THE SLOWDOWN GOES GLOBAL

Key Points


* Weaker growth drives the dollar and commodities


The US slump is going global, fueled by rising inflation abroad, the policy response to it, and credit restraint. Weaker growth is the common factor behind the weakening of commodity prices, a consequent reversal in the terms of trade for commodity producers, and pressure on their currencies. In our view, the slowdown abroad still doesn’t portend a global recession, but the risks have shifted to the downside.


Slumping non-US growth is depressing oil prices and strengthening the dollar. In my view, the relationship between oil prices and the greenback is primarily correlation, not causation; if energy supply factors change, e.g., if OPEC cuts production, the dollar-oil correlation could erode or break down.


* 2. Testing EM resilience to an adverse shift in terms of trade 
Lower commodity prices are transferring income away from the producers. For the EM world, that implies a mix of weaker growth, still-high inflation, and sinking currencies. EM economies are stronger than in the Asian financial crisis, but this is the first real business cycle they have faced in a decade.


* 3. Slowdown fuels negative feedback loop to the US 
The slowing outside the US will unmask the domestic weakness in the US economy and earnings by eroding support for US exports and earnings of US affiliates. The debate now is by how much and what is in the price.

 
* US – the tallest pygmy

The slowdown may underpin a dollar rally by default, as it is forcing portfolio reallocations and deleveraging. The unwinding of long-held trades will eventually create opportunities for patient investors, but volatility and aggressive price action may continue to contribute to risk aversion for now.

Details 


The slowdown that began in the US is going global. It now appears that economies in much of the developed world are slipping towards significantly slower growth, if not outright technical recession. Indeed, our global growth forecasts for both 2008 and 2009, at 4% and 3.5%, respectively, are each 0.1% lower than in July, when we did the last comprehensive update (see Global Forecast Snapshots, September 12, 2008). These annual data mask considerable near-term weakness: In the US, Canada, Europe, Japan and New Zealand, we expect a few quarters of essentially no growth. In our view, the slowdown abroad still doesn’t portend a global recession, but the risks have clearly shifted to the downside.

The sources of that weakness will help determine the consequences: If, as many assume, the global slowdown has been primarily the result of the sharp escalation of energy and food prices between March and mid-July, then the equally sharp reversal of those prices should at least cushion the downturn and prevent recession. We agree that the energy shock was one contributing factor, and lower energy prices clearly will help the oil-consuming countries, while lower food quotes will help the net food importers. 
But soaring energy and food prices aren’t the only story behind the slowdown; far from it. We think that the broader pickup in global inflation is a culprit. As we noted two months ago:

“Higher inflation erodes discretionary income and thus undermines consumer spending. That’s especially the case in emerging market economies where food and energy outlays account for half or more of consumer budgets, where those prices have pushed inflation up to double-digit rates, and where the soaring cost of government energy subsidies is forcing authorities to reduce them. Moreover, high and rising inflation typically is associated with more volatility and uncertainty, which is the enemy of investment and growth. In addition, higher inflation has triggered tighter monetary policies and weaker risky asset prices, which will depress growth in the short run.”

The inflation surge, likewise, is more the result of several years of lax monetary policy and dwindling slack in the global economy, not just an artifact of soaring commodity quotes. Indeed, the surge in commodity prices itself was the product of booming demand and limited growth in supply; equally, it is the global slowdown that is now promoting sharp declines in commodity prices — but not yet in inflation and inflation expectations. Consequently, central banks aren’t likely to declare victory until the coming significant decline in headline inflation proves durable.

Moreover, we believe that the continued tightening of global financial conditions — including the response to higher inflation by many emerging-market and developed-economy central banks — has also been a major factor behind the global slowdown, and that this tightening won’t reverse soon. As a result, the slowdown likely will persist into 2009, will probably be somewhat deeper than many hope, and recovery will probably be tepid when it emerges later next year.

Three consequences of this global slowdown are equally important.

First, the oil price-dollar connection is in my view primarily correlation, not causation. Indeed, as I see it, moves in both oil prices and the dollar — up and down — are the product of a common third factor, namely the shift in relative non-US growth. Thus, the presumed causal connection between oil prices and the dollar, and the claim that Fed ease promoted a weaker dollar and thus higher oil prices, are in my view exaggerated. To be sure, monetary policy differences between the Fed and the ECB contributed to a stronger euro through mid-July. In particular, the Fed’s dual mandate and relatively low inflation expectations gave it latitude to respond to the US financial crisis over the past year, while the ECB’s concerns about second-round effects from higher headline inflation biased it to tighten. But growth differentials also underpinned those expectations and are now in the driver’s seat. If supply, rather than demand, factors change in commodity markets, e.g., if OPEC cuts production, the dollar-oil correlation could erode or break down.
Second, the slowdown will continue to test EM economic resilience.

While lower commodity prices help consuming countries, they are producing a sharp reversal in the ‘terms of trade’ for commodity producers and in their currencies. Simply put, lower commodity prices transfer income away from the producers and back towards the consumers. For the EM world, that implies a mix of weaker growth, still-high inflation, and sinking currencies. EM economies are stronger than in the past, which means currency crises are less likely. But it does not rule out EM 'recessions'; this is the first real business cycle EM economies have faced since the Asian financial crisis, unlike the US-led one in 2001.

Third, weakness outside the US will unmask the domestic weakness in the US economy and in US earnings by eroding support for US exports and earnings of US affiliates. The debate now is by how much and what is in the price. As I see it, barring a global recession, US net exports will turn from being a record-strong contributor to US growth to a slightly negative factor over the next year. And weaker growth abroad is a key ingredient in our strategy team’s forecast of a 7% decline in S&P 500 EPS this year.

There’s no mistaking the evidence for the global slowdown. Following a strong first quarter performance, global growth slumped in the spring.

In Canada and Mexico, the slowdown most clearly echoes the weakness in US activity, with net exports now a significant drag on growth, and both production and employment beginning to show the strain. Since the small net contraction in the first half of the year, Canadian consumer spending has been sluggish, and sliding commodity prices may erode incomes. Manufacturing and production-based indicators have held up well but are at risk. In Mexico, production has already begun to contract.

Elsewhere in Latin America, activity has remained remarkably resilient but is now at risk, and there are signs of softening. Production and demand indicators are still on the rise in Brazil, Argentina, Peru and Venezuela. However, in Chile and Columbia the pace of economic activity has already turned sluggish.

In the UK, our baseline view involves a slowdown rather than a significant recession. But risks are rising: We think there is ~50% chance of a technical recession and ~25% chance of an early-1990s-style recession. GDP will likely contract in 3Q, and we expect a very sharp slowdown in residential investment, more de-stocking, and a 2H08 contraction in consumer spending.

In Europe, we expect the economy to trough over the summer, but recent data point to ongoing weakness. German activity indicators have weakened noticeably, partly reflecting payback from an unusually strong 1Q. In France, manufacturing activity is decelerating sharply, credit conditions are tightening, and housing is softening, while slipping industrial production and business surveys are now confirming the bleak outlook for the Italian economy. In Spain, real house prices are declining, and the correction in the construction sector is still ongoing. In contrast, the Dutch, Norwegian, and Finnish economies are outperforming the euro area, with the latter reflecting strong growth in resources, the CEE, and in Russia. But some of the CEE economies are now at risk, with Poland and Czech likely to slow materially in the coming months and Hungary struggling to emerge from its slow-growth rut. In Denmark and Sweden, tighter monetary policy is already taking its toll.

Turning to Asia, the prognosis for China’s economy will be pivotal. Recent data point to broadening weakness in activity, courtesy of slower export gains. Thus, the outlook for robust growth in China hinges critically on the sustainability of property investment growth. With the easing in monetary policy, the authorities’ orientation has shifted to favor growth, and more ease is coming. But China is not the whole story; growth has slowed in many other Asian economies as tighter monetary policy and diminished capital inflows slow economic activity. Hong Kong, Korea and India are all cases in point. The fears of a Korean financial crisis are overblown, but growth may slow dramatically. Indian consumption and capital spending are both slowing; indeed, consumer durables outlays and automobile sales indicate that the household sector's debt-leveraged spending remains under pressure. In Malaysia, export-oriented manufacturing (28% of the economy) has already fallen to low single-digits, and non-commodity exports such as electronics are also seeing downward pressures. Finally, the Japanese economy has been in a mild recession after peaking in Oct-Dec 2007. Our main scenario is for the economy to trough in Jan-Mar 2009, but political uncertainty will heighten risks of a prolonged and deeper downturn.

A sea change for investors. Although we’ve expected this global growth shift for some time, it has come a bit later and seems to be more broadly-based than even we expected. Both are important: The delayed start of the slowdown nurtured the sense among investors that global growth was more resilient than feared. That encouraged them to double up on decoupling trades, especially as the global economy appeared to be holding up better than the US. The breadth of the slowdown has shattered the conceit that EM economies and markets would be a safe haven from the developed world’s credit crisis. In our view, the slowdown abroad still doesn’t portend a global recession, but the risks have clearly shifted.

In a world where the US may now be the ‘best house in a bad neighborhood,’ the dollar likely will rally as investors anticipate that policies will shift towards ease abroad. While it was long expected, this non-US slowdown is forcing significant portfolio reallocations and deleveraging by investors who are overweight in overseas markets, in carry trades, and in long energy/short financials. Overshooting as those trades unwind will eventually create renewed opportunities for patient investors, but volatility and aggressive price action will continue to contribute to risk aversion for now.

Richard Berner (New York)