Four Investors' Fairy Tales...and Five Ugly Realities About the Coming Severe U.S. Recession
By Nouriel Roubini Given the recent flow of dismal U.S. economic indicators (Q2 GDP report, July payrolls, service ISM, etc.) I am now taking the view that the odds of a U.S. recession by year end have increased from my previous 50% to 70% now. While I have been arguing for the last few months that the risks of a U.S. recession are growing, most investors and the Fed are still in a delusional mode of denial and believe in four fairy tales that are now, unfortunately, slipping by the moment into the dustbin of wishful dreams: Fairy Tale # 1: The U.S. economy will have a soft landing: according to this tale, U.S. growth will continue at its trend rate of 3.5% (as recently argued by Bernanke) or just below trend, around 3.0% (i.e. the Fed staff and the market consensus view). Fairy Tale # 2: If the U.S. slowdown is excessive, inflation will ease and the Fed will come to the rescue with a sharp cut of the Fed Funds rate in the fall. I.e. a reduction in interest rates will prevent a recession from occurring. Fairy Tale # 3: Even if the U.S. slows down, the world will "decouple" (to use Goldman Sachs' term) from the U.S slowdown and will keep on growing at a perky rate in Asia, Europe, emerging markets and Latin America. In JP Morgan's terminology, this "decoupling" is termed as the "rotation in global growth", from U.S. to Asia and Eurozone. Others refer to it as the "locomotive switch with a switch in the global growth locomotive from the sputtering U.S. one to the perky ones in EU and Asia. Fairy Tale # 4: The rebalancing of global current account imbalances is underway and will be orderly rather than disorderly: the Bretton Woods 2 regime of vendor financing of the US twin deficits will continue unabated; and any possible fall in the US dollar will be orderly and gradual. I have spent the last few months debunking these four fairy tales (see my recent blog writings here and here and here and here and here and here). But now some elaboration is needed as more market folks starting to get a reality check into Fairy Tale #1, but they are still in denial mode by believing in Fairy Tales #2, #3 and #4. So, here are Five Ugly Realities that will determine the coming U.S. recession, the Fed failed policy response to it, the equity and financial market implications of it, the global economic consequences of it, and the disorderly rebalancing of the unsustainable global current account imbalances. Ugly Reality #1: The Probability of a U.S. Recession is now 70%. I had been predicting since last fall a sharp U.S. economic slowdown in the U.S. in 2006; I changed my call last June to one of an outright recession - with 50% odds - by early 2007. Given the flow of data of the last few weeks - effectively all of them heading south - I now am increasing my subjective odds of a U.S. recession by year end to 70%. I have reviewed in my latest writings the flow of macro indicators for the U.S. economy: both their headlines and details are simply ugly. At these indicators suggests that the Three Ugly Bears that I warned of since last fall are becoming uglier by the day: the housing slump is becoming a real bust; oil is headed higher and higher and could be soon well above $80; and inflation both core and headline - is rising further forcing policy makers across the world to increase interest rates. Housing alone is now enough to cause a severe U.S. recession since, as I have argued, - it directly reduces aggregate demand (residential investment will fall at an annualized rate of 15% for the next few quarters); - it has a strong direct (wealth) effect and indirect (via Home Equity Withdrawal) effect on consumption; - it reduces employment as 30% of the growth in payrolls in the last few years was directly or indirectly due to housing. On top of the housing bust, the rising oil prices are adding another severe stagflationary shock to the economy. And the interest rate increases "in the pipeline" (to use the Bernanke term) still have to negatively affect the economy as the economy today is reacting - given the long lags of monetary policy - to the effects of a Fed Funds at 4%, not the current 5.25% whose effects will be felt only in 6-9 months. The growing awareness that we are not going to have a soft landing but a severe recession is now clearly spreading among economist, market folks and, even, some policy makers. Last week, super-blogger and leading macroeconomist Brad Delong warned of a recession and even a possible "meltdown". Today, Paul Krugman in the New York Times picks up the theme with the subtle headline "Intimations of Recession" and the not-so-subtle concerned text starting with "Suddenly people have started talking seriously about a possible recession. And its not just economists who seem worried." Also today, the Financial Times is covering the wide-ranging debate in the blogosphere on my recession call. While Rich Miller on Bloomberg headlines with "Bernanke's Ride on Interest Rate `Escalator' Risks Recession" and explains how market folks are now seriously worried about a recession. And my Recession Barometer based on mention of the words recession or stagflation in Google News is now high and rising (over 5,000 for recession). This leads me to the second ugly reality. Ugly Reality #2: A Fed Pause or Even Easing in the Fall Will Not Prevent the Coming Sharp U.S. Recession. Again, markets and investors are well behind the curve on this issue as they are still debating whether the Fed will pause tomorrow August 8th at the FOMC meeting and whether the Fed will have to tighten further in the fall as inflation is still rising or rather pause as inflation may soon peak. The real policy issue now is not anymore whether the Fed will pause or not tomorrow at the August 8th FOMC meeting. It is obvious that the Fed will pause for sure on the 8th - in spite of still rising inflation - as there are strong signs of a severe economic slowdown. The policy issue is not even, anymore, whether the Fed will pause in the fall rather than increase rates further in face of rising inflation. There is, at this point, little doubt - save for a real nasty spike in core inflation - that the next Fed move will have to be an easing, as early as at the September FOMC meeting or as late as November 2006: the sharp U.S. slowdown in growth in Q3 (to as low as a 1.5% growth in the current quarter, on the way to a 0% growth rate by Q4 and an outright recession by Q1 of 2007) will force the Fed to start reducing the Fed Funds rate in the fall. While most market folks are still way behind the curve in being aware that the Fed will not only pause tomorrow but that its next move will be a reduction in the Fed Funds rate, the real and only meaningful policy issue now is whether the coming Fed pause tomorrow and Fed easing in the fall will prevent the coming U.S. recession. My answer to that question, as detailed in my long July 31st blog, is a clear no: as the title of my blog put it "Why a Fed Pause or Even An Easing Will Not Prevent the Coming U.S. Recession I will not repeat now all my detailed arguments on why the Fed easing in the fall will not prevent the coming recession. But let me repeat at least some of the key arguments as they do not seem to have registered yet in the market assessment of what a Fed ease would mean. There are at least five main reasons why a Fed Funds rate cut in the fall will not prevent a U.S. recession: 1. In 2000 the Fed stopped tightening in June 2000 (after a 175bps hike between June 1999 and June 2000). That early pause/stop did not prevent the economy from slowing down from 5% plus growth in Q2 2000 to 0% growth in Q4 2000. Also, the Fed started to aggressively ease rates in between meetings in January 2001 when it dawned on the FOMC that they had totally miscalculated the H2 2000 slowdown (they were worrying about rising inflation more than about slowing growth until November 2000 when it was too late). And this aggressive easing in 2001 did not prevent the economy from spinning into a recession by Q1 of 2001. This time around you will get into the same patterns: todays 5.25% Fed Funds rate reflects the effects on the economy of a Fed Funds rate closer to 4% given the lags in monetary policy and the effects of tightening in the pipeline as Bernanke and Yellen put it. So, pausing or stopping now will not help (like the June 2000 pause/stop did not help) and easing in the fall will be too late, in the same way in which easing in early 2001 did not help. 2. The current slump in housing will have a much more severe effect on the economy than the tech investment bust of 2000 for several reasons. The wealth effect of the tech bust was limited to the elite of folks who had stocks in the NASDAQ. The wealth effect of now falling housing prices affects every home-owning household. The link between housing wealth rising, increased home equity withdrawal (HEW) and consumption of durable and non durables is very significant (see RGEs Christian Menegatti brief on this), much more than the effect of the tech bubbles of the 1990s. This is exactly what San Francisco Fed President Yellen worried about in her speech last week. Last year, out of the $800 billion of HEW at least $150 or possibly $200 billion was spent on consumption and another good $100 billion plus went into residential investment (i.e. house capital improvements/expansions). It is enough for house price to flatten as they started to do recently let alone start falling as they are doing now since they are beginning to fall in major markets for the wealth effect to disappear, the HEW dribble to low levels and for consumption to sharply fall. 3. A housing slump is a triple whammy for the economy. First, the 6.3% fall in residential investment in Q2 will be followed for the next few quarters by a much larger fall, at least 10% and possibly 15% in such investment. Second, the effects on consumption of housing will be severe: already in Q2 durable consumption is falling as falling home purchases lead to lower purchases of furniture, home appliances and other housing-related durable goods. Third, the employment effects of housing are serious; up to 30% of the employment growth in the last three years was due directly or indirectly to housing. As housing slumps, the job and income and wage losses in housing will percolate throughout the economy. 4. Could a Fed pause and easing rescue the housing sector? Of course not, for the same reasons why the Fed pause and easing in 2000-2001 did not rescue the collapse in investment in the tech sector. The reasons why the Fed cannot rescue housing are clear. First, Fed policy in 2001-2004 fed an unsustainable housing bubble in the same way in which the Fed policy in the 1990s fed the tech bubble. Now, like then, it payback time: with huge excess capacity in housing (then in tech capital capacity) even much lower short and long rates will not make much of a difference to housing demand. Real investment fell by 4% of GDP between 2000 and 2004 in spite of the Fed slashing the Fed Funds rate from 6.5% to 1.0%. Does anyone believe that a 50bps or even 150bps easing by the Fed will undo the housing investment bust that is coming in the next two years? No way. Second, a Fed easing in the fall may be too small at most 50bps plus or minus 25pbs and will have too little of an effect on long rates to affect debt servicing ratios of overburdened households. Long rates will not be affected much by a Fed ease for the same reasons the global conditions that determined the bond conundrum of 2004-2005 that a Fed tightening did not affect long rates. Some easing by the Fed will have a little downward effect on long rates and, if inflation is actually rising because of oil and other stagflationary shocks, long rates may actually go up if the Fed easing likely causes increases in long term inflation expectations. Since we are facing stagflationary shocks, the Fed can ill afford to ease too much and too much easing will be counterproductive for bond rates and for housing. Thus, either way households burdened with ARMs and overburdened with housing debt at the time when housing values are slumping, can expect little relief from lower short rate or long rate. The Fed just cannot rescue housing; it can only very modestly dampen its free fall. 5. With aggregate demand slumping for structural reasons that I have extensively discussed before, Fed easing and lower long rate will have very little, if any effect, on private consumption of non-durables and durables (the latter already falling in Q2), non-residential investment (that is already falling in Q2 in its equipment and software component) and residential investment. Ugly Reality #3: A Fed Monetary Easing in the Fall Will Not Rescue the Stock Market: Expect Instead a Bear Market in Equities by Year End. The markets are still in the delusional hope that the Fed easing will come to their rescue. Afterall, the Greenspan-Bernanke's "Asymmetric Asset Bubble Principles" of doing nothing when asset bubbles are rising while aggressively easing monetary policy when bubbles are bursting first created the tech stock bubble of the 1990s and then the housing bubble of the 1990s. But, the Fed is now running out of bubbles to create, as stocks and housing are the two main sources of wealth for U.S. households. Indeed, slowly but surely markets are now realizing that Fed will not be able to rescue the economy this time around and that the recession will be more severe than in 2001. Typical of the knee jerk reaction of Panglossian markets and of Goldilocks-blinded investors to bad economic news, the stock market rallied at the time of the Q2 growth report and, again but briefly, after the payroll figures on Friday. This typical suckers' rally always occurs at the beginning of an economic slowdown that leads to recession. The first reaction of markets to such bad news is always as stock market rally in the belief that a Fed pause and then easing will rescue the economy. This is always a suckers' rally as, over time, the perceived beneficial effects of a Fed ease meet the reality of the investors realizing that an ugly recession is coming and that the effects of such a recession on profits and earnings are first order while the effects of the Fed easing on the economy and stock market are - in the short run - only second order. That is why you can expect another suckers' rally tomorrow when the Fed eases and another one in early fall when the Fed will actually reduce the Fed Funds rate. But, as the flow of lousy macro news builds up day by day in a tsunami of mounting probability of a severe recession, the markets will in due time crash when the unstoppable wave of news and macro developments hits hard a weakened and vulnerable economy; then you will see a serious bearish market in equities and the collateral damage - even the risk of a systemic crisis - and debris will be ugly. And, in this recessionary and bearish world for U.S. equities, expect all other risky assets to underperform (see my detailed discussion here): credit risks and premia will sharply increase, emerging markets equities, fixed income and currencies will all slump (especially those of large current account deficit countries), other G7 equity markets will start drifting down, non-oil commodities will be severely pushed down by the US recession and global economic slowdown; and the US dollar will sharply fall (more on this below). In summary, in 2006 cash will be king. This bearish call for non-US risky assets across the world depends on the fourth Ugly Reality. Ugly Reality #4: The World Will not Decouple from a U.S. Slowdown/Recession Because When the U.S. Sneezes the World Gets the Cold. There is a now another fairy delusion in the market that the rest of the world will somehow weather the coming U.S. recessionary tsunami. While the U.S. shores may get trashed by the mounting forces of rising oil, busting housing and rising inflation leading to higher interest rates, there is the wishful hope among investors that the rest of the world shore are safe from these mounting risks. The argument now presented in the most reputable research shops of the most reputable global investment banks is that, even if the U.S. slows down the world will "decouple" (to use the arguments strongly presented by Goldman Sachs) from the U.S slowdown and will keep on growing at a perky rate in Asia, Europe, emerging markets and Latin America. The argument is that there is enough domestic demand momentum in the four leading Asian economies (China, India, Japan and Korea) and there is now such a resilient recovery of growth in the Eurozone, starting with Germany that the rest of the world can happily weather the U.S. recessionary tsunami. In JP Morgan's terminology, this "decoupling" is termed as the "rotation in global growth" from U.S. to Asia and the Eurozone. Others refer to it as the "locomotive" switch with a switch in the growth locomotive from the sputtering U.S. one to the perky ones in EU and Asia. I have already written extensively twice - starting with by my June 14th essay 12 Reasons Why the World Will Not De-Couple From the Coming U.S. Growth Slowdown Or Why When the U.S. Sneezes the World Gets the Cold - on why the world will not decouple from the U.S. recession. The markets are still in the hope of a U.S. soft landing and in the hope that, if a soft landing is at risk, the Fed will come to the rescue. The reality that the coming U.S. economic developments will hit and hurt the rest of the world has not yet registered in the minds of investors where the "decoupling" or "rotation" fairy tales still dominate. But there will be no decoupling as (to repeat my 12 arguments): 1. Trade links are important in transmitting shocks from the US to the rest of the world, especially for countries that export a lot - directly or indirectly - to the US (China, East Asia, Mexico, Canada, etc.) 2. The oil and commodity price shock is a shock that is common to the US and many other oil and commodity importing countries; actually EU, Japan, China, India depend on oil imports more than the U.S. does. 3. Monetary policy is being tightened in the US and many other economies given global concerns about rising inflation. The era of cheap liquidity is over. See ECB, BoE tightening decisions today and the end of ZIRP in Japan, as well as the recent spate of policy hikes throughout the EM world. 4. Housing bubbles are bursting - or flattening - not just in the US (where the bust is becoming dramatic lately) but also in many other economies as easy liquidity had led to housing bubbles in many parts of the world. 5. The recent fall in equity prices - during the May-June turmoil and the coming one once the U.S. slowdown dawns on Panglossian investors - will not be just US based; it will rather global and more severe in the rest of the world than in the US as foreign markets are more illiquid than the U.S. one (see what happened to EM equities and to the Nikkei and EU stocks in May-June); it will thus have negative effects on global consumption and investment spending and on business and consumer confidence in many economies. 6. The weakening of the US dollar following the US slowdown will lead - and is already leading - to the appreciation of the Euro, Yen and other floating currencies. Given the tentative recovery of the Eurozone and Japan, this appreciation will hurt net exports and growth. 7. Foreign direct investment (FDI) is another channel of transmission: when the US slows down the sales in the US of US-producing affiliates and subsidiaries of foreign firms fall, negatively affecting the profits of such firms in their home base in Japan, Europe and around the world. 8. Risk aversion rose globally in May-June and investors are still a nervous wreck given all the macro, financial and geopolitical uncertainties in the world; thus the downturn in markets will negatively affecting "animal spirits", i.e. business and consumer confidence. Already the mood of global CEOs has totally soured based on the Goldman Sachs confidence index. 9. The US and G7 slowdown will have negative growth and financial effects on emerging market economies that, until recently, had widely benefited from high global growth, high commodity prices and low global interest rates. Lower global growth, lower commodity prices and reduced global liquidity will have negative effects of the real economies of emerging markets, as the May-June sharp market selloff in these markets had been already signaling. 10. The last four global recessions have been characterized by an oil shock and an inflation scare that led to monetary tightening and stagflationary outcomes. The same is happening this time around and global business cycles are highly correlated. 11. There is now a serious risk of a systemic financial crisis - as in the 1987 stock market crash or the 1998 LTCM near collapse. The factors that led to systemic risk in previous episodes of systemic financial distress are present again today. 12. Unlike the 2001 global downturn there is little room for monetary and fiscal policies to be eased to deal with the global slowdown; while exchange rates are now a zero sum game as, in a slowdown, most G7 economies will want to avoid an appreciation of their currencies. Thus, the risks of trade and asset protectionism are rising in a global economy with large and increasing global imbalances and geostrategic risks. And in my recent blog last week, I elaborated in more detail how these 12 specific factors will lead to a slowdown of growth in China, Japan, the rest of Asia, Europe, emerging markets and Latin America. The world will not be able to decouple from the US slowdown. The effects of the US slowdown on global growth may be delayed by quarter or two, as Asia and Europe are now in a cyclical recovery; but each one of these region has its own individual macro vulnerabilities that will rapidly emerge and spread once the US slowdown and recession is underway. Ugly Reality # 5. The Risk of a Disorderly Rebalancing of the Global Current Account Imbalances is Rising: One Cannot Rule Out a Hard Landing of the U.S. Dollar and an Episode of Systemic Financial Risk. The scenario of a US hard landing that I have described above did not even mention the issue of the large US current account deficit and the risks to the U.S. dollar. Indeed, as my co-author Brad Setser points out in his most recent excellent blog, the scenarios of a U.S. hard landing can be based on two very different arguments: either a U.S. consumer burnout or a foreign flight by foreign investors. The four ugly realities that I have analyzed above are based on the consumer burnout view of the U.S. hard landing. But I do not rule out a situation where a hard landing starting from a consumer burnout may lead to a harder landing because of foreign investors flight from U.S. assets. Indeed, in 2005 Brad Setser and I analyzed the risks of a hard landing of the US economy based on the foreign flight argument; we argued that the BW2 regime of vendor financing of the US twin deficits would unravel by 2005-2006. Instead, my argument since last fall - of the Three Bears (slumping housing, rising oil prices, and rising inflation leading to rising interest rates) smashing the Goldilocks of high growth and low inflation is based on a consumer burnout thesis about the U.S. hard landing. However, I still do believe that while the consumer burnout is now the first trigger of the US hard landing, once this US recession is underway the risks of a foreign investors flight will be very large: so we may end up with a double whammy of consumer burnout and foreign flight. It is important to note that last year the BW2 regime did not unravel mostly because of cyclical factors. In 2005, the US dollar appreciated in spite of the downward gravitational force of a larger US current account deficit mostly because of cyclical and temporary factors: interest rate differentials favored the US dollar as the Fed was on the tightening path while ECB and BoJ were on hold; US growth was still perky while Eurozone and Japanese growth were still mediocre; the Homeland Investment Act (HIA) boosted repatriation of US foreign profits; there were lousy political news in Europe; and the returns on US assets especially housing and bonds was still high. This year, instead, the structural gravitational forces pushing down the dollar are aligned with the cyclical factors that are now turning against the dollar: the Fed will soon pause and then ease while ECB and BoJ have just started to tighten; US growth is slowing down while so far Eurozone and Japanese growth are recovering; the HIA has expired; the US administration is in serious domestic and foreign affairs trouble and looks more lame duck by the day; US equities and housing are slumping. This is why the dollar started to fall in the spring as the reality of cyclical factors turning against the dollar started to sink in. But during the global market turmoil of May-June the dollar temporarily recovered because of transitory factors: Bernanke was flip-flopping by signaling that the Fed was not done yet, while the BoJ kept on postponing the timing of its phase-out of ZIRP; and panicky and risk-averse global investors rushing out of emerging markets sought the relative safety of US Treasuries. But this was all temporary: indeed, the paradox and irony of investors fleeing currencies of countries with large current account deficits (Turkey, Hungary, Iceland, and India, South Africa) to find safe haven in the currency of the country with the largest current account deficit in human history the US became soon evident. And as soon as the reality of the coming US recession and the Fed pause and then easing sinks in the investors minds you can expect that the dollar will start falling at an accelerated pace, as it has in the last week. At that point, consumer burnout may well trigger foreign flight. It is clear now that foreign central banks are seriously getting tired of accumulating trillions of US dollar assets on top of the trillions that they have already accumulated; the expected capital losses on these dollar assets will be massive double digit as a % of GDP once the dollar starts to fall relative to RMB, Asian currencies and other current members of BW2 that have even last year financed about 50% of the US current account deficit. And once foreign central banks signal that their willingness to accumulate dollar reserves is slowing down, foreign private demand for US dollar assets will fall even more sharply than the official demand. In fact, carry-trading Asian and other BW2 countries investors will then face the risk of sharp capital losses on their holding of dollar assets; i.e. private foreign demand for dollar assets is complementary, not substitute for official demand. Thus, our 2005 prediction for an unraveling of BW2 by 2006 is still on track to be fulfilled. Once this happens, the dollar may start to fall at a rapid pace at the worst of all times this coming fall, i.e. when the US economy is slowing down, when the risks of trade protectionism in the US Congress are surging, when the threats of asset protectionism are rising (see Unocal-CNOC case and the Dubai Ports case; and now the growing pressure for a protectionist reform of the CFIUS process, and when acrimonious U.S. mid-term elections are coming. Then, the risk that the row between the US and China on the RMB currency revaluation issue will lead to an actual trade war as Schumer is now asking for a vote on his China tariffs bill by September 30th will increase. Then, the risks are that such a toxic mixture of macro, financial and political events will lead to a financial meltdown. In conclusion, markets, investors and policy makers will soon wake up from the delusional dreams and the fairy tales they have been indulging into for too long and will face the five ugly realities that I described above: 1) the U.S. will experience a sharp slowdown followed by a severe recession; 2) the Fed will pause and then ease in the fall but such easing will not be able to prevent the U.S. recession; 3) after a suckers rally following the Fed pauses and easing, stock markets will enter into a bearish contraction phase; and other risk assets will also experience sharp drops. In 2006, cash is king; 4) the rest of the world will not decouple from the U.S. recession and there will be no rotation in global growth as the rest of the world will sharply slow down after a short lag following the U.S. recessionary lead; 5) the risk of a disorderly rebalancing of the growing global current account imbalances is increasing with serious consequences for the U.S. dollar and with the growing risk of dangerous global trade and asset protectionism. Then, in this most volatile and dangerous macroeconomic, financial and geopolitical situation, the risk of a US recession turning into a systemic financial meltdown cannot be ruled out. There are serious similarities between the situation today and the forces that led to the stock market crash 20% in one day in October 1987 But the risk of a financial meltdown is a topic that deserves its own separate discussion in my next blog....Stay tuned at www.rgemonitor.com This Message Sent By: Roubini Global Economics, LLC - 131 Varick Street Suite 1005 - New York, NY 10013-1417 ------------------ Jayson Funke Graduate School of Geography Clark University 950 Main Street Worcester, MA 01610
