Global Economic and Financial Prospects and Risks: 2006

Robert F. Wescott, Ph.D.Rome5 December 2005

6 Forces Shaping World Economy in 2006

1. Reversal of policy stimulus: negative2. Still high energy prices: negative3. Faster global productivity: positive4. Tax/business policies: mixed5. Trade openness: neutral6. Demographics: mixed

Economic Policy Floodgates Closing

-5

-4

-3

-2

-1

0

1

2

-5 -4 -3 -2 -1 0 1 2

2000-2004

2004-2005

US

Canada

Germany

US

Italy

Euro AreaGermanyFrance

UK

Euro Area

FranceItaly

JapanUK

Japan

Canada

Tighter Fiscal PolicyEasier Fiscal Policy

% change in real six month LIBOR

Change in structural f iscal balance as a % of GDP

China

China

Tighter Monetary Policy

Easier Monetary Policy

Source: IMF WEO, Author’s calculations for China

Oil: A Growing Burden on the World Economy

World Oil Expenditure as Percent of World GDP

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%Global Recession

Trigger Level?

Source: EIA, IMF WEO

6 Forces Shaping World Economy in 2006

1. Reversal of policy stimulus: negative2. Still high energy prices: negative3. Faster global productivity: positive4. Tax/business policies: mixed5. Trade openness: neutral6. Demographics: mixed

Perceived Global Investment Risks

-80

-60

-40

-20

0

20

40

60

Canada UnitedStates

Japan WesternEurope

China EasternEurope

OtherAsia

LatinAmerica

Russia Africa MiddleEast

1998 2005

Source: UBS Index of Investor Optimism, August 2005

Percent rating the region “low risk”

minus percent rating it “high risk”

The dollar-euro in 2006

Shaped by long-run, medium-run, and short-run factorsLong run: competitiveness, productivity (good for $)Medium run: current account imbalances (very bad for $)Short run: interest rate differentials, growth differentials (shifting to euro)

Risks to PonderU.S. soft patch?

Energy prices lead to negative industry effects?Housing bubble bursts?

Wrong policies in Europe?Interest ratesLoss of jobs to China

Disequilibrium proves unsustainable?Hypothesis: U.S. consumes, China producesWeakened President Bush?

The Oil Price Pass-Through to Inflation is Falling

Percent change in CPI and core CPI divided by percent change in RAC of oil (during periods of 30%+ increases in oil prices)

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.1

1970s 2000s1990s1980s

CPI

Core CPI

CPICPI

CPI

Core CPI

Core CPI

Core CPI

Source: Bureau of Labor Statistics and Energy Information Agency

Why Isn’t the Dow at 12,800?(Because of Energy Prices)

Change in DJIA when Corporate Profits are up 30% or More (Y/Y)

21.9

-3.3

0.8

31.1

-15.1

6.1

27.7

36.036.0

-20

-10

0

10

20

30

40

2000s1950s-1990s

Average:-4.5%

Average: 21.5%

Source: Bureau of Economic Analysis, Yahoo! Finance

Housing Prices Rising Worldwide

-75 0 75 150 225 300

Hong KongJapan

GermanySwitzerland

SwedenCanadaFrance

DenmarkBelgium

N. ZealandItalyU.S.

NetherlandsAustralia

BritainSpain

IrelandS. Africa

Percent Change, 1997-2005

Source: The Economist

Are Rising Interest Rates Killing the U.S. Refinancing Boom?

10-Year U.S. Treasury Yield and Mortgage Refinancing Index

3

3.4

3.8

4.2

4.6

5

1/2/

2004

2/6/

2004

3/12

/200

4

4/16

/200

4

5/21

/200

4

6/25

/200

4

7/30

/200

4

9/3/

2004

10/8

/200

4

11/1

2/20

04

12/1

7/20

04

1/21

/200

5

2/25

/200

5

4/1/

2005

5/6/

2005

6/10

/200

5

7/15

/200

5

8/19

/200

5

9/23

/200

5

10/2

8/20

05

12/2

/200

5

10

-ye

ar

tre

as

ury

yie

ld

1000

2000

3000

4000

5000

6000 Mo

rtga

ge

Re

fina

nc

ing

Ind

ex

10-year treasury yield (left)

Mortgage Refinancing Index (right)

Sources: Federal Reserve, Mortgage Bankers Association

Greenspan’s Medicine Would Help Europe(Real short-term interest rates)

-2

-1

0

1

2

3

4

5

6

7

I 1

990

I 1

991

I 1

992

I 1

993

I 1

994

I 1

995

I 1

996

I 1

997

I 1

998

I 1

999

I 2

000

I 200

1

I 200

2

I 200

3

I 200

4

I 200

5

Fed funds / ECB policy rate deflated by “core” CPI inflation

US real interest rate

EU real interest rate

Sources: Federal Reserve, Bureau of Labor Statistics, European Central Bank, European Commission

China’s Trend Has Been Sharply UpwardShare of World Economy, PPP Basis

0

5

10

15

20

25

30

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

pe

rce

nta

ge

Source: IMF WEO

High Tech Manufactures: Asia Rising, Europe Declining

Source: National Science Foundation, “Science and Engineering Indicators 2004”

Share of World Production of High-Tech Goods

0%

5%

10%

15%

20%

25%

30%

35%

US Germany France U.K. Italy Japan China SouthKorea

India

1980 1990 2001

Percentage of 18-24 Year Olds in Science and Engineering Programs

0%

1%

2%

3%

4%

5%

6%

7%8%

9%

10%

U.K.

S. Kor

ea

France

Japa

n

German

yU.S

.Ita

lyChin

a

Source: National Science Foundation, Science and Engineering Indicators 2002

Can Disequilibrium Continue? (China produces, the U.S. consumes?)

Current Account Balance (percent of GDP)

-8

-6

-4

-2

0

2

4

6

8

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Source: IMF WEO

Historically, Rising Interest Rates Add Financial Pressures

Monthly Fed Funds Rate

0

2

4

6

8

10

12

14

16

18

20

???

Black Monday

Continental Illinois Bank

Franklin National Bank

S&L Crisis

Penn Central Railroad

Latin American Crisis

High Tech Bubble

Mexican Crisis

Source: Federal Reserve

Bush’s Falling Political CapitalPresident Bush's Job Approval Rating

30

40

50

60

70

80

90

100

11/2

8/20

05

5/23

-26/

05

3/18

-20/

05

1/3-

5/05

10/1

1-14

/04

7/30

- 8/

1/04

5/2-

4/04

2/6-

8/04

11/1

4-16

/03

8/25

-26/

03

5/30

- 6/

1/03

3/24

-25/

03

1/31

- 2/

2/03

12/9

-10/

02

10/3

-6/0

2

7/29

-31/

02

6/3-

6/02

3/22

-24/

02

1/7-

9/02

10/5

-6/0

1

7/19

-22/

01

4/20

-22/

01

September 11 Attacks

Invasion of Iraq Capture of

Saddam Hussein

Re-election and Inauguration

Source: Gallup