Don’t Look Up Too Long
The economic upsurge is almost over.

Mr. Malpass is the Chief International Economist for Bear Stearns.
January 8, 2002, 8:00 a.m.

Remember, the global recession was bowl-shaped, not V-shaped, and on the way down — in fact, the U.S. started down in August 2000 under the weight of expensive oil, high tax rates, and tight money. There are no apparent reasons for a sudden change to a V on the way back up.

Recent economic data has indeed been positive. The December U.S. Purchasing Managers' Index, at 48.2%, was less weak than expected. Consumer confidence rose to 93.7% in December. New home sales rose to a 934,000 annual rate in November, in part helped by good weather. And U.S. vehicle sales were very strong in the fourth quarter.

The U.S. monetary base has also been growing at a relatively strong 8%-9% annual rate. One interpretation is that this will stimulate economic growth. But it's tough to see how. The increase in supply is barely keeping up with the rising global demand for dollars. This leaves no new liquidity in the economy. With interest rates very low, there is almost no "opportunity cost" to holding cash, so the monetary base should be expected to grow more rapidly than usual. Meanwhile, gold and commodity prices have not shown any strength, a sharp distinction from the successful July 1982 monetary stimulus that launched the bull market.

Brace Yourself
It's difficult to forecast a sharp and sustained rebound (or a "Super-V" scenario, as supported by NRO Financial's Larry Kudlow) if one takes into account the strong headwinds facing the world economy in the first quarter:

Weakness in U.S. consumption. Personal income growth has been decidedly weak (a 0.1% decline each month since August). The number of people employed is shrinking rapidly. With the level of unemployment approaching 6%, one can expect consumption to fall, coming into better alignment with weak income and employment. U.S. consumption growth for the first quarters forecasts to minus 1.5%.

Deflation. The dollar appreciated 30% since 1996, putting strong downward pressure on prices. Some sectors have adjusted, such as commodities. Other sectors are still early in the adjustment phase, such as housing and services. Creditworthiness and the strength of corporate balance sheets will remain under pressure. Expect U.S. CPI inflation to fall to 0.8% year-over-year by June.

Costly Capital. Bond yields have moved to levels that are high enough to slow the economy. The BBB 10-year industrial bond index yields 6.9%, a very high real cost considering the low and falling inflation rate. The 10-year Treasury inflation-indexed bond now yields 3.5%, implying strong economic growth. But the bond market is overly optimistic about the outlook for U.S. and world growth. Expect bond yields to fall in the first half of 2002, with the 10-year government yield falling to 4.5% by June from 5.1% now.

Constrained Investment. Outside the U.S., capacity remains plentiful, suggesting a long restructuring phase before new investment plans begin. In the U.S., capacity utilization remains under 75%, with signs that downward pressure on prices will work against a strong rebound.

Weakness abroad. World nominal dollar GDP is in about the middle of its worst contraction since the Great Depression. Japan's recession is already deep, with serious negative repercussions for its financial system. Apart from China, much of the developing world is in or near recession.

Time shifting. Deep discounting pulled January sales into December. Massive interest-rate subsidies pulled first quarter 2002 auto sales into the fourth quarter of 2001. Around the world, September 11 delayed economic activity into October and November, causing the data to show an upsurge. U.S. vehicle sales fell to a 15.9 million annualized rate in September (the lowest since January 1999), then rose to a 21.3 million and 18 million rate in October and November. Expect weakness in the auto sector in the first half of 2002.

Inventory swing. The world hoarded money rather than goods through November 9, then reversed that flow when the U.S. made progress in Kabul (see "Seeing Bottom"). This caused a short upsurge in economic activity. For example, copper prices rose from $0.617 per pound on November 8 to a peak of $0.733 (a whopping 19% increase) on November 30, but have since settled below $0.66.

Friction. Rising costs for insurance and security may have caused a near-term increase in economic activity. But as an expensive new fixed cost, they subtract from the longer-term growth outlook.

In sum, the first half of this year will be relatively weak in terms of the overall economy and corporate earnings. First quarter GDP may decline 0.3% followed by modest 1.7% growth in the second quarter. An extended recession and sub-par recovery will be a disappointment for the equity market and a positive surprise for the bond market, which has priced in a sharp U.S. recovery.