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  1. Global: Twilight Zone

    Stephen Roach (New York), Morgan Stanley's outspoken analyst --


    As the world moves on a slow-motion collision course with war, the wheels of commerce are grinding to a standstill. Financial markets sense the angst and are hunkering down for the duration. Of course, we’re all trained to look beyond the shock -- to focus more on upside of the postwar climate than on the downside of a prewar paralysis. Yet it seems tougher than ever to make that leap of faith. That’s because this war could either end the uncertainty or compound it. It’s as if we’re caught in the twilight zone between two worlds -- hopeful of a return to a familiar equilibrium but fearful of the pitfalls of a new disequilibrium. That lingering uncertainty is not exactly a comforting outcome for financial markets.

    There’s nothing like a quick spin around the world to provide a different perspective to an increasingly tough global climate. Having just returned from a 10-day jaunt to Asia and Europe, I found the world in a very difficult place. The theme I picked up at the recent World Economic Forum in Davos continues to ring true: A US-centric global economy is now almost desperate for another fix from the American growth machine. At the same time, however, the world is increasingly uneasy with US geopolitical hegemony, especially with war looming on the not-so-distant horizon. This asymmetry of global power remains one of the great paradoxes of our times (see my 27 January 2003 essay in Investment Perspectives, “The Asymmetries of Globalization”). Nor do I see it being resolved at any point in the foreseeable future.

    On the economic front, the world now appears to be in the early stages of a fairly predictable shock-induced downturn. America’s labor market data leave little doubt as to the direction of the next move in the economy -- down, not up. The only questions, in my view, pertain to severity and duration. February’s outsize job losses totaling 308,000 workers cannot be dismissed as weather-related statistical noise. As indicated by sharply rising jobless claims data over the past three weeks, conditions in the US labor market are deteriorating markedly. An oil shock always hits corporate hiring; the accompanying confidence shock only compounds the problem. As jobs and income generation come under intensified pressure, further consolidation of the over-extended American consumer seems likely. And without the consumer, the US economy will fold. I reiterate my view that odds of a recessionary relapse in the United States are high and rising.

    Meanwhile, the rest of the world feels the pain even more acutely. Lacking in domestic demand, a loss of support from America eliminates the key driver to the externally-driven global growth dynamic. Barring the immediate emergence of a new source of global growth, the broader global economy could find itself in real trouble quite quickly. Asia, in particular, is starting to feel the impacts of a peaking in the global trade cycle. Korea’s KOSPI index -- an excellent lead indicator for the global economy in recent years -- is falling sharply and now is down some 25% since early December 2002 (with more that 70% of that drop having occurred since the start of 2003). In my meetings in Japan and Singapore, there was a growing sense of foreboding. The mood was even more downbeat in Europe. There’s a growing sense of fear that Germany -- fully one-third of Euroland GDP -- has already entered a recession that could infect the remainder of continental European economies. The Asia and Europe that I saw in the past two weeks wasn’t just fearful over the war. If anything, they were more concerned over current and prospective trends in the only true engine of global growth -- the United States. Unfortunately, that’s precisely what you would expect in a lopsided, US-centric world.

    To be sure, there’s always a case to be made for the upcoming rebound. In fact, the worse it gets on a near term basis, the more compelling the case that the business cycle coil will tighten like a spring. All it would then take to trigger an upturn would be some form of resolution to the shock. Lower oil prices would follow, the functional equivalent of a tax cut for the oil consuming industrial world. Policy stimulus and another inventory cycle would then reinforce the upside. The global business cycle would then embark on the time-honored transition from recession to recovery. And the worst would then be over for bruised and battered financial markets.

    There’s one critical catch to this postwar global healing scenario -- the concept of resolution. No one has a clue as to how this will all play out. Few doubt America’s military supremacy. But to the extent that an urban battle is in the cards, collateral damage to the Iraqi civilian population seems more likely than not. Yet America’s superior technology works better in the open spaces of a traditional battlefield (land and air) than it does in the close confines of city streets. Remember the accidental bombing of the Chinese embassy in Belgrade in 1999? In my view, the possible loss of civilian lives would only serve to inflame already hostile anti-war, anti-American sentiment around the world. Concomitant risks of an Islamic backlash, to say nothing of further terrorist strikes, can hardly be ruled out under such circumstances. That hardly speaks of resolution.

    But the biggest risk to the coming war could well be its aftermath -- the stability (or lack thereof) of a postwar Iraq. Little is known about plans for a post-Saddam regime. Given the largely unilateral military campaign that looms ahead, the odds favor a predominantly US-administered effort. The precedent of the post-World War II occupation of Germany is often mentioned as a model of success. But the record of history is quite clear on how the United States consistently under-estimated the burden of a German occupation. When queried in 1943 as to how long American soldiers would remain Germany after the war, President Roosevelt stated, “For at least one year. Maybe two” (see The Conquerors: Roosevelt, Truman and the Destruction of Hitler’s Germany: 1941-45 by Michael Beschloss, Simon and Schuster 2002). Despite the desire to bring American troops home quickly after a likely victory in Iraq, the risk of a prolonged presence in the defeated nation seems quite likely. Lasting American military presence in the Middle East could well be a lightening rod for further backlash and terrorist activity -- hardly the stuff of resolution either.

    Without a decisive postwar resolution, recovery dynamics in the global economy are likely to be impaired. The downside to oil prices could be limited. The uncertainly factor could persist -- leaving businesses reluctant to hire and consumers unwilling to spend. While the case for war is being framed publicly on grounds of national security, I have little doubt that these economic concerns also creep into political discussions in Washington. Yes, there are also logistical considerations (i.e. Middle East weather and troop morale) that appear to be affecting the rush to battle. But there are also more mundane economic considerations: The longer the delay, the greater the chance of recession -- and an economy that backfires for yet another Bush Administration. On that latter count, I can’t help but think that the President’s economic plan is in serious trouble. If national unemployment now starts to rise as the economy falters, the idea of offering tax relief to wealthier Americans (i.e., cutting dividend taxes) simply won’t fly in the Congress. It will then be back to the drawing boards on fiscal policy -- a bitter pill for the White House to swallow.

    It is far too presumptuous for any of us to claim to have the answers in this twilight zone before war. But the economist can and should weigh in on matters of the business cycle and on the policies that can impact the cyclical outcome. In my mind, business cycle risks are now almost unidirectional -- to the downside. That’s true of the US and also for a US-centric global economy. A shock has come at a point of maximum vulnerability in the cyclical climate -- a combination that has almost always produced recession (see my 5 March essay in Investment Perspectives, “When Shocks Matter”). This same framework has been equally successful in guiding the prognosis for the inevitable post-shock recovery. By definition, all shocks fade -- they either acclimate us to new conditions or there is a fundamental reversal of the circumstances that led to the shock.

    I do not believe that this shock will be the exception to that rule. But I do sense that the now imminent war in Iraq is not your average shock. Postwar norms could be very different than prewar norms. The rules of globalization may well get re-written before our very eyes. If that’s the case, uncertainty could linger -- an outcome that would continue to hobble economic growth. We may understand the business cycle. We may even understand the structural forces that shape the context in which the business cycle fluctuates. But we probably don’t have a clue as to how the biggest risks are likely to play out in this climate of rising geopolitical angst. And we may not know the answer for a long time.

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