Economic Talking Points --- Outlook for 2006
- Dec 13, 2005
This chapter is from the book
Bernard Baumohl
Executive Director
THE ECONOMIC OUTLOOK GROUP, L.L.C.
http://www.economicoutlookgroup.com
(609) 799-4122
December 12, 2005
ECONOMIC TALKING POINTS --- OUTLOOK FOR 2006
- What will the economy do in 2006?
- Will consumers stay in a spending mood?
- What could trigger a recession?
- Where are oil prices heading?
- How high will gold go?
- A look at other countries
- What are the greatest risks to the world economy?
WRAPPING UP 2005
You can’t help but be impressed with the U.S. economy’s performance in 2005. Its resilience in just the last few months has been nothing short of remarkable. Many forecasters feared the catastrophic hurricanes and surge in energy prices would cause serious hardships for consumers and businesses. There was lots of talk of stagflation, recession, a plunge in confidence, a collapse in housing, and consumer spending shutting down. But none of these scenarios materialized.
Instead, what happened took many by surprise, including us. After getting buffeted by weather and oil price shocks, the economy quickly regained its footing. Many Americans did alter their driving habits a bit to consume less gasoline but they continued to shop with enthusiasm. At the same time, companies forged ahead replenishing dwindling inventories and placing new orders for computers, communications equipment and energy-efficient machinery. While consumer confidence levels did plummet to multi-year lows following the storms, they rebounded dramatically the last two months. Buoyed by how well the economy bounced back, investors have recently driven the S"P 500 and NASDAQ to their highest levels in more than four years.
Of course, the economy had some help along the way. The fall/winter weather turned out to be milder than usual and gasoline prices fell 30% since their September peak. Once it cost less to fill up a car, many shoppers took to driving again and rushed off to malls.
Clearly, the national economy dodged a bullet in 2005. New and existing home sales will reach their fifth consecutive record sales. More than 1.8 million non-farm jobs were created through November and the unemployment rate stands at 5%, quite low by historical standards. The underlying rate of inflation is not only within the Fed’s acceptable range but it has actually receded of late. Most astonishing of all, GDP growth in the second half of the year could turn out to be one of the strongest since 2000, an amazing feat given all the turbulence the economy had to absorb in August and September.
WHAT WILL THE ECONOMY DO NEXT?
But it’s now time to turn our attention to 2006. Will the economy’s current momentum continue through next year? Probably not.
A deceleration in economic activity is expected in the first half of the year as debt-strapped households begin to struggle with mounting bills. Spending by consumers will pick up in the second half but the pace will still be relatively lackluster. Corporate expenditures, however, should increase more strongly in 2006 as small and mid-size companies play catch up and invest in capital that’s designed to offset higher labor and energy costs.
For the year as a whole, the economy will turn more sluggish as higher short and long-term interest rates, a weaker housing sector, and an anticipated firming in oil prices later in the year all take their toll. GDP growth should slow from an estimated 3.7% in 2005 to 2.8% in 2006, its weakest performance since 2002.
Three broad themes will emerge to influence economic activity in 2006. First, consumer spending, which has been the economy’s main engine of growth the last few years, will take a breather. We’ll explain why in greater detail below.
Second, the yield curve is expected to steepen and resume a more normal shape. That’s because on the short maturity side we are near the end of the Fed’s interest rate raising cycle, yet yields on longer Treasury notes and bonds are about to edge higher. Foreign investors have been losing their appetite for new U.S. Treasury debt since 2004 and that trend will continue in 2006. Unfortunately, the decrease in foreign demand for Treasury securities comes at a time when U.S. borrowing needs are about to break a new record. An unprecedented $171 billion in new Treasury financing --- double the amount of the current quarter --- will be raised in the first three months of 2006.
Given the changing dynamics in the demand and supply of Treasury debt, yields are headed upwards.
The final theme involves a further deterioration in the geopolitical climate. Rising disillusionment over the war in Iraq, the growing perception of an ineffectual White House, Iran’s brinkmanship over its nuclear program, and worsening relations with China are some of the fiery issues we believe will cast a pall over the economy in 2006.
CONSUMERS WILL BE THE BIGGEST DRAG TO GROWTH
The most vulnerable part of the economy in 2006 will be the consumer. Household spending was the leading driver of economic activity the last two years. But that was when homeowners had money to burn. Americans took advantage of lower interest rates, refinanced their mortgages and went on a spending binge. By far the greatest extra source of cash came from borrowing against the increased value of one’s house or condo. Those assets turned into true cash machines. A Federal Reserve study pointed out that home equity loans have added $600 billion to American consumer spending power the previous year.
But it all comes at a price. The equity homeowners are now left after all that borrowing has fallen to 56%, compared with more than 80% in the 1950s. With the housing sector now cooling and interest rates rising, the home equity cash faucet is about to dry up.
Moreover, both mortgage rates and residential real estate prices have risen to where home affordability for the average buyer has plummeted to a 14-year low. That’s why the current inventory of unsold existing homes on the market is the most since April 1986. True, "new" homes sales did jump in October, but that increase largely reflects long-time fence sitters who are suddenly rushing to lock up current mortgage rates before they climb higher. With the value of residential real estate plateauing and the cost of borrowing higher, applications for mortgages and home equity loans have been on the decline. Refinancings are down more than 20% over the last 12 months and applications to purchase homes have fallen 10% from their peak last June.
Aside from housing, people are being squeezed elsewhere. Americans have been spending more than they earned for the last five years, borrowing an additional $3.8 trillion during this time and bringing total household debt to a record $10.7 trillion. In just the last quarter, consumers spent $531 billion more on an annual basis than they received in disposable personal income. This is the biggest gap between spending and take-home pay we’ve ever seen. No wonder the personal savings rate has been negative for months.
Now for the really ugly news. In the first months of 2006, Americans will not only have to make higher interest payments on much of this debt but they also have to pay off steeper home heating bills and holiday shopping charges. According to the U.S. Department of Energy, natural gas costs for the average homeowner this winter will climb to $1,096, up 48% from last winter. (The average yearly cost between 1999 and 2004 was $586.) Heating oil expenses will rise to $1,577, up 32% from year ago. (The average was $865 over the previous five
years.) Though the average price for all grades of gasoline has declined from its peak of $2.95 a gallon in early September to
about $2.15, this is still 12% higher than a year ago.
Many households are going to be hard pressed to pay for all these expenses.
Wage growth alone is insufficient. Looking over the latest employment report, average weekly earnings in November, a figure that accounts for 85% of the workforce, rose 3.2% over the year. That’s way below consumer price inflation, which jumped to a 14-year high of 4.7%. A more comprehensive measure of pay is the wages and salaries component of the Employment Cost Index, which was up 2.2% in the 3rd quarter, the smallest increase ever recorded.
Will workers at least see faster wage growth in 2006?
We hope so but it’s hard to be optimistic. A close reading of the latest jobs report holds little promise. Both the average hourly workweek and overtime hours, two leading indicators of pay growth, have declined in November. Then there are other troubling signs in the labor market. Looking at the rate of job creation in 2005, we see a downward trend in employment. Monthly payroll growth averaged 198,000 in the second quarter, 147,000 in the third quarter, and for the first two months of this quarter the average dropped to 129,500 jobs.
Some analysts have argued that with household net worth at a substantial $50 trillion, people are under no duress to cut back on shopping. The problem with that argument is that this figure includes about $12 trillion in stocks and bonds and $18 trillion in real estate, assets most people do not routinely rush to liquidate just pay off a monthly credit card bills.
Instead, consumers are more likely to curb spending temporarily until their personal finance is in better balance. What all this comes down to is that we are expecting Americans to make some tough choices in 2006 as to how they allocate their money.
Are we going to see a total bust in consumer spending in the months ahead? No. But clearly something has to give. We believe consumer spending will be disappointing the first half of next year. Our forecast calls for personal consumption expenditures (PCE) to grow at a 2% annual rate in the first six months of 2006 and just under 3% rate in the second half. (In contrast, PCE has averaged a 3.4% increase a year in the last two decades.)
Business
With consumer spending depressed, could business capital expenditures at least grow enough to keep the economy out of any serious trouble? Yes, as long as there’s no sudden implosion of the housing market or a huge imbalance between business inventories and sales.
U.S. companies, flush with $2 trillion in cash reserves, will ratchet up their spending next year in two broad areas. First, money will flow toward post-hurricane reconstruction, such as rebuilding the energy and transportation infrastructures along the Gulf coast. Also driving expenditures in 2006 is the conviction among business leaders that to stay competitive and profitable in the global marketplace they will need to acquire more high-tech, energy-efficient equipment and machinery. By focusing on improving labor and capital productivity, the business sector will be in a better position to keep labor costs under control, hold production expenses down, and still retain both profitability and market share.
But there are some downside risks here too. Factories and wholesalers are now adding inventories on the assumption that consumer outlays will stay strong in 2006. If, as we expect, consumer demand will weaken, then there is the risk companies will end up with more inventories than they want. That could slow future output more severely in coming months. What we need to track at this stage is if the back side of the economy (manufacturing, for instance) ends up growing much faster than the front side of the economy (consumption). Should output greatly exceed demand, it’s a sign the business cycle is maturing and that a more serious economic slowdown, perhaps even recession, may be forthcoming.
Housing
After a spectacular four-year run, residential investment will moderate next year and pose a drag on growth. Higher mortgage rates and steeper home prices are beginning to chip away at demand. The traditional 30-fixed mortgage rate has been increasing for more than two months and we see it approaching 7% in 2006, the highest in more than four years. The inventory of unsold new homes has been climbing for well over a year and as of October stands at 496,000, the highest ever. Our forecasts have housing starts slipping to 1.8 million units in 2006, compared with an estimated 2.06 million in 2005. (Existing home sales, which represent 85% of all residential sales, will drop to 6.25 million units, from 7.1 million in 2005.) The decline in new home construction will have a palpable effect on the economy. Though it accounts for just 5% of GDP, when you add up all expenditures tied to housing (e.g. furniture, appliances and home electronics) plus the impact on construction employment, its influence is much larger. By our estimates, the slowdown in housing starts and overall home sales will reduce GDP growth by 0.5 percentage points next year.
Government spending
The economy will get some lift from increased government outlays to repair the damage done by Hurricanes Katrina and Rita and to pay for the war in Iraq and Afghanistan. Unfortunately, these expenses will come at a time when tax revenues are going to be depressed due to slower economic growth. Our forecast has the U.S. budget deficit widening to $385 billion this fiscal year, $66 billion more than the $319 billion shortfall seen in FY 2005.
As of this writing, the prospect for the budget gap to narrow anytime soon appears more remote than ever. Just when the U.S. faces major fiscal challenges with an unprecedented number of Americans soon eligible for retiree and federal health care benefits, the House and Senate are planning large tax cuts. If such legislation passes without offsetting reductions in spending, the twin budget and trade deficits could swell to a point where it will jeopardize the expansion through an accelerating of inflation, a plunging dollar, and higher market interest rates. The stakes are getting are pretty high. The U.S. cannot be expected to borrow from foreign lenders $2 million every minute of the year indefinitely.
WHAT MIGHT TRIGGER A RECESSION IN 2006?
Whether the economy stumbles into a recession depends on three factors.
- How much will consumers actually slash spending?
- How high will the federal funds rates go?
- Where are oil prices headed?
(1) As we stated above, the growing stress on household finances will cause a slowdown in expenditures, but it will not be enough by itself to trigger a contraction in overall growth.
(2) Our forecast calls for the federal funds rate to top off at
4.75%. To get there the Federal Reserve will raise rates a quarter point this week, then again in January and finally in March under the chairmanship of Ben Bernanke. Given what we know about current economic conditions, 4.75% appears to be the appropriate neutral rate. By definition, a neutral rate neither spurs nor restrains economic growth.
Figuring out where the neutral rate lies has turned into a parlor game of sorts. The problem is that the true neutral fed funds rate is something of a moving target because it is significantly influenced by the stimulus that stems from foreign capital inflows. In other words, globalization has not just brought us cheaper clothing and toys but also cheaper money. These foreign inflows have lowered interest rates in the U.S. and helped fuel housing and other forms of consumption. So the Fed is under pressure to raise short-term rates perhaps higher than otherwise would be the case to offset the simulative impact of foreign capital.
Indeed it is entirely possible that neutrality these days can be achieved only through an inverted yield curve, a situation where short-term rates exceed long term rates. Normally, an inverted yield curve spells trouble for an economy. Every recession in the past was preceded by an inverted curve.
Today, an inverted yield curve does not automatically mean the economy is in grave danger. The inversion has to be steeper than in the past before it seriously cuts into economic growth. By our estimate, if short term rates (say, 3-month
bills) exceed the yield on the 10-year Treasury note by 1.5 percentage points, the probability of recession in the next six months is about 35%. Should the negative spread rise to 2.5 points, the odds increase to 75%. A spread above 3 points, however, means we’re talking about 90% chance of a downturn.
But it is highly unlikely we’re even going to see a sustained inversion of the yield curve in 2006. First of all the economy will be slowing on its own as a result of weaker consumer spending and a softer housing market. That should keep the Fed from precipitously lifting short terms rates. In addition, we expect to see yields on longer maturity Treasuries creep higher in the months ahead.
Why do we see yields rise when the economy is shifting into lower gear?
A couple of reasons. As mentioned earlier, foreign investor appetite for US federal debt is diminishing. These investors bought just 14% of new 10-year notes auctioned so far in 2005, compared with 21% in 2004. Foreign portfolios are so saturated with dollar-denominated Treasury debt that investors have very discreetly been diversifying away from U.S. government securities and into U.S. stocks, other foreign currencies, and even gold.
Another factor pushing up rates is the perception in the bond market that Bernanke, the next Federal Reserve Chairman, will be less inclined to comment on Congressional proposals designed to narrow the deficit. This is a marked departure from Greenspan who, for instance, was a vocal advocate of reinstating "pay-go" rules, in which future tax cuts must be offset by an equivalent reduction in spending. Bernanke’s reticence to speak on these matters in front of Congress adds extra basis points to the 10-year note yield.
Third, though the US economy is expected to slow, global competition for industrial materials will remain high. The rise in commodity prices has caused the headline producer price index to climb at a 6.6% annual rate in 2005 so far, compared with 4.8% the same time a year ago. Now it’s true the rate of increase in core PPI (i.e., excluding food and energy) is much less. However, once the business cycle reaches a mature stage, headline inflation takes on greater meaning in the economy. Higher producer price inflation can become problematic at this point if it consistently rises much faster than productivity growth. The perception among bond investors that sustained increases in PPI might lead to greater retail price inflation down the road can undermine bond values.
Fourth, capacity utilization rates are approaching levels that have previously stoked higher inflation. Historically, when operating rates enter the 80% zone, production bottlenecks start to appear. While U.S. industry is operating at 79.5% of capacity right now, that’s higher than we thought it would be given that non-farm productivity is rising at its fastest pace in two years. One would expect the utilization rate would slip or remain stable when productivity is surging. But that doesn’t seem to be happening. Some economists dismiss the relevance of capacity utilization entirely because globalization has made the metric less meaningful. That may be true. However, the psychological impact of seeing utilization rates cross into the 80% range may nevertheless unnerve fixed income investors.
Finally, our forecast calls for the dollar to resume its fall in 2006. A weakened greenback is always a concern to bond investors because of the potential to import inflation. Rising interest rates in Europe and the likelihood that the Japanese central bank will finally tighten monetary policy in 2006 should accelerate investor interest in the euro and yen. Also depressing the dollar is the deepening hole in America’s external account. The current account deficit is seen to reach $900 billion in 2006, more than 7% of the GDP, and we have no reason to think a turnaround is in the offing. With foreigners already holding more than 54% of U.S. marketable Treasury debt (up from 6% in 1968, 19% by the end of Reagan’s term, and 34% in 2000), one has to wonder how much longer they are willing to finance all that consumption in the U.S.?
(3) The outlook for oil prices
We are not in the camp that believes oil will drop back down into the $40s range next year. In fact, our forecast calls for crude to test its previous high of $70 again.
The return to higher oil prices is due to the global mismatch in the supply and demand for oil. In less than 10 years, the price of crude has jumped from $10 a barrel to more than $70. This tells you that, unlike most commodities, oil is not particularly vulnerable to the business cycle. The leap in prices can be attributed to several factors. We have seen explosive demand from Asia, specifically China and India. These two countries are home to 2.5 billion people and their thirst for energy just keeps soaring. Two quick factoids help illustrate the point: Between 1993 and 2004, the number of motorcycles in China grew from 15 million to 100 million and the number of passenger cars jumped from 700,000 to 7 million! As impressive as these stats are, keep in mind that India’s population is expected to exceed China’s by 2020 and possess even more disposable personal income. These two giant consumers of energy will feverishly compete not just with each other but with the U.S., Japan and Europe for scarce energy supplies. All that global demand will prevent prices from falling below $50 for any lengthy period. Only a worldwide economic depression or a major technological breakthrough in energy production will do that. Meanwhile the world’s hunger for crude will accelerate and push prices ever higher.
Another factor driving crude prices is that recoverable reserves are just not growing fast enough to make up for what is taken out of the ground.
Oil today provides 40 percent of the world’s energy demand; it is the single largest source of fuel. Ideally, producers hope to replace each barrel of oil extracted with a barrel of new proven reserves. But that’s not happening. The problem is not because the world is running out of oil. There’s plenty of crude in the ground in Russia and in the Persian Gulf region. It is simply more difficult to locate new reserves and pump the oil out without the latest hi-tech exploration and drilling equipment. Unfortunately, many emerging countries are uncomfortable bringing in Western partners who can supply this technology.
On top of the demand/supply imbalance, add another $10 to $20 a barrel to crude as a premium to reflect the additional geopolitical risks associated with oil. Most of today’s production and reserves are located in the most politically volatile areas of the world. The Persian Gulf/Middle East region is rife with turmoil. Venezuela faces a crisis between the government and foreign oil companies operating there. Nigeria is often dealing with civil unrest and border disputes over oil. Russia’s crackdown on Yukos, the imprisonment of CEO Mikhail Khodorkovsky, and the aging infrastructure at other Russian oil companies raises questions whether the country will be a reliable supplier in the future. Given the tightness in supplies, any serious disruption in the flow of oil from these high-risk locations could push the price per barrel towards $100.
As for 2006, oil is expected to reach $65 a barrel by mid-year and $70 to $75 in the fourth quarter. In our analysis, a level above $75 for a sustained period (3 to 6 months) will place the U.S. economic expansion in jeopardy.
A look at inflation
Consumer price inflation will moderate in 2006. A slower economy, healthy productivity growth and aggressive cost cutting will work to contain inflationary pressures. Fierce global competition should also limit consumer price inflation. Companies have had only limited success passing costs on to consumers in the past. Moreover, with profit margins still high, there is little reason for firms to raise prices and risk antagonizing customers. The best news from an inflation standpoint is that U.S. labor costs have been declining for two consecutive quarters. The economy cannot generate higher core inflation on a sustained basis when labor costs are so well behaved.
The result: After climbing about 3.7% in 2005, the CPI should trend down to 2.9% in 2006. Looking at the Fed’s favorite inflation gauge, the core PCE (personal consumption expenditures, less food and energy) price index will remain ensconced in the 1.75% to 2% zone.
HOW HIGH WILL THE PRICE OF GOLD GO?
One question we keep getting is if inflation is so tame, why has the price of gold shot up to a 24-year high of more than $500. In our view, global investors today are looking at this precious metal with a different perspective. What’s influencing the demand for gold is not so much inflation worries, but a series of rather unique developments. First, foreigners (such as OPEC oil producers) are taking a serious look at what to do with the surplus of dollars they hold as a result of massive US current account deficits. Simply loading up their portfolios with even more dollar-denominated securities looks increasingly risky given how overweight they already are with these assets. But where else can they go? There is no other world reserve currency that has the depth, liquidity, and safety of the greenback.
Given their determination to gradually re-balance their portfolios away from dollars, foreigners are finding gold to be a suitable monetary reserve asset. It serves as an attractive long-term inflation and currency hedge, especially when there is shrinking gold supplies from mines.
Another reason for gold’s rising popularity is because millions of citizens in India and China enter the middle class every year. They possess more disposable personal income and this has driven up the demand for jewelry. In India alone, consumer demand for gold rose 55% in the first half of 2005. About 75% of world gold consumption is for jewelry.
A third factor buoying gold prices is that more people have subscribed to the strategy of crises investing (or, as some label it, apocalypse investing). Gold, which bottomed in 1999, has been on a tear since the 9/11 terrorist attacks. Many investors feel a palpable unease these days as they listen to constant reports of suicide bombers, the potential of a bird flu pandemic, the acquisition of nuclear technology by countries that support terrorism, and the mess in Iraq. In short, the world appears more vulnerable than ever to the kind of geopolitical shocks that can result in major global consequences. Such thinking has led a growing number of investors to consider gold more seriously as a permanent asset class for their portfolio. As a result, we believe gold is headed higher and may reach $650 an ounce in 2006.
THE INTERNATIONAL OUTLOOK
India
Looking ahead, we still favor India over China as a place for investment. China has chosen to focus largely on specializing in manufacturing goods, which in the final analysis is a commodities business. India, in contrast, has taken the smarter route and used its comparative advantage as an English speaking country and low cost labor, to set up a massive service sector economy. Its service industry has taken off and now constitutes over half of India’s $700 billion economy.
What’s especially impressive is how the country built up its information technology field and the way that has boosted wages. Service sector pay has surged by as much as 25% a year in some areas of the country, significantly lifting disposable personal income.
Also, keep in mind that China has been beset with social unrest this past year and continues to be run by an autocratic Communist leadership. In contrast, India is far more stable and has a 50-year tradition as a democracy. Though India’s population at 1.1 billion comes in second to China, the latter’s long-standing one-child policy means that within a decade or so, India will have an even larger and more youthful population than its neighbor. India’s economy expanded about 7% in 2005, and it will probably grow 9% in 2006 because of stronger output in both the service and agricultural sectors.
Brazil
Latin America’s largest economy grew an estimated 2.8% in 2005 after surging 4.9% in 2004, which was the fastest pace in a decade. The latest slowdown will turn out to be temporary. Economic growth should rebound to at least 4% in 2006.
Brazil has been taking all the right steps to get its financial house in order. Standard " Poors and Moody’s both raised the country’s credit rating in 2005 and that will allow Brazil to borrow from the global capital markets at a lower cost. Two years of relatively strong economic growth and healthy exports have substantially increased its foreign reserve holdings, widened its trade surplus and narrowed the country’s budget deficit. Brazil’s has also smartly restructured its debt to reduce reliance on bonds that are subject to floating rates.
While its benchmark short-term interest rate currently stands among the highest in the world at 18.5%, at least it demonstrates the country’s commitment to keep a lid on inflation. Interest rates should come down in 2006, which is one of the reasons we believe the economy will accelerate.
Brazil has been consumed by the worst high-level government corruption scandal in its history this past year, but it appears President Lula himself has not been lethally tainted. News of the scandal did hurt Lula’s popularity early on, however his approval ratings have since stabilized. Lula, who took office in January 2003, is expected to win re-election in October 2006. We continue to like Brazil because it has successfully adopted smart, free market policies that include a tight rein on spending and a firm stance on fighting inflation.
Japan
Is the country finally back? Yes, we believe so. Japan’s economy has now grown for the fourth year in a role, the longest spell since 1997. In the first half of 2005 it grew at the fastest pace in a decade, and then put in another strong performance in the third quarter. Most gratifying is that contributing to this activity isn’t just exports but also domestic demand. We see evidence that consumer spending is fueling the economy in a way not seen in ten years. Furthermore, wages and salaries are rising and unemployment stands at a seven-year low. We expect to see the economy remain well balanced in 2006 with domestic demand continuing to play an important driver of economic growth. Since consumer spending makes up more than half of Japan’s economy, we expect overall GDP growth in Japan to reach 2.3% in the fiscal year ending in March, and 2.6% growth in FY 2006.
Stronger growth and positive core-inflation numbers will prompt Japan’s central bank to abandon its four year policy of near zero short term interest rates and begin to tighten again. With the country’s seven-year bout of deflation over, the JCB will likely begin to raise rates during the first half of 2006.
More trouble ahead for Europe Europe
What’s with these guys?
Just before European Central Bank officials raised the benchmark short-term rate for the first time in five years on December 1st, they tried to lay the intellectual groundwork for the move. The ECB cited worries that faster economic growth was increasing the risk of inflation and that it was time to tighten monetary conditions to prevent that. The central bank then raised rates from 2% to 2.25%.
What red flags prompted the ECB to act? Apparently this:
Consumer price inflation has been roaring at an absolutely unacceptable 2.2% clip in 2005, way out line out of line with the ECB’s own 2% cap. Also worrisome for Europe’s central bankers was economic growth had been racing along at a blistering 1.5% pace.
It’s hard not to be facetious here. In effect, the ECB has decided that full employment in the euro zone is a jobless rate of around 8.5%, and that maximum trend growth for the
region is no greater than 2%! How pathetic is that? By
contrast full employment in the U.S. is 4% to 4.5%% and the economy’s long-term growth trend is close to 4%.
Was the ECB’s move really necessary? Not in our onion.
Europe is being buffeted by massive joblessness, anemic wage growth, high oil prices, social upheaval, and a lack of strong political leadership. If the ECB’s latest move turns out to be just the first in a series of rate hikes, it will terminate the euro zone’s barely noticeable economic pulse and perhaps trigger more riots. The fact is Europe has had several episodes of aborted recovery in the past and the ECB should have waited longer make sure this recovery takes hold. With both fiscal and monetary policy now set to tighten in 2006, our forecast has GDP growth in Europe increasing at a supersonic 1.5% in 2006, the same as 2005.
WHAT ARE THE GREATEST RISKS TO THE WORLD ECONOMY IN 2006?
Iran
Without question, the single greatest threat to economic and political stability in the world is Iran’s pursuit of nuclear weapons. Teheran denies any such intent, of course, and argues that its nuclear research is for peaceful purposes. However there is now unanimity among Western intelligence agencies (which is rare these days) that Iran’s underlying plan is to be a nuclear military power. The country has also been refining its next generation of Shahab missiles, which can carry a nuclear warhead. What all this means is that Iran, a state sponsor of terrorism with ties to Hezbollah, the Taliban, and Al Qaeda, will shortly have an intermediate range missile capable of dropping a nuclear bomb with a reach that extends from Tel-Aviv and Riyadh all the way to Berlin, Rome and even Paris. Making matters even worse, Russia has recently agreed to sell Iran 29 sophisticated anti-aircraft missiles. These missiles are tough to locate and track for the West because they are placed on mobile vehicles.
The big question is how close is Iran to actually possessing a nuclear weapon? There is some debate on this because of the country’s propensity to build covert underground sites for its fuel enrichment cycle. But the most disturbing assessment came in the last few days from International Atomic Energy Agency chief Muhammad El Baradei, who noted that Iran is only "months away" from having nuclear bombs once it reopens its huge underground Natanz nuclear facility. Though it would take about a year for the Natanz plant to come on line once the decision is made to activate it, the disturbing fact is a nuclear weapon is now within reach for Iran.
There is thus a foreboding sense that a major, high-stakes, confrontation with Iran is all but inevitable, one that could quickly engulf other countries in the region. A nuclearized Iran with a record of secretly aiding terrorists poses a terrible danger not to just to the Middle East but to the world. So far, all diplomatic efforts to halt Iran’s pursuit of nuclear activities have failed. Israel knows it cannot afford to sit back and wait indefinitely in the hope that international pressure might some day prevail. Remember, Iran has never been shy about its determination to destroy Israel, a point made clear recently when Iranian President Mahmoud Ahmadinejad suggested the Holocaust never occurred and called for the Jewish state to be "wiped off the face of the map."
Prime Minister Ariel Sharon has already said that Israel would never allow Iran to come into possession of nuclear weapons. As a result, an Israeli strike against Iran’s most advanced nuclear facilities is increasingly probable. The U.S. could also be involved in such military action, though it presently has its hands full with Iraq and Afghanistan. Even Europe may feel justified in joining some military campaign against Iran.
Of course, all these scenarios come with many major uncertainties. How will Russia and China respond? How might oil prices behave when OPEC’s second biggest producer comes under attack? Will such military action further radicalize Muslims around the world?
Clearly, time is running out. How Iran’s nuclear program gets resolved in the year ahead will have huge implications for world order.
U.S. external debt
We’ve touched on this subject earlier but it bears repeating.
With so much of the U.S. budget and trade deficits financed by foreign lenders, any loss in confidence in the U.S. economy or in the federal government’s ability to pay interest to holders of Treasury securities (regardless of whether its to foreign creditors or to the Social Security Trust Fund) can lead to a catastrophic fall in the value of the U.S. currency. So far, the U.S. has been able to maintain that absolute confidence. But it may not last indefinitely, not with an embattled Presidency, a sharply divided Congress, a messy war, and looming entitlement liabilities. If Washington does nothing to halt the deterioration in the government’s balance sheets, a crack in confidence is inexorable and the consequences for the dollar and the U.S. economy could be major.
The mess in Iraq
There is growing disillusionment with the war in Iraq. So much so that President Bush is now in a serious bind. Unless the U.S. makes tangible progress very soon towards establishing a viable and secure democratic government in Iraq, Bush’s approval rating will stay at record low levels and it could fracture the unity of the Republican Party. On the other hand, if U.S. troops leave before that job is done and the insurgents continue to wreak havoc in Iraq, it will reinforce the view that the U.S. cannot fight and win unconventional war. That perception could embolden Islamic militants to target other U.S.-friendly countries in the area, including Jordan, Saudi Arabia, and Kuwait. Therefore how the war in Iraq evolves in the next twelve months could have a profound impact on U.S. foreign policy, oil production and prices.
China
Relations with China could take a turn for the worse in 2006. One area of special concern is its massive effort to beef up naval military power. China needs increasing amounts of oil and gas to feed its double-digit growth economy. It cannot rely solely on domestic production because the country doesn’t produce enough. Nor does it want to be overly dependant on the vagaries of the global oil marketplace. So China’s main national security objective at this time is to lock up sources of energy for the future. One way it has chosen to accomplish this is to establish naval dominance in the western Pacific and Indian Oceans. Doing so allows China to control vital sea lanes in the region and to make a grab for offshore oil and gas deposits. China spent an estimated $90 billion in defense in 2005, the third highest behind the United States and Russia. That has got to make Japan, Indonesia, Australia and India increasingly uneasy.
Another issue is whether President Bush’s weakened political status will make China’s leaders less inclined to cooperate with the U.S. over North Korea or in resolving U.S.-Chinese trade and foreign exchange disputes. Given Bush’s lack of approval ratings and his lame duck status, Beijing may chose to negotiate on substantive issues more seriously with the next U.S. president.
In any event, one confrontation seems just about certain. The stage is to set for another battle between Congress and China over the Renminbi’s artificially low value. Though China did reset its value last July, the currency has risen just 0.4% against the dollar since then. Key members of Congress are demanding that China allow the Renminbi to appreciate much more, or risk the imposition of tariffs on its goods as well as other penalties. Our sense is that 2006 will prove to be a particularly difficult year for U.S.-Chinese relations.
========================================================== THE ECONOMIC OUTLOOK GROUP FORECAST SUMMARY - Baseline projection REAL GDP (quarterly, annualized - and yearly) 2005 1Q = 3.8% 2Q = 3.3% 3Q = 4.3% 4Q = 3.3% (forecast) 2006 1Q = 2.5% 2Q = 2.5% 3Q = 3.0% 4Q = 3.1% 2003 = 2.7% 2004 = 4.2% 2005 = 3.7% (forecast) 2006 = 2.8% (forecast) PERSONAL CONSUMPTION EXPENDITURES (quarterly, annualized – and yearly) 2005 1Q = 3.5% 2Q = 3.4% 3Q = 4.2% 4Q = 2.0% (forecast) 2006 1Q = 1.4% 2Q = 2.5% 3Q = 2.9% 4Q = 3.0% 2003 = 2.9% 2004 = 3.9% 2005 = 3.3% (forecast) 2006 = 2.5% (forecast) INFLATION FORECAST ( CPI , % change from year ago, and yearly ) 2005 1Q = 3.1% 2Q = 3.4% 3Q = 4.7% 4Q = 3.6% (forecast) 2006 1Q = 3.1% 2Q = 3.0% 3Q = 2.9% 4Q = 2.9% 2003 = 2.3% 2004 = 2.7% 2005 = 3.7% (forecast) 2006 = 2.9% (forecast) UNEMPLOYMENT RATE (End of period) 2005 1Q = 5.2% 2Q = 5.0% 3Q = 5.1% 4Q = 5.2% (forecast) 2006 1Q = 5.3% 2Q = 5.4% 3Q = 5.3% 4Q = 5.1% (forecast) 2003 = 6.0% 2004 = 5.4% 2005 = 5.1% (forecast) 2006 = 5.3% (forecast) NON-FARM PAYROLLS ( Monthly average) 2005 1Q = 182,000 2Q = 198,000 3Q = 147,000 4Q = 137,000 (forecast) 2006 1Q = 130,000 2Q = 140.000 3Q = 175,000 4Q = 165,000 2003 = 7,800 2004 = 184,000 2005 = 166,000 (forecast) 2006 = 153,000 (forecast) FED FUNDS FORECAST (End of period) 2005 1Q = 2.75% 2Q = 3.25% 3Q = 3.75% 4Q = 4.25% (forecast) 2006 1Q = 4.75% 2Q = 4.75% 3Q = 4.75% 4Q = 4.75% TREASURY 10-YEAR NOTE YIELDS (end of period) 2005 1Q = 4.48% 2Q = 4.00% 3Q = 4.30% 4Q = 4.55% (forecast) 2006 1Q = 4.60% 2Q = 4.65% 3Q = 4.80% 4Q = 5.10% CURRENCY FORECAST (U.S. Dollar vs.) 2005 End-Year USD/Yen = 119 Euro/USD = $1.17 2006 Mid-Year USD/Yen = 113 Euro/USD = $1.20 End- Year USD/Yen = 107 Euro/USD = $1.26 OIL (NYME NEAR-MONTH FUTURES) End 2005 = $60 Mid 2006 = $65 End 2006 = $70 MAJOR U.S. STOCK INDEX FORECASTS End of 2005 DJIA = 10,945 S"P 500 = 1294 NASDAQ = 2310 End of 2006 DJIA = 11,760 S"P 500 = 1405 NASDAQ = 2550 ==========================================================
THE ECONOMIC OUTLOOK GROUP, L.L.C.
is a consulting firm that evaluates global economic trends and risks. It also conducts on-site corporate seminars on how to locate and analyze key economic indicators for executives who want to stay ahead of the business curve.
Bernard Baumohl is the author of "The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities" (Wharton School Publishing,)
THE ECONOMIC OUTLOOK GROUP, L.L.C.
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