Traders Cooperative

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*** Stephen Roach 1-23-06 ***


Global: Between the Lines

Stephen Roach (New York)
January 23, 2006

I can think of no better way to kick off the year than by indulging in the total immersion of MacroVision. This two-day event -- internal workshops on the first day followed by interactive sessions with clients on the second day -- is designed to challenge every strand of our macro DNA. It is, first and foremost, a time-out from the blur of market and business demands. It provides us with an extended period for real-time debate with our colleagues and clients from around the world. It is a deep drill into the big issues that we believe will shape the global economy and world financial markets in the year ahead.

Over the years -- 15 of them when the event was limited to our worldwide team of market strategists and economists, and now five years that included some of our smartest clients -- we have spent a lot of time refining the drill. The good news is the process works. MacroVision has had a great track record of success in coming up with many a big call. There was “global healing” in 1998-99 and the great “deflation scare” in 2003. Last year, the conclusions were especially prescient -- well-contained inflation, no bond bubble, and the outperformance of European equities. Alas, there were also some important misses in 2005 -- especially, the dollar and oil prices. But the overall score for the calls coming out of last year’s MacroVision was about as high as it gets. That gave the assembled crowd pause for thought in peering into 2006. It’s always tough for groupthink to put together two good years in a row.

I won’t bore you with the details, but we follow a carefully structured process in driving the debate toward actionable investment conclusions. Our internal deliberations start out with a broad list of discussion topics; this year’s agenda included the liquidity cycle, volatility, post-bubble adjustments, inflation targeting, the commodity super-cycle, and the global saving glut. We then spend a good deal of time narrowing and reshaping the results into three thematically-driven issues that we believe will be key in shaping the financial market debate in the year ahead. That sets the agenda for the client day, which this year focused on the following themes:

* Reforms, restructuring, and returns

* Consumer rebalancing

* Global capex boom?

We rely on a form of triangulation in order to boil down the results of MacroVision to their essence. Different groups debate each of the topics from very different perspectives -- first internally and then with clients. The magic of MacroVision occurs in what we call our synthesis sessions, where we bring the entire group together and compare and contrast the findings of the various workshops. This unmasks the tensions in our collective analytics -- the rough edges that often lead to the most powerful conclusions of the exercise. As a global macro junkie, the synthesis exercise has always appealed to me the most.

As I pondered my notes from this year’s MacroVision, I was particularly struck by the interplay between the consumer and the capex sessions. In general, the group was quite upbeat on the US and global consumption outlook. There was little sympathy for my long-standing complaint about the excesses of the asset-dependent American consumer. Few seemed concerned that an income-short consumption dynamic might falter as the housing bubble now started to deflate. Actually, few seem concerned about the US housing bubble, period. As one participant put it, “American consumers will continue to buy -- it’s our way of life.” As long as employment held up, went the argument, so would household spending. The group was nearly unanimous in believing that there was only modest downside to US consumption, at worst. Furthermore, they argued, any such slippage would likely be offset by improved consumption in Japan, Europe, and China. The global consumer was given a clean bill of health for 2006 by the MacroVision consensus. I was truly the skeptic -- on the outside, looking in.

The second thematic conclusion of MacroVision 2006 was equally compelling -- that any global capex recovery was likely to be limited. This was one of our most popular topics this year, and nearly all of our some 65 participants were at one of the two capex sessions. The group felt strongly that businesses in most major economies would remain reluctant to increase productive capacity -- with, of course, the important exception of China. Instead, incremental growth in capital spending was generally expected to be earmarked toward replacement outlays, especially for short-lived IT equipment. Two possible exceptions were noted -- infrastructure -- especially water, roads, and transportation -- and energy exploration and refining. Private equity participants reinforced this view; one noted. “Not one of our portfolio companies is thinking of adding significant capacity.”

Putting these two conclusions together -- solid consumption and modest gains in capital spending -- unmasks what I believe could well be one of the more important inconsistencies of this year’s MacroVision. I have always viewed capex as a “derived demand,” highly sensitive to business expectations of future demand growth. By contrast, I put far less emphasis on those models that treat capex as an autonomous demand -- driven more by business-sector-specific trends in cash flow and profitability. If I’m right -- and if the MacroVision consensus is correct on the consumption outlook -- then the derived-demand approach would argue for a far more vigorous capital spending outcome than the consensus is currently looking for.

A sharp pickup in business fixed investment could have very important implications for the global macro call. For starters, it would mean a much stronger outcome for world GDP growth than most are expecting, with the world economy drawing added support from the twin engines of both consumption and capex. Insofar as financial markets are concerned, an upside global growth surprise could be far more important than a sector-specific conclusion on consumption or capex. Such an outcome could well lead to a sharper cyclical rise in inflation than the consensus is looking for. And that, of course, could turn the financial market climate from benign to malign -- complete with a rout in the bond market, a deterioration in spread markets (credit and emerging-market debt), and more aggressive tightening by the world’s major central banks. As one MacroVision veteran put it, “This would be the ultimate pain trade.”

Such a scenario would also be strikingly reminiscent of the classic boom-bust cycles of yesteryear -- but with an important twist. Over the years, capital spending booms have typically signaled game over for most expansions. The cyclical rise in inflation and interest rates that such an outcome would elicit is invariably the coup de grâce. The trick comes in figuring out the leads and lags. If the investment cycle starts surging, the momentum of project completion is typically hard to arrest. That leads to the traditional end-of-cycle overhang on the supply side of the global macro equation. At the same time, there is good reason to worry about an increasingly fragile demand base. Not only would wealth-dependent US consumers be clobbered by a sharp rise in interest rates, but consumption growth elsewhere in the world may be much slower to move to the upside. All this hints at the possibility of a classic imbalance between global supply and demand. The twist comes on the price front. Even in the context of a possible cyclical pickup in inflation, the peak inflation rate in this cycle is likely to be quite low -- possibly no higher than 3% in the industrial world. As a consequence, in the bust that follows, the ensuing cyclical deceleration of inflation could well result in another deflation scare.

That possibility was not on the radar screen of this year’s MacroVision participants. As usual, we did a fair amount of polling of the group’s macro expectations over the next year. As can be seen in the accompanying table, the consensus was focused on another Goldilocks-like outcome for the real economy and financial markets -- limited interest rate risk, a modest rise in the stock market, a slight weakening of the dollar, and another year of outperformance by emerging market equities; among the developed-world equity markets, Japan was the favorite, followed by the US and Europe in that order. Like most of our macro polling these days, the group had a very autoregressive perception of the outlook -- extrapolating mainly on the basis of the latest trends. These are the polling results that always worry me the most -- momentum-driven scenarios that are not based on deep convictions. Should the story change for any reason, such a fickle consensus would undoubtedly head quickly for the exits -- a classic set-up for sharp and disruptive adjustments in financial markets.

MacroVision 2006 Polling Results

Year-end 2006:
MS Macro Team
MacroVision Consensus

Fed funds rate
4.75%
5.0% or higher

10-yr Treasury yield
5.0%
4.5%

10-yr German bund yield
3.4%
3.75%

Dollar-euro cross rate
1.25
1.25 to 1.30+

Yen-dollar cross rate
110
110

Oil price (WTI)
$70
$60

S&P 500
1300
1300 to 1400+

China industrial output
13% or lower
13% or lower

US C/A deficit, % GDP
6.75%
6.75%

Best performing asset
EM equities
EM equities

The MacroVision consensus was quite accurate in calling financial markets in 2005. The crowd at this year’s gathering is positioned for an equally benign outlook for world financial markets in 2006. But the most intriguing conclusion was between the lines -- the implied risks of an upside surprise to global growth and a more cyclical outcome for the markets. My baseline call for global rebalancing has never felt lonelier. As we passed in the halls, many of the clients had a hard time making eye contact with me. Was it the height of complacency or well-founded optimism? We’re about to find out.

http://www.morganstanley.com/GEFdata/digests/20060123-mon.html