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WAITING FOR THE ASIAN TSUNAMI
Prepared by
The Northern Trust Company
A series of economic seismic shocks has occurred throughout Asia starting this past summer. After an earthquake has taken place on the ocean floor, a tidal wave is sometimes generated. Tsunami is the Japanese word for this tidal wave. In the U.S., we are waiting for the tsunami from the Asian economic shocks to hit our shores. Already we are getting sketchy reports of “wave damage” from some U.S. corporations with substantial business in Asia, such as Oracle and Boeing. But official government damage estimates have yet to be filed. We know the economic tsunami is coming, we just don't know how big and damaging it will be.
The initial damage to the U.S. economy will be a slowdown in export growth. We estimate that exports will account for about 13% of U.S. real GDP in 1997 and will have grown, on an annual average basis, about 12¼% this year. About 30% of nominal U.S. exports of goods end up in Asia. But Asia may not be the only source for weaker U.S. exports in 1998. One of our fastest growing export markets in recent years has been Latin America. Some economies in that region are expected to experience slower growth next year. One of these, and one of the largest economies in Latin America, is that of Brazil. Because of a new fiscal austerity plan that has been introduced, the Brazilian economy is expected to grow little, if at all in 1998. Our fourth largest single-country export customer is the UK. The British economy has been the envy of Europe in recent years (Maggie Thatcher's legacy?). But with the Bank of England trying out its newly-acquired independence, UK economic growth is anticipated to slow in 1998 as a result of aggressive monetary policy tightening in 1997. So, taking Asia, Latin America, and the UK into consideration, U.S. export growth in 1998 is likely to slow substantially.
The economic damage doesn't stop with exports, however. Weaker exports will trigger smaller tsunamis. The slowdown in U.S. production from the weaker export sector implies slower employment and personal income growth. This will result in slower personal consumption growth. Corporate profit growth will be moderated through various channels. Most obviously, those U.S. corporations that export a lot to Asia, Latin America, and the UK will see their profit growth slow. Those corporations that generate profits in Asia will be penalized when those foreign-generated profits are translated back into U.S. Dollars because of the sharp depreciations of many Asian currencies. Corporate profit growth would likely be moderated by the above-mentioned slowing in U.S. consumption spending. Slower growth in U.S. corporate profits in 1998 is likely to result in slower growth in corporate capital spending as well. Business fixed investment spending has been a key driver of U.S. economic growth in recent years.
There are some offsets, however. Personal taxes are being cut in 1998. This could provide some lift to consumer spending. The Asian tsunami and its secondary waves will accomplish what the Fed was preparing to accomplish via a tighter monetary policy. We now anticipate that the Fed will hold the funds rate steady at 5½% for an extended period of time. This implies that the entire interest rate structure also will remain at its relatively low level current level for an extended period of time. The low interest rate structure should be a plus for the residential real estate sector–construction, sales commissions, and furniture purchases.
Inflation is expected to remain benign in 1998. Industrial commodity prices have plummeted on expectations that Asian demand will be sagging. OPEC has authorized an increase in its production ceiling. Higher production in the face of slower Asian demand should hold down energy prices in 1998. The sharp appreciation of the U.S. Dollar versus a number of Asian currencies should keep the trend of declining import prices intact. So, will the U.S. experience consumer price deflation in 1998? We think that the odds are against this because of continued price increases for consumer services. Services account for 57% of the total CPI. Core services–services excluding energy services–account for almost 70% of the core CPI. Shelter rental costs–apartment rents, hotel room rental rates, and implicit rents on owner- occupied houses–account for about 28% of the total CPI and about 36% of the core CPI. The appreciation of the dollar in the foreign exchange market will not hold down these shelter rental costs because housing is not an internationally-traded service. If, as we expect, the demand for housing is stimulated by the low interest rate structure, then shelter rental costs could be on the rise in 1998. Most other consumer services also are not traded to a large extent internationally. Therefore, the service sector prices will be held down only marginally by the stronger dollar. But because the service sector is labor intensive by its very nature, and because we expect labor markets to remain tight in 1998, human capital capacity constraints could boost service sector inflation next year. Anecdotal reports are that medical costs will rise at a faster pace in 1998, too.
As mentioned above, we expect the Fed to maintain its current funds rate target of 5½% for an extended period of time. The Fed wanted a slowdown in economic activity in order to alleviate building inflationary pressures, and now it looks as though the Fed is going to get its wish. Early in October, the fixed-income markets were pricing in a November Fed tightening, and perhaps additional tightening in 1998. After the Asian turmoil, expectations of Fed tightening have been removed from the interest rate structure. The recent events in Asia clearly work in the direction of holding down U.S. inflation. As investors are coming to believe that low inflation is here to stay, a relatively high inflation premium in longer maturity U.S. bond yields is being reduced. This lowering of inflation expectations would be reinforced by the slower pace of U.S. economic activity that we are forecasting.
Although there is little doubt that the Asian upheaval will negatively affect U.S. economic growth, there still is considerable doubt as to when and by how much. And therein lies the basis for continued volatility in the fixed-income markets. If there is not evidence of a U.S. economic slowdown early in the first quarter, then we could see a temporary back-up in bond yields as investors begin to raise the odds again of some Fed tightening. Slowdown or not, unit labor cost growth is likely to start accelerating as faster labor compensation growth is not matched by productivity growth. If the economic activity is not showing evidence of significant slowing in the face of rising unit labor costs, the Fed will start contemplating a tightening move again. So, it could be a race between how quickly the economy slows and how quickly unit labor cost growth accelerates.
On the other side, if the Asian tsunami hits our shores quickly and it produces a rapid response in terms of weaker consumption and capital spending, then we could be looking at a very sharp deceleration in U.S. economic growth in the first half of 1998. Regardless of rising unit labor costs, the Fed would start to contemplate some easing of policy.
We, here, are splitting the extremes. We believe that the Asian tsunami will hit the U.S. economy in the first half of 1998, and it will not be a glancing blow. But because the U.S. economy has a lot of forward momentum from domestic demand, the Asian blow will only slow us down, not drown us. This scenario suggests that the economic and inflation data will not show much trend month to month. This suggests a lot of debt market volatility as sentiment changes rapidly. If our middle-of-the-road economic forecast is close to the mark, then the Fed will hold the funds rate at 5½% for the year, and other interest rates along the yield curve in 1998, on average, are likely to be around current levels.
December 12, 1997 Paul L. Kasriel and Asha G. Bangalore
The Northern Trust Company
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