Global Transitions
John Mauldin's Outside the Box

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Introduction

With a new year just weeks away, investors are weighing expectations and asking questions about what lies ahead. Each year presents its own set of opportunities and challenges, especially in are ever-increasing global economy. Today's "Outside the Box" features a letter by Stephen Roach on the impending transitions of this interconnected marketplace.

Stephen S. Roach is Managing Director and Chief Economist of Morgan Stanley, and is widely recognized as one of Wall Street's most influential economists. His published research has covered a broad range of topics, with recent emphasis on globalization, the emergence of China, productivity, and the capital market implications of global imbalances. In his letter "Global Transitions," Roach analyzes the sources of past growth amidst the backdrop of a global economy and highlights the forthcoming changes on where to expect it from next. In addition, he addresses the growing "consensus" of the soft-landing scenario for U.S. housing.

On a side note, Roach mentions a companion piece by his normally bullish colleague, Richard Berner. In "It's a 'Growth Recession,' Not a Lasting Downturn," Richard not only forecasts lower growth but also lower profits. To view the article, click here and then scroll down.

I hope these articles help to form your investment outlook from a global viewpoint...enjoy. For what it's worth, I will be on CNBC at 7:45 this Tuesday morning talking about hedge funds.

John Mauldin, Editor

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Global Transitions

By Stephen S. Roach | New York

After four years of the strongest growth since the early 1970s, the global economy is entering an important transition. The character of that transition is the subject of endless debate. Financial markets are currently priced for a Goldilocks-like soft landing -- a benign slowdown that tempers inflation and interest rate pressures. The risk, in my view, is that global growth could fall well short of consensus expectations -- with important implications for unsuspecting markets.

I suspect that our current baseline forecast offers only a hint of the coming transition in the global economy. While our projected 4.3% increase in world GDP for 2007 remains well above the 45-year growth trend of 3.7%, it falls significantly short of the 5.0% increase we currently estimate for 2006. The anticipated downshift is broad-based, with the US and Europe leading the way in the developed world and a slowing in Asia ex Japan -- especially China and India -- standing out in the developing world (see accompanying table). Our downwardly-revised US forecast reflects the repercussions of a post-housing-bubble shakeout, whereas the slowdown in Europe is expected to be driven by fiscal consolidation in Germany and Italy, along with the lagged impacts of ECB monetary tightening and a stronger euro. In an increasingly interdependent world, it also makes sense to mark down our growth forecasts in Asia, largely because it will be next to impossible for the region's export-dependent economies -- especially China -- to avoid the impacts of a slowing of end-market demand in the US and Europe.

Downshifts in the US and China should not be taken lightly. By our reckoning, these two economies have collectively accounted for over 60% of the cumulative growth in world GDP over the past five years -- including direct effects (43%) and the indirect effects traceable to trade linkages (at least another 20%). A key question for the global outlook, in my view, is not whether new sources of global growth have emerged on the scene -- the so-called decoupling thesis -- but whether we have gone far enough in marking down our forecasts for the US and China.

Our US team now concedes that America has lapsed into a temporary "growth recession" -- econo-speak for a growth rate that is sluggish enough to allow the unemployment rate to start rising again (see the 11 December dispatch by Richard Berner and David Greenlaw, "It's a 'Growth Recession,' Not a Lasting Downturn"). They are now looking for three quarters of just 2% annualized growth in real GDP over the 3Q06 to 1Q07 interval -- a downward revision of 0.6 percentage point from their previous forecast. This scenario has soft-landing written all over it -- a surgical strike on the housing market that leaves the rest of the US economy relatively unscathed. The growth recession is expected to be relatively short-lived, giving way to a projected 3.0% annualized rebound in real GDP in the final three quarters of 2007.

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In cutting their near-term growth forecast, *** and Dave concede that the risks remain on the downside. I couldn't agree more. The difference between us is that I would assign a higher probability to those risks than they do. I fear that the soft-landing crowd has been too quick to pounce on the first signs of softening as confirmation of the endgame to the current downturn. Experience teaches us to be wary of the lags in jumping to premature conclusions about the scope and duration of cyclical adjustments. Take the residential construction sector, for example. Employment in the residential building and specialty trade contractors industries, combined, has now declined by 110,000 from the February 2006 peak -- reversing only 15% of the cumulative run-up that occurred over the preceding five years. With housing starts already down 35% from their peak, it seems perfectly reasonable for employment in this sector to fall a good deal further -- a headcount reduction that would constrain overall labor income generation and put heightened pressure on personal consumption.

It's not just the nascent recession in homebuilding. Also at risk are the related businesses like furniture, appliances, mortgage finance, and real estate brokers. And, of course, there is the likely unwinding of the consumer wealth effect. Only asset-driven wealth effects can explain how a decade of frothy consumption growth (3.7% in real terms) has exceeded after-tax real income growth (3.2%) by an average of 0.5 percentage point per year. With the last bubble now bursting, I suspect that the wealth effect is about to turn negative for overly-indebted, saving-short US households -- dragging consumption growth below the pace of income generation as rational households abandon asset-based saving strategies and return to more of an income-based approach. As consumption slows, demand-driven capital spending should be quick to follow -- precisely the inference that can be taken from a weak capital goods report in October. The lesson of post-bubble shakeouts is important here: When a booming sector goes bust -- dot-com six years ago, housing today -- there are no built-in firewalls that contain the ripple effects. The US soft-landing scenario does not adequately allow for these risks, in my view.

Moreover, I am highly suspicious of the idea that the rest of the world is likely to be insulated from a US growth shortfall. China, the fourth-largest economy in the world, devotes an outsize 35% of its GDP to exports -- and the US is its biggest external market. In Japan, the second-largest economy, exports are 17% of GDP, and the US and China are its two largest customers. For Canada, the 8th-largest economy in the world, exports to the US account for fully 27% of its GDP. In Mexico, the world's 13th-largest economy, US exports make up 24% of its GDP. And these are just the direct effects. Supply-chain linkages throughout the world -- especially to Asian suppliers of the Chinese assembly line such as Korea, Taiwan, and Japan -- will compound the impacts of a demand shortfall in China's largest export market, the US. It would be one thing if the non-US world could draw incremental support from improving internal demand -- especially private consumption. But consumption shares are still falling in China, and a recent downward revision underscored a similar and very disappointing development in Japan. Moreover, European consumption is currently adding no more than one percentage point to pan-regional growth. With Asia and Europe lacking any vigor in their autonomous consumption dynamic, global decoupling seems all the more a stretch. That raises yet another important question mark for the global soft-landing scenario.

The China factor bears special mention -- not just because of the export linkages noted above but also because of some important developments on the internal demand front. The Chinese seem increasingly determined to cool off an overheated investment sector -- hardly surprising with fixed investment now nearing an unheard of 50% of GDP. A failure to bring an increasingly irrational capital allocation process under tighter control is a recipe for capacity overhangs and deflation. The Chinese are mindful of these very risks and are hard at work in shifting their growth focus. Reflecting the combined impacts of administrative controls and monetary tightening, there has been a discernible slowing in the growth of both industrial output and investment in the final months of 2006. I expect more of that to come in early 2007 -- sufficient to take Chinese real GDP growth down from the blistering 11.3% comparison of mid-2006 into the more sustainable 8-9% range by year-end 2007. Meanwhile, the Chinese are hard at work in laying the groundwork for a pro-consumption tilt to the growth dynamic -- consistent with the better balance that a higher-quality growth experience ultimately requires. For China, this could well mark a critical transition in its remarkable economic development -- with important implications for Asia, the broader global economy, and for what has been an increasingly China-centric dynamic at work on the demand side of major commodity markets.

The year ahead is not just about a looming transition in the global business cycle. It could also mark an important transition in the globalization debate. I suspect that the focus is likely to shift away from the brilliant successes of China and India toward an increasingly politicized pro-labor pushback from the rich countries of the developed world. The income shares of the major industrial economies are all at extremes -- record high returns to capital and record lows for labor shares. Courtesy of an increasingly powerful IT-enabled globalization that is now affecting both tradable manufacturing and once non-tradable services, job growth and real wages in the high-cost developed world remain under unusual pressure. That's great for corporate profits but very tough for real wages. A pro-labor shift in the political power base of the industrial economies -- already evident in the US, Germany, France, Italy, Spain, Japan, and possibly Australia -- could lead to a reversal of these trends. It opens up the possibility that the pendulum of economic power might well begin to swing from capital back to labor. Such a development, in conjunction with our forecast of a significant slowing in global GDP growth, implies a weaker-than-expected top line for global businesses. That could have profound consequences for the earnings cycle that continues to underpin ever-frothy world financial markets. Moreover, to the extent any pro-labor shift has protectionist overtones, it could also prove to be a stern test for globalization, itself.

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In looking to 2007, my main message is to be wary of extrapolation. After a powerful four-year boom, an important transition lies ahead for the world -- both on economic as well as on political terms. The consensus appears to be unprepared for the full extent of the transition that could well occur -- banking on the benign outcome of a soft landing in the US to be offset by accelerating growth elsewhere in a decoupled world. The official baseline forecast of the IMF is quite consistent with such a sanguine prognosis. It calls for a 4.9% increase in world GDP next year -- virtually identical to the 4.8% average gains over the 2003-06 period. The Morgan Stanley forecast of 4.3% global growth is already well below that consensus. As post-housing bubble adjustments begin to play out in the US, the lags of an interdependent and still unbalanced global economy are only just beginning to kick in. And a new group of politicians is only just beginning to take the reins of power. All this underscores the possibility that we may not have gone far enough in factoring in the downside risks to global growth in 2007. Transitions are never easy -- especially when juxtaposed against the complacency spawned by four fat years.

Conclusion

Your just thinking about the transition to Christmas analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.

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Posted 12-11-2006 4:32 PM by John Mauldin