Morgan Stanley's Roach predicts "growth recession" in 2007

A slowdown in US consumption and Chinese output will lead to a setback. Protectionist measures from the US are seen as the biggest risk to global markets, says Roach.
Known as a long-term bear on the US economy, Morgan StanleyÆs US-based chief economist Stephen Roach didnÆt disappoint yesterday as he laid out a scenario for global growth next year that is well below the consensus and noted that the projected slowdown will be a disappointment for global equity markets and have ômeaningfulö negative implications for commodities.

However, the slides on global imbalances and the implications of the US current account deficit, which have featured so prominently in RoachÆs presentations over the past couple of years, were tucked away towards the bottom of the pack. Instead, his projections of a slowdown were primarily based on a view that the two engines of global growth û the US consumer and the Chinese producer û will both run into strong headwinds in the course of 2007.

The US and China have directly accounted for 43% of global growth in the past five years and if you include indirect effects, the two growth engines have accounted for about two thirds of all the increase in global activity in past five years. Consequently, if they start to slip, so will the world economy.

ôThere is a much greater chance that growth will fall short of consensus expectations by a meaningful margin than exceed it, so donÆt get too comfortable with celebrating the sustainable boom,ö he warned.

Speaking at a Morgan Stanley investment conference in Singapore, Roach also warned that the potential of the US introducing protectionist measures against China is the biggest risk to global financial markets today and one that investors should take very seriously. The fact that the democrats have taken control of both the senate and the house of representatives following last weekÆs mid-term elections will make no difference and the issue remains very much on the table.

ôThe Democrats are very sensitive to the need to embrace and adopt pro-labour policy to relieve the economic hardships that have been bearing down acutely on American workers over the last decade,ö Roach said, noting that since the beginning of 2005 congress have introduced no fewer than 27 bills that would impose some form of trade sanctions on China. The fact that one of them was withdrawn in September sparked some hopes in China that the threat was over, but the remaining 26 bills clearly shows that isnÆt the case, Roach said.

The new chairman of the senate finance committee could play an important role here, given that he is the co-author of a ôvery seriousö bill that will re-write US trade policy, in particular the semi-annual liberations the treasury goes through to decide whether or not a US trading partner is guilty of currency manipulation.

ôThe bill that he has proposed will most certainly put the pressure on for some type of trade sanctions against China,ö Roach added.

With regard to global growth, Roach projects a slowdown to about 4% or below for 2007, which compares with the consensus view that the global economy will continued to chuff along at the 4.9% pace that marks the average for the past four years.

While acknowledging that the world economy has performed better than he anticipated since 2001 û even in the face of unprecedented outbreaks of terrorism, energy shocks and global imbalances û he stressed that past performance is not a guarantee for future returns.

In the US, personal income will come down as the housing recession deepen, Roach argued as noted that so far, only about 12% of the employment that was added in the home building sector over the past five years as the market expanded has been reduced.

ôWe have 88% more to go. When Greenspan tells you that the housing market adjustment is almost over, I think that is a widely optimistic assumption on his part and the bursting of bubble has yet to have a major impact on consumption.ö

The home building impact will knock 1 percentage point off US GDP, related industries like housing, furniture and appliances, real estate brokerage and mortgage financing will knock another half percentage point off and the consumer wealth affect probably another point. That would reduce GDP by a minimum 2 percentage points, which based on the US being a 3.5% growth economy, would leave positive growth of 1.5%.

ôIt is not a recession, but it is a growth recession and it is weak enough for the unemployment rate to rise and it is fragile enough so that if something else bad happens we could tip quite promptly into recession,ö he argued.

China on the other hand, faces the macro economic challenge of realigning the structure of its unbalanced economy to derive a greater portion of its economic growth from personal consumption while scaling back the contributions from exports and fixed asset investments.

The latter two sectors will amount to about 85% of ChinaÆs GDP this year and are still growing at a year-on-year rate of roughly 25%.

ôChina does need to slow down its overheated investments right now. At 50% of GDP this year, the investment sector is at risk of generating excess capacity which is eventually quite deflationary and at 35% and rising, the export sector is at risk of generating trade frictions and protectionist actions from ChinaÆs major trading partners, especially the US,ö Roach argued.

The investment sector will be held back not by any central back policies, not by fiscal policy and not even through currency policy, but instead will be accomplish by continued administrative cooling-off measures targeted primarily at materials, but also towards the auto and residential property sectors. The result, Roach projects, will be a slowdown in industrial output growth to about 11%-13% from a peak of 19.5% in the middle of this year.

ôIf this occurs you better believe there is going to be a reduction in global commodity demand growth with important implications for commodity prices,ö he said, adding that China, which accounted for only 5% of world GDP last year, was responsible for 9% of the crude oil demand. It also swallowed up 22% of the aluminium, 35%-40% of steel, iron and coal and nearly 50% of all the cement in the world last year was poured in China.

Mathematically in event of a slowdown in ChinaÆs industrial output there has to be a reduction in global commodity demand,ö he said, brushing away talk of a commodities ôsuper cycleö.

He is also skeptical toward the views that Asia will be able to decouple from the US and run its own course, noting among other things that there is no other market capable of picking up the slack when US consumption starts to fade. The reason is the sheer size of the US consumer market, which amounted to $9 trillion last year. This is 20% larger than the European market, 5.5 times the size of EuropeÆs largest consumer Germany, 3.5 times the Japanese, nine times the Chinese and 17 times the Indian market.

ôI am a bull of the Indian consumer, but at one seventeenth the size of the American consumer, it is not going to fill the void of a housing bubble-induced slowdown in US consumption. The only consumers able to do fill the void are those least likely to do it û the consumers in Japan and Germany,ö Roach said.

However, there is one thing that could continue to turn all other arguments on the head û liquidity. As Roach noted: ôWe can talk all we want about economic fundamentals, about global imbalances, about energy prices, about US consumers and Chinese producers, but as long a there is liquidity out there, investors could care less."

So far, central banks have limited the incremental liquidity in the banking system but have done little to deal with the extraordinary excesses of liquidity that were injected into the system in 2001-2003 and the low interest rate climate that underpins it.

While short-term real interest rates in the major economies have risen from the rock bottoms hit in 2003-2004, they are still below the average that prevailed from 1991-2000. Until they go above the average, Roach said he believes there will be ample liquidity to support a sustained financial market.

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