This is the time of the year when we push our scratched and cracked crystal balls to the limit as we extend our forecast horizon out a year. It’s an exercise we always conduct with great trepidation, but this time it feels more uncertain than ever. While the recent momentum in the global economy is encouraging on the surface, the fundamental tensions of an unbalanced world are deepening. That may imply more momentum over the short term, but it raises serious questions about what lurks over the horizon.
Our first cut at the global outlook for 2005 sounds only a soft note of caution. After expecting world GDP to accelerate to 4.2% in 2004 (a fractional upward revision from our prior forecast of 4.1%), we look for a deceleration to 3.7% in 2005. This is rather ironic: All the world gets out of a massive reflationary policy gambit is one year of above-trend growth. Moreover, relative to the global economy’s longer-term growth trend of 3.6%, the 0.6-percentage-point overshoot we project for 2004 falls well short of the more vigorous and sustained rebounds of past global business cycles, especially those of the mid-1970s and early 1980s. A prompt return to trend in 2005 would mark one of the most anemic global recoveries on record.
Our deceleration call for 2005 hits most regions of the world. The US is expected to lead the way, hardly surprising after the blistering 4.7% growth pace we now estimate for 2004. As fiscal and monetary policy stimulus wanes, our US team believes that a significant portion of next year’s growth surge will come at the expense of gains to follow, and they expect a 3.8% gain for 2005, a slowing of nearly one percentage point. Not surprisingly, we also look for a slowing in US-dependent Latin America in 2005, as a 3.8% rebound in 2004, the region’s strongest growth in five years, gives way to a 3.3% gain in 2005.
Deceleration is also expected across the board in Asia — China, Japan, Korea, and most other economies in this trade-dependent region. Asia ex-Japan is expected to remain the world’s fastest-growing area with 6% average gains in 2004–05. But even this region has its limits. Indeed, as Asia continues to suffer from a deficiency of domestic demand, the US-led slowing in global trade that we anticipate in 2005 will begin to curtail the region’s cyclical impetus in early 2004.
Asia has become the hope of those who believe a US-centric world has found a new growth engine. I don’t buy it. First, today’s Asia is basically a story of China and Japan, with increased emphasis on the former. Our operative view on China is that the authorities are engineering a soft landing after an unsustainable growth surge in 2003. On the back of a credit bubble, excess is evident in coastal-region property markets — especially Shanghai — and in infrastructure spending. China’s central bank has moved to tighten monetary policy, and bank lending is slowing in response. We expect this reduction in the supply of credit to temper property and infrastructure investment in 2004, leading to a significant reduction in Chinese import demand, from 40% growth in 2003 to 20% in 2004. This would have a marked impact on the rest of an increasingly China-led Asia, particularly Japan, Korea, and Taiwan, where exports to China appear to have accounted for more than 50% of aggregate export growth in 2003.
That could prove especially vexing for Japan, currently the new “darling” on the global recovery watch. Japan’s recent cyclical improvement has two major sources, capital spending and exports. For an economy that remains deeply mired in deflation, a capex-led recovery, which only exacerbates the existing overhang of supply, does not appear to be sustainable. On the export side, China’s slowdown should prove especially problematic for Japan, since exports to China accounted for 73% of total Japanese export growth in the first eight months of 2003. But with the yen continuing to rise — testing the ¥100 threshold versus the dollar by late 2004 or very early 2005, according our currency team’s forecasts — the impetus to Japanese external demand will be under even greater pressure. For those reasons, I continue to believe that the risks remain on the downside of our Japanese growth forecast.
Europe is expected to buck the global deceleration trend, as we look for pan-regional growth of 2.1% in both 2004 and 2005. That hardly qualifies a still structurally impaired European economy as a new engine of global growth. By our reckoning, Europe is on a modest recovery path at best after its double-dip recession in 2001–03. As such, it never went to cyclical excess — the main reason it is not expected to fall victim to the global deceleration story. The good news is on the domestic demand front, especially private consumption, as the Euroland unemployment rate is expected to drift down from around 9% at present to 8% by the end of 2005. But this is offset by the potential impacts of a strengthening euro, underscoring downside risks to European external demand and even capital spending. Unlike most, our European team continues to believe that the reform story is unfolding in a measured and encouraging fashion — especially in Germany, widely perceived as the weakest link in the Euro-growth chain. But their optimism is guarded, particularly as they concede that the euro is now close to breaching a worrisome pain threshold.
The pieces of the global puzzle do not do justice to the big-picture themes that are likely to play out on the world stage over the next few years. Particularly worrisome, in my view, are the ever-mounting imbalances of a US-centric world. Nowhere are they more evident than in our forecast of America’s gaping current-account deficit, a shortfall that we estimate will rise to an astonishing 5.8% of GDP in 2005. Not only is that a record for the US, but in dollar terms — $710 billion — it is a record for the world, requiring foreign investors to provide America with nearly $3 billion of capital inflows every business day by 2005. America’s current-account deficit is a by-product of what I view as two of the world economy’s most unsustainable trends — a saving-short, overly indebted US that is living well beyond its means, and the inability or unwillingness of the rest of the world to stimulate domestic demand. While our call for global rebalancing has been frustrated over the past year, the buildup of capital-flow and currency tensions makes such a realignment increasingly likely over the 2004–05 period.
World financial markets are not priced for such intensified macro tensions. Instead, hopes of a classic synchronous global recovery are in the air. What the markets are missing, in my view, is the price the world has paid to climb out of the near-deflationary abyss of the last recession. Central banks have made the riskiest bets in modern history — policy rates of “zero” in Japan, 1% in America, and 2% in Europe. At the same time, fiscal authorities have upped the ante as never before, with government budget deficits of 7% in Japan, 4% in America, and 3% in Europe. And the authorities have colluded in currency management in a period of unprecedented external imbalances.
The main problem with these extreme policy gambits is that there is no easy way out. If central banks move to normalize short-term interest rates, increasingly leveraged bond and credit markets could be vulnerable. The fiscal conundrum could be even more serious. Even a vigorous cyclical recovery in the US will not touch the long-term tax reduction and entitlement programs that are likely to produce ever-widening structural budget deficits. And Europe’s recent suspension of the Stability and Growth Pact to accommodate Germany and France raises serious questions about the region’s long-term commitment to fiscal discipline. Equally disconcerting is the possibility of an accelerating decline in the dollar. If that occurs, it seems reasonable that foreign investors would finally demand compensation for taking currency risk on dollar-denominated assets — pushing long-term US real interest rates higher.
All this points to the bond market as the next arena in which mounting global tensions are vented. The confluence of several forces — central bank exit strategies, undisciplined fiscal policies, and dollar risks — underscores the potential for a sharp backup in long-term interest rates. Ironically, in this climate, it doesn’t take inflation to be bearish on bonds. Heaven help us if that risk comes into play. To me, this is the next logical step of the world’s post-bubble shakeout — first in equities and now in the fixed income instruments that benefited from central banks’ strategies to contain initial damage from the bubble. Most believe that the long nightmare that began in early 2000 is now over. I don’t. In my view, there was never an easy way out, especially as the authorities reacted to the popping of one bubble by creating other bubbles. The bill for speculative excesses and global imbalances has yet to be paid. As we peer into 2005, that’s the biggest risk of all
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