil exporters have channelled — directly or indirectly — an increasing amount of their windfall revenues into alternative investment vehicles and new markets. Take, for example, the rise of hedge funds and the explosive growth in structured financial instruments. The outstanding notional amount of exchange-traded and over-the-counter derivatives contracts snowballed from US$77.3 trillion (or 245% of global GDP) in 2000 to more than US$400 trillion (or 840%) last year (see Brave New World, November 21, 2006). Likewise, in search of higher yields, private capital flows to emerging economies soared from US$50 billion a year in the 1980s to US$675 billion last year. It may be ‘so far so good’, but the wave of liquidity that has boosted global GDP growth beyond its trend rate and depressed term premiums could easily become a source of financial volatility, as we have witnessed several times in recent years. Commodity producers will have less money to recycle into the global capital markets. Morgan Stanley’s economics team expects a marginal slowdown in global growth this year and no major financial accident in the foreseeable future. Nevertheless, there are clear signs of excesses, especially in the commodity markets, and the marked increase in correlation between commodity prices and liquidity metrics suggests a looming vulnerability that may spill over into other markets. This is why we think that the simultaneous correction in commodity prices and the growth rate of global liquidity is not a coincidence. Oil-exporting countries may have already started cutting down the accumulation of foreign assets. In turn, coupled with the cumulative effective of monetary tightening in the developed world, the reduction in recycled petrodollars lowers global liquidity at the margin and thereby puts upward pressure on term premiums. Unfortunately, although better economic management and flexible currency regimes have moderated financial volatility and made the global economy less vulnerable, developing countries remain exposed to the unwinding of liquidity-driven leveraged positions and the risk of a chain reaction in financial markets.
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