Paging Dr. Doom
Why do stock investors seem so nervous these days? Maybe they've been listening to Morgan Stanley's pessimistic chief economist, Stephen Roach
By Donna Rosato

(MONEY Magazine) – Oil shock. Recession. A market crash to rival Black Monday. That's what Morgan Stanley chief economist Stephen Roach fears could be on the way. And to think, this guy works for a company in the business of selling stocks. Are things really so bad? MONEY quizzed one of Wall Street's most outspoken bears in late August.

Q. Alan Greenspan says the economy is doing just fine. But you call this a "mythical recovery." What makes you think that you know better than the Fed?

A. Forecasting is as much art as it is science. Two people can look at the tea leaves and come up with a very different future. But job growth is pathetically anemic, and wages and salaries have barely grown in this recovery. What's boosting the economy is extraordinary fiscal and monetary stimulus. The question is: How will the economy fare as we return interest rates to more normal levels and as Washington runs out of bullets [to stimulate growth through spending and tax cuts]. I'm worried about that.

Q. If you were Alan Greenspan, what would you do now?

A. You can't raise interest rates in the face of an oil shock or a weak economy—you could send the U.S. and the world into recession. The Fed is really in a tough place. I would say there's a 40% chance of a global recession if oil prices remain in the high $40s per barrel. The best move for the Fed right now would be to keep policy on hold until it has a better understanding of where oil prices will finally shake out.

Q. Isn't the weak jobs picture just the flip side of productivity—corporations doing more with less and boosting profits? That's good for investors, right?

A. There's more to a recovery than corporate profits. Ultimately, if workers don't share in the productivity gains they're responsible for, that will put consumer demand under pressure and the recovery will falter. My key concern is that consumers are overly indebted and lacking in savings and will have to focus on repairing their household balance sheets and boosting their savings. That will come at a cost of weaker consumption growth.

Q. You blame a lot of this job weakness on outsourcing. Hasn't this sort of thing been going on forever?

A. It has taken some new and important twists. Ten years ago there wasn't nearly the same scale and scope to these activities. But the Internet has really changed the way high-cost countries like the U.S. can connect with low-cost labor. Now, with the click of a mouse, you can extract offshore services from places like India. And not just in data processing and call centers, but increasingly in higher-value activities like software programming and the professional expertise of doctors, lawyers, accountants, actuaries. There's huge pressure on companies in high-cost economies to keep cutting costs.

Q. You've also been warning of an oil-shock recession. But the U.S. isn't as oil-dependent as it used to be. And if you adjust for inflation, oil prices aren't anywhere near their historical peak.

A. I have very vivid memories of every oil shock since the early 1970s. I've heard the same thing every time—"that we're less dependent on energy and it's not going to hurt." Every time that's been said, we've gone into recession. Today's economy is vulnerable because of the current-account deficit, the lack of job growth and of a savings cushion, and because our policy levers have been pushed to the maximum. So the risk of a renewed recession is a very serious possibility for 2005.

Q. Let's turn to housing. You're talking about a possible bubble there too.

A. We have turned the American home into a gigantic ATM machine, where anytime you need money—to take trips or to buy DVD players made in China—you go to a friendly lender. Meanwhile, we are building up debt the likes of which we've never seen and drawing down our savings to lows we've never seen. We're doing this at a time when we're getting older. Aging baby boomers are going to need savings. We're doing the wrong thing at the wrong time.

Q. But there's never been a national housing panic, and homeowners' debt as a percentage of their disposable income has been pretty flat. True?

A. It is fair to be concerned about a housing bubble. Even though debt service is flat, it's flat at a historically high level. If interest rates were to kick up even slightly for any reason, then debt-service rates would be even higher. With the Fed marching toward normalizing interest rates, the interest expense on these record levels of consumer debt will be a real drag on consumer purchasing.

Q. You recently issued a warning about the possibility of a crash on the scale of 1987's Black Monday. Why?

A. I don't want to make too much of a replay of what happened in 1987. But there are some similarities in the way in which the foreign funding of U.S. debt is taking place. A shift from private foreign investors buying to foreign officials [such as central banks] has been evident over the past six months. The shifting mix says that private foreign investors are pulling back and official sectors are stepping in to fill the void. That's strikingly reminiscent of the first nine months of 1987. Of course, there were a lot of other things going on then that aren't going on now. The stock market in the summer of 1987 was much more overvalued than today's market. But we can't afford to be sanguine about the vulnerabilities of our markets to a change of heart by foreign investors.

Q. Do predictions like that freak out your colleagues at Morgan Stanley?

A. I'm not Morgan Stanley's official stock market strategist. I'm an amateur investor and not one who is charged with giving the official firm view. [Morgan Stanley chief strategist Byron Wien believes the second half will be better for stocks than the first half.] My conclusions would lead one to be more concerned about the stock market than our official view.

Q. Some people think of you as sort of a perma-bear. When was the last time you were bullish?

A. I have had a negative view of the world for most of the past five years. I was very nervous about the excesses that were building in late 1999 and 2000 driven by the stock market bubble, and I was very concerned about the aftershocks on the U.S. and global economy once the bubble burst. With the exception of four quarters of strong GDP growth from early 2003 to early 2004, I actually feel that my concerns were in large part vindicated. The cautious view I've expressed over this five-year period has withstood the test of time.

Q. So on a scale of 1 to 10, with 1 being bullishly confident and 10 being extremely worried, how nervous should investors be right now?

A. I think the U.S. stock market is at risk. While investors have lowered earnings expectations, they have in large part embraced the official view of Alan Greenspan and others that this is just a soft patch that will give way to a renewed recovery. I'm at a 7 or an 8.