Forty percent probability of global recession in 2005?

Is it possible? Morgan Stanley economist Steve Roach has got even more bearish. Just when you thought there was nothing else for him to get pessimistic about, he writes this in his latest weekly essay:

The delicate equilibrium in world financial markets may be starting to unravel. The dollar has broken out of its recent range, credit spreads are widening, equities are sagging, and riskless sovereign bonds are well bid. The message is worrisome: For an unbalanced and increasingly vulnerable world economy, the unrelenting rise of oil prices spells mounting risks of global recession in 2005.

... So far, the real side of the global economy has held up reasonably well in the face of this [oil] price spike, buying into the long-standing consensus forecast of a sharp and imminent reversal of oil prices. The longer that forecast turns out to wrong, the greater the threat to a complacent world. For this reason, alone, I continue to place a 40% probability on a global recession in 2005.

It's interesting to compare Steve Roach's views with those of PIMCO bond fund manager Bill Gross. Both are pessimistic about the economy. Gross has focused more on the risks of inflation combined with economic stagnation, while Roach has worried more about full-blown recession as the U.S budget and trade deficits are corrected.

The key area of agreement, however, is the dollar: Gross and Roach each expect it to fall significantly as foreign governments stop financing the current account deficit by buying Treasuries. With their two essays this week both commenting on the outlook for the dollar, perhaps analysts can now refer to the weak-dollar-prediction as The Gross-Roach Theory, or The Big Bug in the Global Economy Theory.

The key area of difference is the outlook for real interest rates. Bill Gross' view is that the Fed will not be able to risk raising real interest rates significantly because the U.S economy is too debt-laden. Roach, in contrast, writes that:

In my view, a weaker dollar would, instead, be more of a signaling mechanism — sparking a back-up in US real interest rates as foreign creditors demand compensation for taking currency risk. For an overly-indebted US economy, higher real interest rates would impair credit-sensitive domestic demand, boost national saving, and reduce America’s claim on external saving. These are the characteristics of a classic current-account adjustment.

While Gross and Roach are both bearish on economic growth, their disagreement about real interest rates leads to different investment conclusions. Gross believes that low, capped real interest rates could lead to higher inflation, so the best investment strategy is to buy TIPS which currently price-in low inflation and rising real interest rates. But if Roach's predictions are correct, TIPS would be a terrible investment. The falling dollar would force the Fed to raise real interest rates, U.S domestic demand would contract and the savings rate would rise, and a recession would probably lead to low inflation or even deflation. The combination of rising real interest rates and falling inflation would be the death-knell for TIPS.

Who should you bet on (assuming you accept their underlying bearishness)? It's your decision. But note that as the manager of the world's largest bond fund, Bill Gross has a lot more riding on this.

Links and article tools:
The full text of Roach's essay, titled Cracked Facade is here.

The full text of Bill Gross' November Investment Outlook is here; I consider its investment implications here.

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