Economic Outlook 2006

SMA 21st Annual Economic Forecast 2006 is my coverage of the SMA/Harvard Club annual confab featuring David Hale and Lyric Hughes-Hale

The Strategic Management Association and The Harvard Club jointly sponsored the Economic Forecast 2006 featuring David Hale and Lyric Hughes-Hale. David presented his encyclopedic knowledge and perspective on global economic trends, while Lyric shared her insights on China in Part II of the evening (she was the founder of China Online and has focused on China for several years.).

As usual, I present my notes, followed by my insights. Here are my notes from David’s presentation (Part I of the meeting).

Economic Forecast 2006

• Background:
  For the past 2-3 years, we have enjoyed a relatively benign economy globally. 2004 saw world economic growth of 5%, and we haven’t had a major financial crisis in the past 3-4 years. Developing countries have been doing quite well as commodities tend to be a large part of their economies, and U.S. and China prosperity and demand have pushed commodity prices high.
• Political risks:
  • International: Iraq is in chaos, and it’s difficult to see a resolution soon. Iran has had nuclear weapons ambitions for 40 years, beginning with the Shah. Of course, it is a major oil supplier, and with Iraq’s production disappointing and unlikely to improve soon, sanctions would be difficult. North Korea is a hermit kingdom that probably has three nuclear bombs. Taiwan’s independence movement is a threat currently, but the current president will probably lose power in 2008.
  • U.S. mid-term elections: due to well publicized corruption, Republicans have been discredited and risk losing their majority in Congress. Democrats have a huge advantage due to several corruption scandals. If they regain Congress, Democrats will certainly move to repeal many of the Bush economic initiatives such as tax cuts, capital gains, etc. This could mean a significant stock market plunge in 2007. Voters will have an unsavory choice between corrupt Republicans and incompetent Democrats.
  • Avian flu is a classic exogenous variable. If it becomes transmissible between humans, consequences could be grave. The SARS crisis completely stopped travel in Asia. It could seriously interrupt trade and destroy significant economic value in Asian companies.

• U.S. economy: relatively benign, but risks are there.
  • In the past 4-5 years, housing inflation has averaged 65% nationwide due to low inflation. This has caused homeowners to feel richer, and consumer spending has led growth in the U.S. economy. However, we now have an unprecedented $3 trillion in borrowing. One of Bernacke’s goals will be to engineer a soft landing for housing inflation, to curtail borrowing and increase the savings rate.
  • We expect a significant correction in consumer spending in 2007, but not a recession. It will be a soft landing, but U.S. economic growth between 2.5% and 2.7% for the year. Growth in the economy will shift to corporate investment. Corporations are awash in cash, and they have kept capital investment low for the past two years or so. The global economy will generally be export-focused in 2007-2008.
  • Fed funds: at what level will interest rates break the housing spiral? At the current pace of 0.25% increases, we will hit 5% by May 2006. It’s interesting to note that the housing inflation globally seems to be an Anglo-Saxon trend, as housing prices have seem similar appreciation in Australia, the U.K., New Zealand and Scandinavia. In Britain and Australia, interest rates of 5% stopped the housing appreciation, so we expect U.S. housing prices to respond similarly. There will be pain in pockets of the U.S. housing markets that have experienced the greatest appreciation such as San Diego.
• Other regions: Europe continues to have high social overhead, and it will continue to be stagnant, growing between 0.5% and 1.5% in 2006. Note that that would be an improvement over the past few years. Structural problems will continue to plague economic growth. Japan has been in a recession for the past 15 years. Five million workers have been fired, which is a profound change in their social contract. We expect growth of 2.5% for 2006.
• China: obviously a huge and growing force in the global economy:
  • Background: China has 25 years of economic reform. In 2005, GDP was 9.9%, and China’s economy was $2.2 trillion, fourth behind the U.S., Japan and Germany respectively. Capital spending is an astounding 45% of GDP.
  • Exports represent 30% of the economy, and foreign firms (U.S., South Korea, Japan) have $600 billion of investment in China. China has $800 billion in exports, third in the world, after the U.S. and Germany. Wal-Mart imports a huge portion of its goods from China.
  • Growing consumption is leading to wage inflation. Internet penetration is high in China.
• Oil: By analyzing the rapid growth of oil demand by China, India and other developing countries, it is self-evident that there will be few combustion engines by 2020.
• Developing country summary: in general, high raw material prices will continue to bode well for developing countries in Central Asia, Africa and Latin America. However, politics in Latin America are uncertain at best and dangerous at worst:
  • Bolivia just elected a populist, and Peru will have a close election, with a populist and a pro-business centrist running too close to call. Most countries have been privatizing their inefficient industries, but the trickle-down to the people has not materialized, and discontent is rising. Chavez in Venezuela and Castro in Cuba are figures that have won the imaginations of many voters. Populist victories would be catastrophic from a foreign investment perspective and would isolate these countries. Foreign investment would quickly evaporate in the face of renationalization policies.
  • Mexico is struggling with this dynamic as well. Elections this year will probably put the opposition in Congress, which will not destabilize economic policies but would reduce the chance of passage of much-needed reforms. Mexico currently plays a vital role as a low-cost producer within the North American Free Trade Agreement bloc, and its position is significantly threatened by China. If Mexico doesn’t push through reform, it will see its competitive position vis à vis China continue to erode, and it may never recover.
• Concluding points: The U.S. has seen 18 months of increasing interest rates, and this will continue this year until spring, when increases will stop. There will be a major change in the U.S. business cycle, as consumer spending diminishes in its portion of spending, and corporate investment becomes the engine of the economy. The major oil find in Canada may see the Canadian dollar appreciate significantly against the U.S. dollar.

Analysis and Conclusions

• Conditions look darned good for management consulting!! Current corporate liquidity and the relative lack of investment in 2001-2004 are reliable indicators of strong demand for consulting.
• The shift in global demand for commodities is a strong indication of a shift away from the industrial economy in the medium term. There are simply not enough raw inputs to go around. The U.S. still consumes a mind-numbing percentage of the world’s raw inputs, and China’s economy will attain a similar size within a relatively short period of time. Let’s not forget India, Korea, Brasil and other rapidly growing, populous countries. The only way to avoid prolonged war (over raw materials) is to diminish the industrial economy’s relative value to the point that raw inputs become far less relevant. In concert with this, we will need to transform how raw materials are used, but this is eminently possible once people collectively understand that it must be done, and the stakes are not so high.
• It’s obvious that, although western countries have paid lip service to investing in alternative energy, we will have to get serious quickly because necessity will demand it. This is not to mention the possibility of the growing environmental consequences of combustible fuels in terms of climate change. We have serious lock-in with respect to internal combustion. China and other rapidly emerging economies will challenge our industrial economy lock-in due to their demand for raw materials and their contribution to global pollution.
• From an economic point of view, we have two potentially serious exogenous threats that are not going away any time soon: disease epidemics and rogue nuclear powers, with terrorism playing first alternate. Each of these points to the need for unprecedented flexibility to mitigate this risk because the range of potential interruption to too great to deal with in any other way. Avian flu could shut down many businesses for weeks; interruptions would be significant in any case. Having the potential to have people work from home would be key. Certain terrorist threats might be mitigated in a similar way.
• Having more suppliers could prove useful, while many businesses have had the policy of eliminating suppliers to reduce complexity. They need a completely new, loosely coupled model to use to redefine their relationships with suppliers. In this context, the value of a network is that its organization is self-healing in the face of a point of failure. Many businesses have exposed themselves to significant risk by paring their suppliers.
• Of course, we all hope that none of these will materialize, but if one does, it will make our lock-in painfully obvious and produce widespread, profound change quickly. Environmental practices and resource utilization come to mind as well as our ideas about the organization of work. It would certainly reshuffle social, economic and political priorities.