The Irony of Complacency

Morgan Stanley Chief Economist Steven Roach offers a sobering look at the potential pitfalls in the economy in 2006:

So far, so good, for an unbalanced world -- the sky has yet to fall. And the longer a lopsided global economy continues to chug along with impunity, the more the broad consensus of opinion becomes convinced that this is a sustainable outcome. This increasingly complacent mindset may be about to meet its toughest challenge: A likely turn in the liquidity cycle appears to be on a collision course with ever-widening global imbalances. This could well be a lethal combination that triggers the long-awaited capitulation of the American consumer -- heretofore the mainstay of a US-centric world.

With the benefit of hindsight, the hows and whys of a benign outcome for the world economy in 2005 are crystal-clear. Basically, it was another year of “follow the leader,” as a US-centric world continued to draw sustenance from the seemingly unflappable American consumer. Sure, there were a number of other factors that came into play elsewhere around the world -- namely, the apparent healing of the Japanese economy, an improvement in Euroland late in the year, and the ongoing boom in China. But suffice it to say, were it not for another year of solid support from US consumer demand -- our latest estimates put real consumption growth at an impressive 3.5% in 2005 -- the rest of a largely externally dependent world would have been in big trouble.

What did it take for the American consumer to deliver yet again? It certainly didn’t come from the traditional income-generating capacity of the US labor market. Private sector compensation outlays expanded only 2.5% in real terms over the 12 months ending November 2005 -- a full percentage point below trend and an especially disappointing outcome following the anemic pace of labor income generation in the first three years of this expansion. In fact, by our reckoning, in November 2005, private compensation remained nearly $390 billion below the composite trajectory of the past four US business cycles. With America’s internal income-generating capacity continuing to lag, US consumers once again tapped the home equity till to draw support from the Asset Economy. According to Federal Reserve estimates, equity extraction by US households topped $600 billion in 2005 -- more than enough to compensate for the shortfall of earned labor income. Comforted by this asset-based injection of purchasing power, consumers had little compunction in stretching traditional income-based constraints to the max. The personal saving rate fell deeper into negative territory that at any point since 1933, and outstanding household sector indebtedness -- as well as debt service burdens -- hit new record highs.

So much for what happened in 2005. The big question for the outlook -- and quite possibly the most important macro issue for world financial markets in 2006 -- is whether the American consumer can keep on delivering. My answer is an unequivocal “no.” Three factors lead to me to this conclusion, the first being the distinct likelihood that a shortfall in internal labor income generation persists. Specifically, I do not expect the US labor market to break the shackles of globalization and unwind the increasingly powerful global labor arbitrage that has played a key role in restraining employment and real wage growth over the past four years. Second, I believe that asset effects will be far less supportive to the American consumer in 2006 than has been the case in recent years. This reflects the likelihood of a distinct slowing in home equity extraction -- driven by the combination of moderating house price inflation and a sharp deceleration in home mortgage refinancing. Third, in an environment of subpar income generation, in conjunction with diminished wealth effects from the Asset Economy, the saving-short, overly indebted American consumer will instantly become more vulnerable to ever-present shocks. Look no further than 4Q05 for validation of the “vulnerability factor” -- a likely “zero” growth rate for real personal consumption expenditures in the immediate aftermath of a Katrina-related supply shock to the energy complex.

Of those three factors, the asset effect is most likely to be the swing factor for the US consumption outlook. This is precisely where the liquidity cycle comes into play. In my view, the froth in asset markets -- first equities in the late 1990s and, more recently, property -- is a direct by-product of a powerful surge in global liquidity. In 2005, our global liquidity proxy -- the ratio of the narrow money supply to nominal GDP for the G-5 (US, Euroland, the UK, Japan, and Canada) plus China -- rose to a level that we estimate to be nearly 60% higher than that prevailing in 1995. That may now be about to change. Courtesy of central bank policy normalization -- led by America’s Federal Reserve -- in conjunction with an important shift in the mix of global saving, there is good reason to look for a much slower flow from the global liquidity spigot in 2006.

A turn in the global liquidity cycle is likely to affect the American consumer through domestic and international channels. The domestic angle comes from a dramatic flattening -- and periodic inversion -- in the slope of the US yield curve. In my view, the slope of the curve matters a great deal in driving the equity-extraction effects of the Asset Economy. From the standpoint of financial intermediaries, a flatter curve alters the economics of the cut-rate lending programs that have been supporting such activities. A sharp recent deceleration of home mortgage refinancing activity -- down 45% from the mid-2005 peak -- is a perfect example of this development.

The international angle arises from a likely reduction in non-US saving, a natural outgrowth of increasingly successful efforts to stimulate domestic demand in the world’s major surplus saving economies -- Japan, Germany, and China. That would tend to absorb saving and, therefore, reduce the flows of private sector excess liquidity that have been recycled into dollar-denominated assets in recent years. That, in turn, would draw into question the overseas subsidy to domestic US interest rates, as well as the equity extraction fueled by such an abnormally low rate structure. Foreign central banks, of course, have the option to fill the void through official purchases of dollar-denominated assets. But, as recent public statements from monetary authorities in China and Korea suggest, the pendulum is swinging more toward increased diversification in the mix of foreign exchange reserve portfolios.

All this points to a shift in the non-US liquidity cycle -- a development that could have important implications for America’s massive current-account financing needs. That would then heighten pressure on the dollar and US real interest rates, thereby putting America’s equity extraction cycle under even greater pressure. That does not bode well for the income-short US consumer. Experience tells us it is usually unwise to bet against the American consumer. While I think there are compelling reasons to go against the grain in 2006, I do so with great trepidation.

Excess domestic liquidity is the high-octane fuel of the Asset Economy and the consumer-led growth dynamic it fosters. Excess global liquidity is also responsible for the funding of America’s massive current-account deficit. Yet as the liquidity cycle now turns, the rules of engagement in the Asset Economy are likely to meet their sternest challenge. That’s a big deal for the income-short US consumer, leaving households with little choice other than to cut back discretionary spending. From the start, that’s been the only real option for meaningful progress on the road to global rebalancing. The irony of complacency is about to strike again. The day of reckoning for an unbalanced world could be close at hand.