Bear Trap?
Stephen Roach (New York)
The US stock market is flashing yet another in a long string of recovery calls. The S&P 500 is now up 20% from its October 9 lows, little different from its two preceding rebounds — 21% recoveries off both the September 21, 2001 low as well as off the July 24, 2002 low. In each of those two earlier instances, there was hope that meaningful cyclical revival was at hand. Yet those hopes were ultimately dashed by double-dip scares. Is the current rally in the stock market any different from the two that preceded it? Or is it just another bear trap — a rally that fails in the face of the unrelenting dip-prone tendencies of America’s post-bubble business cycle?
My fear is the latter — yet another rally that falls victim to lingering weakness in the US economy. While I’m straying a bit off my perch as an economist, that’s not my intent — even though our warm and cuddly strategists have been making economics calls for as long as I have been at Morgan Stanley. Instead, my purpose is to suggest that just as the past two rallies missed the looming double-dip scare, the current one could be guilty of the same oversight. As I see it, the US economy remains stuck in a subpar growth channel, at best — with real GDP growth averaging around 2%. There will be quarters when the economy exceeds this bogey — the first and third quarters of this year, for example, with growth rates of 5.0% and 3.1%, respectively. But there will also be quarters when the economy falls short of this threshold — the second and fourth periods of this year, with growth rates of 1.3% and an estimated 0.7%, respectively. In the former instances, a seemingly vigorous economy will appear to be on the road to self-sustaining recovery. In the latter cases, the economy will seem to be hovering at its "stall speed" — easily toppled into renewed recession by just the slightest shock.
This seemingly schizophrenic character of economic recovery is the essence of the post-bubble business cycle. Restrained by the headwinds of excess debt, subpar saving, excess capacity, a massive current-account deficit, and the lack of pent-up demand, there is a compelling case for a persistently subpar recovery, in my view. And that’s basically been the case over the four quarters of this year. According to our latest estimates, real GDP growth will average just 2.5% over the four quarters of 2002, literally half the cyclical norm. Moreover, after stripping out an 0.9 percentage point lift from the inventory cycle, our estimates suggest real final demand growth has averaged only 1.6% over the same period — one of the weakest demand recoveries on record. This weakness hasn’t appeared out of thin air. It’s precisely what the model of the post-bubble business cycle would predict. Moreover, to the extent that the bulk of the inventory lift is in the past, there’s good reason to believe that prospective GDP growth will settle out somewhere in-between this year’s pace of output growth (2.5%) and final demand growth (1.6%). Hence, my belief that 2% is a reasonably good approximation of the underlying subpar growth that can be expected, for as long as the above-noted headwinds continue to howl. In my mind, that’s probably for another couple of years.
Therein lies the problem for the US economy and the latest rally of an ever-hopeful stock market. Sure, the high-frequency data are pointing to yet another fillip in the real economy. Ted Wieseman documents these trends in detail elsewhere in today’s Forum. But this is precisely the pattern that was evident after the shock of 9/11 as well early this past summer. And yet in both instances, those seemingly classic cyclical rebounds quickly morphed into full-blown double-dip alerts. As long as America’s post-bubble headwinds continue to blow, I continue to believe that it will be exceedingly difficult for the US economy to mount a self-sustaining, vigorous cyclical recovery. The saw-tooth pattern over the four quarters of 2002 is likely to be the rule, not the exception, in this post-bubble era. Dick Berner has argued persuasively that since policy stimulus has now shifted into high gear, a growth payback can be expected in 2003. I certainly agree with his assessment of policy, but I continue to have grave doubts about the ability of these policies to achieve traction in the real economy. As I have stressed for some time, the three sectors where policy normally bites — consumer durables, homebuilding, and business capital spending — all seem to be in a zone of excess that is unresponsive to variations in interest rates or taxes (see my October 25 dispatch, "The Limits of Policy"). The model of the post-bubble business cycle allows for precisely this type of muted response to policy actions, as the authorities get increasingly frustrated by "pushing on a string."
Meanwhile, I think the Fed finally gets it. The "it" in this case is deflation. A remarkable speech by Fed Governor Ben Bernanke says it all (see his November 21 address "Deflation: Making Sure ‘It’ Doesn’t Happen Here" posted on the Fed’s Web site). This speech, on the heels of the larger-than-expected 50 bp monetary easing of November 6, leaves little doubt in my mind that the Fed has gone into a full-blown anti-deflation drill. Sure, Mr. Bernanke couches his remarks with the predictable caveat that he feels the chances of deflation are "extremely small." Alan Greenspan has said precisely the same thing in recent days. But Fedspeak is always laced with a profusion of caveats that would make Wall Street disclaimers look brief by comparison. The bottom line is that the Fed has mounted a full-scale assault against deflation — precisely what their own playbook suggests. Indeed, as the Fed research staff recently suggested in its thinly-veiled references to the "Japanese experience," as the odds of deflation rise beyond a trivial threshold, I believe the central bank needs to treat this possibility as its central case (see Ahearne, et. al., "Preventing Deflation: Lessons from Japan’s Experiences in the 1990s," International Finance Discussion Paper No. 729, June 2002). Fed actions and rhetoric leave little doubt in my mind that this threshold has now been breached.
Which takes us full circle to the perils of subpar growth in this post-bubble business cycle and their related implications for the stock market. If I’m right on the 2% underlying growth call on the US economy going forward, this anemic pace is well below America’s 3–3.5% potential growth rate. Consequently, it would result in an ever-widening "output gap" — with utilization rates continuing to decline in both labor and product market markets. In English, that spells rising unemployment and further downward pressure on an inflation rate that is already closer to outright deflation than at any point in half a century. In my view, the Fed can’t even afford to flirt with such risks. By launching a full-scale frontal assault on deflation, it has finally put its cards on the table: By catching the "shorts" by surprise, the Fed is attempting to lift the real economy by playing the time-worn equity wealth effect. Sadly, we’ve been to this well all too often in the past seven years. Why should this rally be any different from those that have ultimately failed in the past?