Global Outlook: Precipitous Decline or Slow Economic Adjustment?

by Scott B. MacDonald and Keith W. Rabin

NEW YORK (KWR) The usual set of strikes in France, the possibility that reform of Japan's postal bank will be diluted, and apprehension that the Bush administration will not make much headway on reducing the sea of red ink on the federal fiscal ledger all point to one thing – a certain warped convergence between the world’s major economies. In a very simple sense, U.S., European, Japanese and even the Chinese economies need each other – to maintain a status quo that allows them to put off politically painful and hardnosed economic reforms. The current system of mutual support – the flow of funds from Asian and European investors into the United States in the form of Treasury and corporate bonds and, in return, the active stance of U.S. consumers in buying imported goods with that borrowed money, keeps Japanese, Germany and French companies pumping out products, making profits and workers employed. At some point the music in this dance must come to an end and the band paid. Yet, this day of reckoning could well be postponed for several more years. While this will make the inevitable meltdown all the more harsh -- until the carousel ride stops, the party goes on.

The sad thing is all the players recognize the problems. For the United States, it is a combination of large fiscal and current account deficits, a top-heavy reliance on the consumer, an alarming depletion of personal savings, a pressing need for tort reform, and serious issues concerning social security. For Japan, its is the government’s massive build-up of debt to about 150 percent of GDP, the need for further structural reforms such as postal system privatization, a continuing reliance on the export sector, and a rapidly aging population.

For the Europeans, in particular the continental giants of France, Germany and Italy, critical reforms are required in terms of labor markets, pension systems and competition laws. Current efforts remain inadequate. Failure to reform has resulted in anemic economic growth, higher-than-expected government spending and deficits and, in some cases, a failure to meet EU Growth and Stability Pact targets. Europe also has to consider similar, though not as extreme, demographic trends as Japan.

China has also bought into this system. It is in the process of a massive economic transformation. For it’s leadership to be successful, it must have strong economic growth and some ability to distribute its national wealth. To achieve this goal, China needs markets for its goods and the ability to source industrial inputs such coal, copper and oil. China also requires some degree of stability in international currency markets, hence its glacier-like approach to allowing its currency to float. If Europe, the United States and Japan were to embark upon needed reforms, economic growth in those countries could slow. If that were to happen, the current great Chinese leap forward which started in 1978 could sputter. Any major slowdown could result in social unrest, perhaps even upheaval.

What all of this means is that the United States, Europe, Japan and China are locked into their current patterns of economic growth. The nagging issues of high unemployment, looming pension and social security crises, and untidy fiscal accounts are likely to continue. As for China, do not look for any floating of the currency in 2005 and for growth only to modify down to 8 percent in 2005 from last years, 9.6 percent. China will achieve a soft landing, but is likely to be longer and bumpier than many expect.

What keeps this system in place is that no one really wants to see it collapse. Change will be painful for everyone, so it remains easier to push the day of reckoning further into the future, beyond current political terms. The U.S. current account deficit will continue to be a problem, with no one wanting to make the adjustments – in terms of allowing the Euro or Yen to appreciate too much to threaten growth. We have already seen a recent round of squabbling between Europe and Asia over who will assume the burden of another round of dollar weakening. In 2004 it fell more on Europe; now the Europeans want to see the Asians pick up some of the adjustment burdens. Japan was quick to indicate it might intervene in international currency markets, especially if the dollar/yen ratio drifts toward the 100 mark.

The results of failing to act on economic problems in the world’s largest economies is likely to be one of ongoing budget and current account deficits in the United States, marked by periodic weakening in the U.S. dollar. Japanese economic growth, while positive, is likely to remain below its potential, and the nation will struggle to deal with the public sector debt it has taken on. As for Europe, the pressures on pension and social services are likely to mount, as there will be fewer people to support an aging population. And Europe’s large economies will face strong pressures to move businesses further East to countries like the Ukraine, with well educated populations, but far lower wages and social costs.

The ultimate result of this system is a long, range-bound era of moderate to weak economic growth, eroded by a lack of the changes badly required to address population shifts and the necessary economic transition. At some point, something may give – a plunge in the dollar that does not stop, an unexpected currency move by China, or a major financial meltdown caused by mistakes with derivatives. Such a meltdown could be far worse than anything seen in recent history due to the accumulation of debt and structural inefficiencies – sadly all of which could have been corrected at an earlier period.

From an investment standpoint, however, the key question is whether we will see things unwind in a slow economic crumble or a precipitous drop off the cliff. The former would suggest the Fed is likely to continue or even reverse its “measured pace” posture. Under that scenario, current trends such as rising commodity prices, an out-performance of emerging over developed markets and even perhaps the “bubble-like” appreciation of U.S. real estate markets may continue for sometime. A drop off the cliff, however – and many extremely smart investors have patiently waited and underperformed over several years believing this to be inevitable – would have ominous implications.

While entirely possible – and even justified based on the underlying fundamentals – it is hard to see how anyone would benefit from an abrupt systemic shock and major economic dislocation. This does not mean it will not happen, and things could certainly get out of hand. Massive liquidity, however, and the complementary though admittedly dysfunctional relationship highlighted above, does indicate that a more gradual adjustment is entirely possible. While this does not eliminate the potential for manic, volatile swings as we seek to determine whether inflation or deflation will gain the upper hand. It does, however, argue against a doomsday “imminent depression” in the immediate future. These alternatives have very different implications for both fixed income and equity investors.