The U.S. economy is slowing. The evidence has been clearest in the housing market, where boom is rapidly turning to bust nationwide home prices are now falling on an annual basis, housing starts and sales are down 10% to 30% from their cyclical peaks, and there are over a million more homes than a year ago standing unsold on the market. Given the importance of the housing boom to U.S. household spending and confidence in recent years, we must expect that the economic impact of the now-busting market will be far broader than just a bit less building and a few out-of-work real estate agents. Consumer spending is likely to weaken noticeably. And with the consumer accounting for 70% of gross domestic product, so goes the U.S. consumer, so goes the U.S. economy.
And so goes the global economy? Some think so. They argue that the exceptional growth we've seen in other parts of the world, notably emerging stars like China, ultimately traces back to the willingness of U.S. consumers to keep their wallets open. As U.S. demand weakens, the argument goes, those economies that have largely grown by satisfying that demand will start falling like dominoes. At the other end of the spectrum, some argue that growth in emerging markets has actually been far less levered to the U.S. than commonly thought. Coupled with recoveries in other rich countries like Japan and Germany, they say, stronger growth in the rest of the world can in fact compensate for U.S. weakness, keeping the global economy robust. Smart, thoughtful analysts can be found at either end of this spectrum, and at each point in-between.
The fate of the global economy is obviously important to the lives of billions. But it is important on far narrower bases, too. Canadian equity investors have been beaten up lately by lower prices for commodities and the companies that produce them; the weaker the global economy gets, the more raw-material demand will soften and the greater the pressure we can expect on Canadian stocks ahead. Our federal government is no doubt watching anxiously, too. The upside revenue surprises that have allowed the tax cuts, higher spending and healthy surpluses of recent years have likely had more to do with global economic (and commodity price) strength than anything specifically Canadian; the more world growth weakens, the more the budget will be squeezed and the more difficult the policy choices will become.
Analyzing what happens to the world economy amid a U.S. slowdown is tricky. First, we can't be sure how much the U.S. will weaken. Second, we can't be sure how much growth in other countries has been levered to U.S. growth. And third this is the trickiest one we have to figure out how those individual economy responses will themselves interact in an increasingly intertwined world, and indeed reflect back on the U.S. itself. It obviously doesn't do to say that China will be OK because Japan is OK, and that Japan will be OK because China is OK. We have to judge how they and the other 170-odd economies in the world will jointly respond to the likely loss of the U.S. consumer ahead.
Merrill Lynch did that in a special publication released in September entitled Global slowdown, local strength: Sources of demand in 2007 a collaborative effort among economists globally, who cover 50 countries accounting for more than 90% of world GDP. Our conclusions, as one might expect, were somewhere in-between the extremes. The global economy is likely to slow in 2007. Realistically, it could hardly be otherwise, given that the U.S. accounts for 20% of global output, and that the other 80% has doubtless been driven at least somewhat by U.S. spending. But we do expect resiliency in much of the rest of the world. While the cushions of course vary by country, two stand out across most regions we looked at greater policy flexibility and momentum in independent domestic demand. Thus, in an environment where we expect U.S. growth to nearly halve from 3.3% to 1.8% in 2007, we see only a moderate slowdown in global growth from 5.2% to 4.4%. Call that weaker but not weak below each of the past three years but well above the quarter-century average. Whether that's strong enough to satisfy the bulls out there, however, remains to be seen.