The world does not build American houses. That should be its economic saving grace in 2007. The soft-landing consensus in the U.S. looks too optimistic, but stirring domestic demand and enhanced policy flexibility elsewhere are likely to cushion the blow to global growth.
The U.S. economy is already slowing noticeably. On a year-over-year basis, real economic growth slowed to 3% in the third quarter of 2006–the lowest since early 2003. And it's likely to get worse. At this point, the primary drag is coming from the direct effects of the burst housing bubble. A year ago, resale home prices were rising at a 17% annual rate; they're now falling at a 3% rate, the worst result in at least 38 years. If home prices are falling, why build more houses? Indeed, they're not being built: housing starts are down 34% from their peak. That decline has already taken half a point off total U.S. GDP. With product still in the pipeline and inventories of unsold homes at all-time highs, anticipate further declines in the market.
For the U.S. soft-landing scenario to be correct, the impact of housing on the economy must be limited to this ongoing correction in construction. But the chances of it remaining so limited look slim. A broader dampening impact on consumer spending can be expected via two primary channels. First, the prior run-up in house prices allowed consumers to amass record debts and spend more than they earned, reflected in a negative savings rate. Households now need to repair their balance sheets, curbing spending to (probably at worst) match their means. Second, there are still about half a million more Americans employed in residential construction than at the outset of the building boom in 2003. Those jobs will very likely be lost, plausibly tipping over an already sluggish labour market, and implying that consumers' underlying means will be under pressure. Less income, along with less willingness to part with that income, means less spending by the 70% of the U.S. economy that is the consumer. That's where the bumpier landing will come from. We're not expecting a recession in the United States, but the 1.7% real GDP growth we're forecasting for the new year may make it feel like one, especially when laid against the boom of the past four years.
But again: the world does not build American houses, so it will be spared a direct hit from imploding residential investment. On the other hand, the world does sell to American consumers, and their prospective weakness presents a big challenge to global growth.
However , it is a challenge that most countries and regions seem better positioned to deal with than at any point over the past decade or more. It is telling that in the same week we learned that the U.S. manufacturing ISM (a critical cyclical indicator) fell into contractionary territory for the first time in more than three years we also saw Japan's Tankan and Germany's Ifo (the countries' primary economic sentiment surveys) each hit 15-year highs. Japan and Germany remain the second- and third-largest national economies in the world, and after years of torpor both are showing clear signs of recovery in household spending and business investment. Faster-growing demand in these regional heavyweights should help replace lost U.S. demand for their emerging-economy neighbours in Asia and Europe.
For developing countries more generally, broad structural improvements of recent years should importantly offset any cyclical pressures on growth. Government balance-sheet and cash-flow positions in emerging economies have improved, leading to widespread sovereign debt rating upgrades. Macroeconomic policy has generally become more transparent, partly due to the availability of better and more timely data. Greater currency flexibility, in conjunction with more disciplined macro policy, has reduced the risk of the sort of financial crises that so bedeviled emerging markets through much of the 1980s and 1990s.
Pulling this all together, we expect global growth, excluding the United States, to come in at 5.3% in 2007, not far off 2006's generational best of 5.8%. Including the U.S. drags the global forecast down to 4.5%, the lowest in four years, but still above the 20-year average. Slower, but not slow.
Though the world economy is likely to take a bit of a hit in the new year as the growth baton is passed from the United States to the rest of the world, the trend should actually be seen as a positive for growth further out. The global economy has been unbalanced for years, summarized in the emergence of a massive U.S. current account deficit. Disorderly rebalancing, perhaps via a run on the dollar, has long been a primary risk. The expected rotation in growth will contribute to a more orderly solution, as the weaker U.S. economy will naturally import less, even as it sells more to a stronger rest of the world.
I am not saying that the outlook is without significant risk, only that the primary sources of risk appear to be shifting. While there are a number of developments that could plausibly derail a relatively sanguine global view, what I'm most worried about is, well, the general lack of worry out there.
The combination of strong growth, solid policy, ample liquidity and the relative absence of accidents has dampened volatility in global financial markets, leading to wafer-thin risk premiums in all asset classes. With the price of risk down, hedge funds have taken on more risk to achieve the sorts of returns that keep them in business. Of course, higher leverage is fine–until it isn't. And if it becomes a problem across this increasingly important investor class, it becomes a problem for the financial and real economies of the world.
History teaches that stability can breed instability via complacency and overreach. Let us hope that lesson does not have to be learned again in 2007.
David Wolf is head of Canadian economics and chief strategist at Merrill Lynch Canada in Toronto