Coldwater Economics

Blog Has Moved

noreply@blogger.com (Michael Taylor) — Wed, 03 Aug 2016 14:10:00 +0000

I have moved this blog to my new website http://coldwatereconomics.com.

You can find the latest updates here:

http://www.coldwatereconomics.com/blog/

The New Normal and Global Flattening

noreply@blogger.com (Michael Taylor) — Sun, 24 Jul 2016 13:06:00 +0000

Much has been written about the ‘new normal’ as the long, grinding and stubbornly acyclical expansions which have characterised the US, the UK and to an extent Europe in the aftermath of the implosion of Western financial institutions. For Asia, the acyclicality of the West’s post-crisis expansion, at a time when central banks have deployed extraordinary policies in attempts to spark a recognizable business cycle into life, has resulted only sharp volatility of capital flows. During the initial period of near-zero Western interest rates, the result was a flood of capital into Asian economies which bore no relation to underlying trade flows. But since the recovery of the dollar in mid-2014, this flood abruptly reversed, with the outflows again fundamentally divorced from any underlying trade dynamic.

The new and seemingly purposeless volatility of capital flows, unrelated to savings imbalances either in Western or Asian economies (since the private sectors were almost universally running cashflow and savings surpluses), has distracted attention from a development in trading patterns which, in time, is likely to have a lasting impact.

But since the beginning of this year, a new stage of quasi-stabilization has been emerging, both in terms of capital flows (as shown in the stabilization in Asian fx reserves), and in terms of the reversion roughly to trend growth of both G3 imports and NE Asian exports.

So it is time to start thinking about the likely implications of this new stabilization. I think one of its key characteristics will be a global flattening of pricing opportunities, which will gradually result in the unexpected rediscovery of Western inflationary pressures, as well as unexpected upward pressures on Asian currencies. (Perhaps this is how the reversal of the great Western bond bull market is finally discovered.) In addition, we ought to expect something of a convergence in rates of growth and return on capital. In fact, the ‘new normal’ may turn out to usher in a great flattening.

A major part of the dynamic powering globalization has been a sharp discovery of regional comparative advantages, in which Asia discovered a its comparative advantage was for low-cost mass manufacture, whilst the West discovered it retained comparative advantage in higher value-added manufacture. As this discovery was a dynamic and expansive process drawing in ever-larger pools of labour, so the terms of the deal underpinning this aspect of globalization were that although Asia’s (in particular) share of trade in world low-cost manufacture rose inexorably, the growth in volume of exports was offset by a fall in prices. By contrast, although the West lost volume, it’s ability to price its remaining exports was retained.

This underlying equilibrium generated a familiar divergence in the terms of trade (ie, movements of export prices relative to import prices) between the West and NE Asia. The chart below shows how, typically, whilst terms of trade for the US and Germany have remained roughly stable since 2000, NE Asia’s slid by approximately 40% between 2000 and 2011. NE Asia’s exporters (including here Japan, S Korea and Taiwan) could win market share, but at the cost of emphatically being unable to price their goods.

However, looking again at the chart, it becomes clear that the long-term sustained fall in NE Asia’s terms of trade relative to those of the US and Germany has stopped - and in fact if we re-base terms of trade to Jan 2010 =100, it turns out that after the final fall in 2011, NE Asia is no longer losing out in terms of trade. Rather, it is at worst holding its own, and arguably, is now raising its terms of trade relative to the West. In global terms, it seems either that NE Asia has finally won or lost the ability to price its goods according to market dynamics in ways which are no longer very different to those of West. Either way, the fundamental pricing dynamic which underpinned the globalization to which we are accustomed no longer applies.

UK Economy's Vulnerability and Resilience

noreply@blogger.com (Michael Taylor) — Tue, 05 Jul 2016 11:33:00 +0000

The impact of Brexit on the UK economy in the long term is, obviously, incalculable, and will remain so, since it is currently a world of infinite hypotheticals. But in the short term, it is possible to outline the template upon which will be printed a likely fall in consumer confidence, a hiatus in investment spending, and a c10% devaluation of sterling against the dollar. It is also possible to measure the current pressures on private sector cashflows, and the cyclical pressures being experienced by business and labour markets.

In general terms they suggest that the current UK expansion, which has been fundamentally acyclical, is finally becoming a bit ‘leggy’: cashflows are slightly strained, return on capital has peaked, and labour productivity is falling. None of these deteriorations are extreme, and within the context of an acyclical expansion this would raise the prospect of a ‘soft patch’ of slowing growth marked by slowing consumer spending, slowing investment growth and slowing employment growth. Since the cycle has not been generated, accelerated or even supported by increases in credit, one would not expect that ‘soft patch’ to degenerate into a recession.

The uncertainties generated by the Brexit vote, however, are likely to intensify all these current mildly negative trajectories, and consequently the chance of a recession have increased.

By contrast, the c7% fall in sterling against the dollar almost certainly does not generate the potential for an inflationary break-out of any importance for monetary policy. Currently, consensus expectations for UK inflation are unrealistically high, and one cannot read any positive relationship between sterling/dollar rates and changes in inflationary momentum in the history of the last 20 years.

Current Momentum
Consider first the momentum indicators which seek to track the story told by monthly data releases. In fact, these have little compelling to say. In 6m momentum terms:
i) domestic demand momentum is being sustained on roughly the same course as it has for the last two and a half years;
ii) after a modestly soft patch during 4Q15 and 1Q16, industrial momentum is currently being modestly regained. There is a problem with the data, however, since the current recovery is hostage to extremely volatile results for April which stand every chance of being significantly revised down in months to come;
iii) monetary conditions have been very significantly relaxed during the last six months, helped mainly by a weakening of sterling against the SDR, a fall in real interest rates and, to a lesser extent, and acceleration in broad money supply. In the past, there have been occasions when such a loosening of monetary conditions has been followed by a modest strengthening of domestic demand momentum, but the relationship is not compellingly strong.

Private Cashflow Pressures

Rather, to gain insight into Britain’s current position in the business cycle, we need to look first at current private sector cashflow stresses, and then also at trends in returns to capital and labour.

There are two indicators which track Britain’s private sector cashflows:

i) the quarterly private sector savings surplus/deficit, obtained by subtracting public sector net borrowing from the current account balance;

ii) the flow of cash between the private sector and the banking sector. In theory, the movements of these two should be closely related, but of course, the more complex a country’s financial system, the more frayed that relationship will be.

In the immediate aftermath of the financial crisis, Britain’s private sector moved negligible net surplus savings flows to a surplus peaking out eventually at around 6% of GDP in year to early 2010. This financial caution has been very steadily eroding since then, with the surplus fully eroded to the start of 2015, and moving to a deficit of approximately 2% of GDP by 1Q16. The gradual but sustained erosion of the savings surplus was one element which supported domestic demand during a time of net de-leveraging and negligible real wage growth.

Any severe or extended spike in financial caution can be expected to reverse these trends, with the private sector moving back into savings surplus and in the process depressing domestic demand.

The second indicator of cashflows tracks the net movement of private sector cash directly into or out of Britain’s banks: specifically, the chart below looks at the 12m change in private sector sterling deposits minus the change in private sector sterling loans. It finds the same dramatic deleveraging undergone in 2009/09, followed by a gradual relaxation since then. As with the PSSS chart, it suggests that by the 12m to early 2015, net cashflows between the private sector and Britain’s banks turned negative, and have remained slightly negative since.

Neither the PSSS chart nor the private sector/bank cashflow chart suggest current private sector economic behaviour is particularly extreme. Another way of seeing this is in the changes of private sector sterling bank debt/GDP, which fell from a peak of 144% in 1Q10 to 104% in 2Q15. The subsequent net rise in debt (implied also by the emergence of a private sector savings deficit) has raised that debt/GDP ratio, but only to 106%, which would still be the lowest since 2004.

Nevertheless, since 2010 domestic demand momentum has been underpinned by a gradual easing of financial caution. If that caution is now reversed as a result of Brexit, we can and should expect a negative impact on domestic demand momentum. This is a medium-term vulnerability.

Cyclical Underpinnings: Returns to Capital and Labour

But there are also longer-term vulnerabilities which suggest that the underpinnings of Britain’s current business cycle are already deteriorating in ways typically seen towards the end of a cycle. Namely: returns to capital have peaked, and labour productivity is now dropping. The normal cyclical response to these two late-cycle phenomena are i) to slow investment spending and ii) to slow employment growth.

First, my return on capital directional indicator peaked at the beginning of 2015, and has been in steady decline since then. (The indicator expresses nominal GDP as a stream of income from a stock of fixed capital, with that stock being estimated by depreciating nominal capital investment over a 10yr period. It can be seen as proxy for asset turns in a Dupont analysis.) Capital spending tends to react fairly predictably to changes in this measure, accelerating when returns on capital are rising, but slowing some time after ROC peaks.

The lag between the peak of the ROC directional indicator and the slowdown in investment spending is not stable, however: investment mistakes get made at the top of the cycle when animal spirits are particularly inflamed and bank credit freely available. However, the post-crisis UK expansion has been unusually non-cyclical (reflecting the negligible impetus given by the crippled banking system), with animal spirits remaining cautious and a complete lack of net new sterling bank lending. So the reaction to ROC peaking arrived quickly, but has so far been mild. In 2014, immediately prior to the peak of the ROC directional indicator, nominal fixed capital formation grew at 7.9%; in 2015 that slowed to 4.7%, with the sharpest slowdowns arriving in 4Q15 and 1Q16.

It is more difficult to draw similar linkages between changes in labour productivity and employment, if only because of the impact of essentially uncontrolled immigration can be expected to constantly lower the supply curve in a way which will allow employment growth to survive falls in labour productivity. Despite this, the general expectation survive that rises in labour productivity (here shown as real GDP per worker, less the change in capital per worker) are followed by rises in labour demand, whilst falls in labour productivity undermine demand for labour. Currently, this measure of labour productivity has been in modest decline since 2014, and that decline has been followed by a slowdown in the rate of growth of employment.

With both return on capital having peaked, and labour productivity declining, in cyclical terms, the stage is set for a downturn. However, note that in both cases, the deterioration is very moderate in historic terms: the return on capital indicator is still higher than the pre-crisis peak; in pre-crisis terms, the modest fall in real output per worker would be seen as a qualified success. As the UK expansion has been fundamentally acyclical and unaccompanied by credit excesses, so these typical late-cycle phenomena are hardly grim enough to trigger an outright recession. Rather, absent the uncertainties caused by Brexit, they would suggest nothing much worse than a ‘soft patch’ of slowing growth.

Sterling Weakness and Inflation Prospects

By the end of July, sterling had fallen 7.8% from the May average valuation against the US dollar. If this devaluation is assumed to not be reversed in the coming months, might this generate a sufficiently sharp rebound in inflation to dictate a tightening in monetary policy, rather than the loosening currently being suggested by Bank of England chairman Mark Carney?

The first thing to realize is that prior to the Brexit vote, there were negligible inflationary pressures to be found in the UK’s CPI data. May’s CPI rose only 0.3% yoy, and in 6m momentum terms, there was still negative momentum. The chart below shows the spread of likely possibilities, based on extrapolating 5yr seasonalized trends, and deviations from them (current 6m deviations as well as 1SD above and below).

They suggest inflation rates averaging around 0.2% yoy in 2Q, staying roughly around there for the next nine months (with a range of 0.1% to 0.3%). This is far below current market consensus, which foresees a rebound in inflation rates to around 1.5% yoy by 1Q17. Such a rebound would represent a deviation above 5yr trends of approximately 1.5SDs - possible but unlikely.

Moreover, weakness of sterling against the dollar is no good indicator that such a deviation against trend is likely. The chart below shows the relationship between sterling strength/weakness against the dollar and underlying 6m CPI momentum. Generally, if sterling weakness against the dollar reliably generated inflationary forces, one would expect to see these two lines moving predictably in different directions. Rather, to the extent that they are at all synchronised, the correlation appears to be positive: a strong sterling seems to have been associated with above-trend inflation, whilst a weakening sterling looks to be associated with weak inflationary momentum. But in neither case is the relationship statistically interesting.

Reflections on the Revolution in Britain

noreply@blogger.com (Michael Taylor) — Mon, 27 Jun 2016 13:43:00 +0000

“By the deep cultural instinct of a free people, this amazing, unprecedented restoration [of parliamentary accountability] was accepted without riots, or police, or revolution. It is the most momentous thing I have seen in nearly 40 years covering British politics, and the most moving.”

- Charles Moore

“We must learn from brexit: Elderly xenophobes will lie to pollsters to hide their racist views, then vote for destructive policies anyway.”

- Anil Dash

Revolution? It’s a big word, but justified. If you doubt it, consider the global Establishment consensus deployed for shock and awe by Remain campaign: Metternich himself could only have dreamed of such a comprehensive conservative coalition. And consider now the response of some of those whose fates are hostage to Remain: counter-Revolutionary plans which fully deserve to be recognized as deranged and in a narrow sense, contemptible. The instinct to cut out the middle-man and send in the tanks is barely repressed.

Although there are many many things which the counter-revolutionaries don’t understand, primarily because they no longer share a language with the rest of their fellow countrymen, they are right in one thing: Brexit is a decision which threatens the extraordinary privileges they enjoy and which have now proved intolerable to their fellow citizens. In that, the outraged hostility they are now directing to their fellow citizens is understandable.

I have been, and am, pro-Brexit on the grounds that, since all policymakers are flawed, democratic accountability matters above all else. But that’s probably not why most people voted to leave. As we look through the dust and poke through rubble, it also seems to me that this revolution is best understood as a response - the first serious response, albeit delayed - to the collapse of the western financial system in 2009. It represents a demand for a different type of economic settlement, and that in turn demands a different type of financial system.

Language matters. One of the most perceptive readings of the current political situation came from (of all people) a Houston-based poet Anis Shivani writing in (of all places) Salon. He was writing about US politics, but his analysis certainly extends to the UK referendum:

“The neoliberal economy has become pure abstraction; as has the market, as has the state, there is no reality to any of these things the way we have classically understood them. Americans, like people everywhere rising up against neoliberal globalization (in Britain, for example, this takes the form of Brexit, or exit from the European Union), want a return of social relations, or embeddedness, to the economy.”

He asserts that “capitalism today is placeless, locationless, nameless, faceless”, and that the difference between Mitt Romney and Donald Trump is that “while Trump’s entire life has been orchestrated around building luxury and ostentatiousness, again things one can tangibly grasp and hold on to (the Trump steaks!), Romney is the personification of a placeless corporation, making his quarter billion dollars from consulting, i.e., representing economic abstraction at its purest, serving as a high priest of the transnational capitalist class.”

You don’t have to agree with Shivani’s ultimately conclusions (for which, read the article) to see that he’s on to something. Moreover, the logical consequence of fully buying-in to the abstracted politico-economic set-up is precisely the loss of the language in which to talk to that part of the electorate for which ‘social relations’ and ‘embeddedness’ are the very stuff of everyday life.

It plays out in the US: forget the policies - Trump is (scary) funny to listen to; Hillary is a grind. And it played out in the UK referendum Boris is (absurd) funny, Nigel Farage ‘likes a pint’ and the Remain campaign kept name-checking more experts you’ve never heard of say that at some unspecified time in the future Brexit might mean a loss of family income equivalent to £4,300. Or alternatively, it might mean World War III or the collapse of Western Civilization. OK, thanks, mine’s a pint.

The shape of that settlement isn’t yet clear, but elements of it are, and they are not usefully explained as being ‘right wing’ or ‘left wing’, or ‘socialist’ or even ‘capitalist’. If Britain gets it right - and is there a country anywhere in the world more capable of re-inventing itself? - 23rd June may yet come to be seen as ushering in a new chapter of economic development. And London’s financial markets are likely to be right at the centre of it. We do live in exciting times, even if right now the danger is more obvious than the opportunity.

Language matters. This loss of essential language has two major consequences: it made it impossible for Remain to talk to the electorate in a language they could relate to; and second - and now more importantly - it means that the wider Establishment does not yet have the vocabulary it needs to understand what has just happened. Currently, it merely flails. This will change in time, but right now this generates a third consequence which might lead to bad investment strategies: its forecasts about likely future developments and trajectories are unlikely to score any better than chance.

A couple of examples of this failure of language might help illustrate the points. First, the Remain campaign was keen to persuade the electorate that British people were not ‘quitters’. What I think they were trying to connect with was the British people’s notion of themselves that they tend to be very resistant to foreign pressure. ‘We shall never surrender’ etc. But since ‘we shall never surrender’ wasn’t available (for obvious reasons) the speechmakers substituted ‘quit’ and ‘quitters’. But ‘quitting’ doesn’t have the meaning (use) that the speechwriters needed: Brits are proud of ‘quitting’ smoking, and they’re perfectly happy to tell you they’ve ‘quit’ a lousy job. ‘Quitting’ in these senses, is, in fact, the opposite of ‘giving up’: in fact, most of the time, for Brits ‘quitting’ is an act of virtuous though sometimes pig-headed self-assertion. Whoever lit upon ‘quitting’ as a word is either a foreigner (an American, perhaps?) or someone who hasn’t talked with many fellow Brits over the last 20 years.

Perhaps more seriously for current policy, and definitely for future forecasts, is the notion that leaving the EU appealed mainly to those who have been ‘left behind’ by globalization. The people being referred to here tend to be those living in Northern towns which have suffered through 45 years of de-industrialization. But the key problem with the language used is that it quite wrongly implies that for everyone else the problem has gone away - after all, those people have been ‘left behind’. But they haven’t: they are absolutely still here. And in fact, that’s the most important point of all being made by the referendum. There is no sense at all in which the ‘left behind’ aren’t still right here, right now.

What’s more, they are far more ‘embedded’ than you, dear reader, are likely to be, since you are all priests of some standing in globalized capitalism.

The two sets of people likely to be least-embedded in their society are i) Londoners (because of the size of the place, the national and international churn of its population, and its central preoccupation precisely with the abstractions of globalization; and ii) young people, particularly students, because by definition they’ve not yet had time to become ‘embedded’ in their society. These are precisely the people who voted to Remain, and they are also the people now likely to be making forecasts about the future.

The difference between London and the rest of the country which hosts it has long been globally anomalous. This is not so much an opinion as a measurable fact: one of the most robust relationships in economic geography it that there is Zipf distribution in the size of towns and cities within a given polity. London simply doesn’t fit this law: it is far bigger than the frequency of cities in the UK of smaller size would suggest. In fact, London conforms to the Zipf law distribution of cities only if you include the rest of Europe in the sample: purely in these terms, London is revealed as the capital not of the UK, but of Europe. (Sorry, everyone, I’m not making this up, this is simply how the maths works).

This divorce not only left London without a language with which to talk with, or even listen to, the rest of the people of the UK, but also seemingly contemptuously hostile towards them. It was not a good starting point for a political campaign in which the vote of a non-Londoner was no less important the vote of a Londoner.

History Matters. I have no theory of history, but it does seem that sometimes the past can be a good interpretive guide. For instance, if the nations of the EU are split, you can be all-but certain that they divide precisely along the lines taken the Thirty Years War. And in Britain, if you want to know fundamentally what sort of ‘political’ person you are faced with (or are yourself), you ask: ‘Which side would you have been on in the Civil War’. This breaks down between the Cavaliers (‘wrong but romantic’) which supported Charles I, and the Roundheads (‘right but repulsive’) who fought for Parliament (etc, long story).

Right now, everyone in Britain knows the answer to this question, for themselves and for others too. The Cavaliers were all-too obviously for Remain, asserting essentially the divine right of trans-national legislators, and manned by the princes of the Establishment (in this case, the notable Labour princelings of Will Straw and Stephen Kinnock). An at the end, the found themselves, relying on an unsteady and unnatural alliance between the Scots and London aristocrats. Although Prince Rupert wasn’t actually called from the grave for one last hurrah, his descendents were in the saddle all the way through. The Brexiteers meanwhile were, with uncanny precision, the Roundheads, asserting the primacy of parliament (long story), and even drawing strength from precisely those parts of England which brought forth Cromwell. Before long, I expect they’ll propose union with the Netherlands and mess up Ireland.

If you want to translate that into different views on political ‘legitimacy’, the Remainers asserted that political legitimacy was won by national and international creditation of particular ideas and policies; the Brexiteers asserted political legitimacy still rested with the people.

Globalization. The Chinese spokesman followed that country’s oracular tradition when he told the UK papers: ‘A brick has been prised out of the mansion of globalization.’

I think this is right: the British decision to pull out of the EU may just represent the first decisive step in re-casting the terms upon which globalization takes place. Britain has an extraordinary and possibly even protean ability to re-invent itself quite fundamentally every few decades, and this looks and feels like the start of another re-invention. If we are all lucky, we may look back on the 23rd June vote as the first step the West took to re-invent its economy in a way which acknowledged and finessed the collapse of its financial system in 2009. If so, we are seeing nothing less than a revolution.

To explain why, and possibly how, let’s ask a fundamental question: why do we put up with the inequalities generated by capitalism in the first place? Well, first, from a personal point of view the market provides a wonderful and, to me, natural, outlet for my creative (and destructive) energies. And, hurrah, it rewards me for it at the same time. From a systemic point of view, however, we tolerate the inequalities of capitalism because there’s overwhelming evidence that it delivers the goods in terms of improved and enlarged qualities of life.

This has never been more abundantly true than during the last 25 years, where (very broadly) the introduction of capitalism has lifted probably upwards of a billion people in China alone from a condition of enslaved and immiserated poverty to one of material decency. This is the great economic and moral good achieved by this round of globalisation - let no-one doubt that. We have witnessed, and participated in, the greatest improvement of the human condition any generation has ever experienced.

But notice that there’s an implicit trade being made here, in which an increase in inequality is granted as the acceptable price of improved living standards for all. Now let’s think again about how that trade has been working out recently, in Britain.

What is “Left Behind”? To do so, one needs again to have some knowledge of what it means to be ‘left behind.’ I honestly doubt that most people in London have any idea (or possibly, interest) in what it means. I do, because I’ve been in flight from it all my life. Here comes the personal history: I come from Huddersfield, the 11th largest town in Britain, with a population of roughly 164k. When I was being brought up (the 1970s), the town’s key industry, textiles, was dying, week by week, month by month - I’d count the chimneys on the way to school, and the count fell and fell. Nevertheless, the textile industry bequeathed a social and infrastructural legacy which is visible to this day: on the one hand the Huddersfield Choral Society got to sing in a splendid high-Victorian copy of Amsterdam’s Concertgebouw; on the other hand, the town invented rugby league, and spawned the Luddites. Nowhere, I dare say, was more ‘embedded’ - and even today, although saying you’re from Huddersfield has vertiginously negative social cachet, at least you are without doubt ‘from somewhere’.

Now, consider this: whilst Londoners admire the new extension to the Tate Modern, and ponder the possibilities of a ‘garden bridge’ over the Thames, Huddersfield has been told there’s not enough money to keep open an Accident and Emergency Unit in its hospital. Reader, if you go on a field trip to Huddersfield to discover what being ‘left behind’ means, don’t collapse in shock, because there will be no A&E to keep you alive if you do. In truth, this shrinks health provision back not just to Victorian conditions, but to pre-Victorian conditions. Tell me, then, that the deal between greater inequality and ‘delivering the goods’ is working for places like Huddersfield.

Obviously, it’s easier not to know, and not to care because, as I say, in the grand scheme of things, globalization has delivered munificently on its promise. But the grand scheme of things is, as Anis Shivani says, now absolutely abstract. What language would you use to explain its virtues to the ‘left behind’ of Huddersfield? Tricky, I’d say.

The unwillingness to listen has evidently hardened among many of Britain’s Establishment into a most extraordinary inability to hear even the plainest message. You hear intelligent, well-educated and presumably well-meaning TV reporters front up to a ‘left-behind’, who patiently explains that he/she can’t get a doctor’s appointment, a school place, a house, a job with a permanent contract, and the TV reporter duly turns to camera and says something along the lines of ‘And it’s this fear of immigration that’s been driving the Brexit vote’. And from there it’s but a hop skip and jump to Anil Dash’s insult: “Elderly xenophobes will lie to pollsters to hide their racist views, then vote for destructive policies anyway.”

EU bureaucrats have this excuse: they genuinely do speak a different language. But what excuse does the British TV reporter have?

What’s changed? “Globalization has been chugging along pretty well now for decades, and you yourself say that the northern industrial decline set in decades ago. So what’s changed now? Why has the previously tolerable suddenly become intolerable. What’s changed?”

The answer is that over the last few years, two factors have combined to dramatically recast the economic foundations upon which which consent for globalization rested:

i) The EU imposed effectively uncontrolled immigration policies at the same time as its Euro policies were beggaring much of southern Europe; and

ii) The western financial system collapsed.

Separately, both these would probably have been tolerable: when combined, they become very sharply toxic.

To understand why, let’s consider first what’s happening to the meat-packing business which is the biggest single employer in my market town. It’s doing ok, but a friend who’s been working there for years tells me it no longer offers any permanent jobs at all - instead, it relays through teams of East Europeans on short-term temporary contracts. The obvious point to make is that, of course, access to an basically infinite and therefore infinitely flexible low-skilled labour force must have a negative impact on anyone competing for low-skilled jobs. What’s more, we can be pretty certain that the negative impact can be only partly relieved by legislation.

The less obvious point is that for a business - for my meat-packing factory - it sharply changes the terms of labour/capital substitution. If the meat-packing factory encounters unexpectedly strong demand, it will simply import more East Europeans to cope with demand. It is easier to do, less risky, and leaves a lighter balance-sheet footprint, than to invest in new machinery.

In short the company gains nothing by investing to raise labour productivity, and loses nothing by not investing. But if labour productivity is not raised, ultimately real wages will not/ cannot rise either.

As the chart shows, between 2009 and late-2014, there was effectively no growth at all in capital per worker in the UK economy, reversing the steady 3-4% growth experienced previously. The jolt upwards seen in 2015 reflected only the slowdown in hiring, and since capital investment has since slowed sharply (it rose only 1.6% yoy in nominal terms in 1Q16), we shall probably see the flatline return.

What is the alternative? Next door to the meat-packing factory a different factory makes meat pies: the manageress told me the other day, she spends her time shouting “ship-ka, ship-ka” (“szybko” - it’s Polish for ‘quickly’). No doubt her enthusiasm works wonders, but even so, on an economy-wide basis, real output per worker, once adjusted for capital per worker, is declining.

The loosening of the labour markets is one part of the equation; the other is the inability/unwillingness of the banking system to finance investment. Loans to the non-financial corporate sector have been falling continuously since late 2008, with net repayments since then of £133.8bn. Nor is this simply a reflection of banks’ overall asset base contraction: loans to non-financial private corporations as a proportion of the balance sheet has also shrunk by approximately a quarter during the same period.

Remember that the key question remains: “why do we put up with the inequalities generated by capitalism in the first place?” and the answer is that it delivers the goods. It is this combination of infinitely flexible labour markets and a financial system which is not, and quite possibly cannot, allocate savings towards corporate investment which not only is no longer delivering the goods for a majority of people right now, and, just as importantly, is unlikely to deliver the goods in the future, because its problems are systemic. In such a set-up, the inequalities generated by capitalism are no longer tolerable. That is the verdict of the referendum.

What Happens Now 1: Economics, Corporate Behaviour and Finance

If this is what underpins the verdict, then one only has to run the film backwards to see where it ends. First take away the assumption of an infinitely expandable/infinitely flexible workforce. If growth is no longer underpinned simply by adding labour, then growth will either a) stop or slow or b) have to be generated by productivity improvements. Once you’d exhausted the improvements brought about by shouting ‘ship-ka, ship-ka’, that means investment in capital equipment, training and, possibly, infrastructure.

In turn, this means that the UK financial system will have to rediscover a way of financing capital investment. The experience of the whole western banking industry strongly suggests that it doesn’t currently know how to do this; the experience of Japan suggests that once you’ve lost that skill, you don’t get it back. (Financial systems can fail in two ways: it can lose money by allocating savings to the wrong assets; or conversely, it can fail by being unwilling/unable to allocate those savings into any risk assets at all. Before 2009 western banks failed the first way; after, they are failing the second way).

In addition, however, we cannot expect companies to suddenly discover an appetite for expanding their balance sheets by investing in fixed assets. In a non-inflationary or deflationary world, everyone understand that asset-turns are king.

So my guess is that the way forward for the financial services industry must be equipment leasing. Financial companies with unavoidably large balance sheets (ie, insurance companies) can be expected to develop equipment-leasing arms which:

i) will allow companies to expand capital stock without expanding their balance sheets,

ii) allow insurance companies a far larger return than is available on bonds; and

iii) can be expected to attract extremely generous tax-treatment from a government eager to stimulate private investment.

So, go to it, friends.

What Happens Now 2: Game Theory and Diplomacy

In the short term, however, there are good reasons to expect the leaving to take time. The fact that Britain has voted to leave the EU has all the force of a new fact which disrupts many of the forecasts and expectations which existed before that fact. One of the more important is that it strengthens the supposed hand Britain has to play in its negotiations to leave. The best way to appreciate this is through game-theory.

In a predictably finite game, it always pays to defect, whilst in an infinitely extendible game, the defection strategy is merely one of mutual destruction. Now that Britain has chosen to leave, the game itself has changed, from infinitely extendible to almost certainly finite. So in those circumstances, it pays individual EU countries to ‘defect’, which effectively means accepting good bilateral trading terms with Britain, rather than try to impose poorer terms as a group. For example, were Britain to offer free-trade terms to Germany’s auto manufacturers, would Germany’s government really rule this out in order to respond to the desire of, say, Belgian waffle-producers to play hard-ball?

These calculations become even more advantageous to UK negotiators if there are, in any case, doubts about how long the EU will maintain its current membership. This is a different type of the same game: no country would want to be a member of the hold-out group imposing mutually damaging trade barriers if significant other currently EU economies had already defected.

The most obvious way for the EU to avoid these game-theory negotiating pitfalls is to hurry the process as much as possible, in the hope that no-one notices that the game itself has fundamentally changed. For Britain, of course, the opposite is true: the longer it takes to play the hand, the stronger that hand is likely to be. There’s no surprise that the EU wants a quickie divorce; but unless the terms are good, any UK games-playing negotiator worth his salt will want to drag things out.

And there’s a further element to the time-dimension: the longer the time taken, the more likely the unity underpinning the EU’s negotiating strategy will be undermined anyway by the eruption of other crises (Greece again? Refugees? Budget problems? The demands of domestic politics in Italy, France, Spain, Germany etc).

For all these reasons, although the EU institutions and some of its members may fervently desire a punitive settlement of scores with the UK ‘pour encourager les autres’, not only economic self-interest, but the logic of the changed game suggests they will ultimately be unwilling and probably unable to impose it.

(As I write this, the news tells me that six of the founding EU countries have met in Germany and are ‘putting pressure on Britain’ to settle the terms of the divorce quickly. It’s difficult to determine who realizes the game has changed and who doesn’t, although certainly the reporter doesn’t.)

Time to Take China's Official PMIs Seriously

noreply@blogger.com (Michael Taylor) — Fri, 03 Jun 2016 10:43:00 +0000

China’s PMIs, compiled monthly by the China Federation of Logistics and Purchasing, are among China’s most useful monthly indicators, as they are not just timely, but also detailed and plausible both for their internal consistency and because they have a track record of getting major turns in trend right. Looked at in detail, May’s Manufacturing PMI paint a coherent picture of China’s manufacturers beginning to gear up in response to an improvement in the external trading environment which is nowhere to be found, yet, in other official data. This otherwise hidden upturn shows up dimly but consistently across export orders, imports, buying of inputs, inventory policies, work backlogs and pricing.

PMIs are too a good an idea to be left to fulfil their potential. The idea of surveying managers who have to run their businesses responding to perceived short-term changes in the market environment is obviously attractive. If anyone feels the cross-currents of an economy, it must surely be them. They also hold out the promise of producing a speedier verdict on current and near-future market conditions than is possible for the fuller surveys demanded by the production of conventional industrial indicators (eg, industrial output, exports etc).

So when done properly, they are extremely valuable. The best examples come from the US, where the timely ISM manufacturing index and to a lesser extent the extremely timely various regional industrial surveys have earned the right to be trusted.

But problems surface in Europe. There is certainly room for good PMIs in Europe, since official data tends to surface slower than in either the US or Asia, and in certain countries - the UK for example - the official statistics organizations currently seem incapable of generating stable series, even granted the extra time they take to produce them. A commercial organization, Markit, has encamped on the space vacated by Europe’s official statisticians, and the beginning of every month litters Europe with a confetti of PMIs. To put it mildly, I am sceptical about their worth. I will confine myself to two observations. First, the minute sensitivities suggested by the results (the Eurozone manufacturing PMI, for example, has a standard deviation of only 0.6pts out of 100 during the last 12 months) is undermined by a lack of transparency about they are arrived at. Second, there is no significant statistical relationship between movements in the manufacturing PMI and movements in Eurozone industrial output.

The problems of Markit’s European PMIs tend also to cast a shadow over the credibility of the surveys it constructs in Asia. This is a shame, because in several countries, including India and Indonesia, credible manufacturing PMIs could be very useful.

Some Asian countries produce their own, and of these, there’s no doubt that China’s is potentially the most important. I believe China’s official manufacturing PMI is becoming a genuinely useful tool which provides timely, detailed and plausible information about the state of China’s economy.

The reason why I think China’s official manufacturing PMI should be taken seriously is that the headline figure is accompanied by 12 subindexes covering different aspects of the production phase, and that in the five cases where those subindexes can be checked against subsequently-released industrial data, they tend to tell similar stories. Moreover, those aspects which check out are central to our understanding of China’s industrial cycle: output, exports, imports, inventories and pricing.

First, we can compare the PMI subindex for output with year-on-year movements in industrial output. Since 2012, the changes in the PMI output subindex have generally moved in line with changes in the yoy changes in industrial output. Most recently, since the middle of 2015, the output PMI has signalled growth in output stabilizing at historically low levels. May’s subindex extends this trend, but signals no new deterioration.

The convergence between the export orders subindex of the PMI and actual US$ export growth is less clear, but captures well the deterioration in trading conditions endured since the middle of 2014. Currently, there is a recovery in the export orders PMI emerging that has yet to be seen in China’s raw trade data.

Much the same can be said of the relationship between the imports PMI subindex and the imports reported in the trade data: there appears to be a general overlap of changes in trend, and currently there is a rise in imports recorded in the PMI subindex which is not yet coming through in the trade data.

When it comes to pricing, the relationship between the input prices PMI subindex and the monthly PPI yoy is much closer: both record the intensification of price deflation seen since the middle of 2014, and both are now signalling a recovery in price pressures since the end of 2015.

Finally, we can compare the finished goods inventories PMI subindex with changes in inventories of finished goods contained as a line item in the monthly industrial profits data release. Again, the stories they tell mostly complement each other, although over the past few months, the PMI subindex has signalled a modest recovery in inventory-holdings which is not yet showing up in the industrial profits series.

In none of these cases is the relationship between the PMI subindex and the reported data exact, but in each case it seems that the same trends and changes in trend are captured in both. Because of that, we should be paying close attention to the official monthly PMIs: they seem genuinely to provide both an early lead on forthcoming data, and another source from which to triangulate other Chinese data. Moreover, given the difficulties and uncertainties surrounding China’s official data, triangulating for internal consistency is always central to any interpretation of the data.

In addition, the fact that these subindexes seem reasonably plausible lends credibility to other of the subindexes. This is particularly important because the employment PMI subindexes reported both in the Manufacturing PMI and the Non-Manufacturing PMIs provide practically the only timely and regular pointer to changes in China’s labour market that we have access to. The health of the labour markets is one of the top two economic priorities of China’s policymakers (the other is inflation). As the chart shows, currently these subindexes suggest the declines in the manufacturing sector during 2015 have been moderating since the beginning of the year, whilst employment in the services sector is largely unchanged. The net result suggests that the deterioration in China’s labour markets is moderating, though conditions are not yet improving.

So what do these official PMIs tell us about the state of China’s economy? May’s Manufacturing PMI was unchanged at 50.1, suggesting nothing better than stagnation - although this is an improvement from the deterioration signalled between August 2015 and February 2016. The non-manufacturing PMI retreated 0.4pts to 53.1, suggesting expansion has slowed towards the lower end of a trend growth seen over the last year.

The Manufacturing PMI subindexes, however, contain clear positive signals for both exports and imports, and slightly improved signals for both output and inventory policies. This slight improvement also shows up in quite strong upturn in trend for buying of inputs, and a noticeably slower erosion of work backlogs. In addition, there is a clear retreat in deflationary pressures reported since 2H2014.

China's Frantic Policy Pulse and the Inflation Threat

noreply@blogger.com (Michael Taylor) — Fri, 13 May 2016 15:21:00 +0000

The recent stop-start yo-yo of China’s monetary policy reflects not just the attempt to keep policy loose enough to stabilize the economy without fundamentally de-railing the strategic necessity of fundamental reform. It also reflects the fact that China’s inflationary potential is far greater, and is looming far sooner, than is recognized. So far, in a world concentrated on deflationary threats, an inflationary outbreak is on virtually no-one’s horizon. Except, perhaps, in the People’s Bank of China.

Financing slowed very sharply in April: the addition to aggregate financing was a mere Rmb751bn, which was the lowest monthly gain since October 2015; bank lending slowed to Rmb 556 bn, on a monthly movt which was 0.6SDs below consensus. Over the last four months, the monthly aggregate financing total has been unprecedentedly volatile: January’s Rmb 3,425bn feast was followed by February’s Rmb 825bn famine; in turn that was followed in March by surprise gains of Rmb 2,336bn, whose largesse was revoked by April’s shockingly feeble Rmb 556bn.

This yo-yo accurately reflects the unprecedented volatility of PBOC’s open market operations. The chart below shows PBOC’s weekly interventions, and it resembles nothing so much as a cardiac arrest followed by defibrillation. It is a mistake simply to view this volatility primarily as a seasonal phenomenon, although the need to finance the end of the tax year, and then Lunar New Year holidays does drive some of the volatility. But even accounting for these flows, the volatility of the last few months is unprecedented. Twice PBOC has flooded the market with liquidity (end-January, middle of April), only subsequently to claw back the money over the succeeding weeks.

There are two main reasons why the central bank is unwilling to commit to the sort of grandiose monetary relaxation we’ve become used to elsewhere in the world, and indeed, in China during the slowdown of 208/09. First, there are the well-rehearsed set of strategic reasons why no repeat of the credit splurge of 2009/10 is to be expected. An excessively generous monetary policy do nothing to foster the transformation of the economy from an excessive investment/low return on capital model, to a model based on improving returns on capital and sustained growth in consumption. And in practical terms, it probably wouldn’t deliver the goods: in the 12m to December, the efficiency of finance had deteriorated sufficiently so that Rmb 100 of new aggregate financing was associated with only Rmb 25 of extra GDP growth. So not only would a 2009-style credit splurge subvert core strategic policy goals, it wouldn’t even work particularly well.

At the same time, however, China’s authorities have long blamed the collapse of the USSR on the disruption caused by the ill-considered and clumsy haste of structural economic reforms, and the need to avoid anything similar is axiomatic. As a result, in order to advance the long-term strategic goals, sufficient support must be given by monetary and fiscal authorities in the short term to sustain the economy in reasonable health. Whilst in the West there is a tendency to see the policy choice as binary (either tough reforms or monetary accommodation to flunk them), the Chinese authorities say they see things very differently: accommodation now in order to underpin the viability of reforms in the medium term.

There is, however, an additional factor which circumscribes how generous PBOC can be: inflationary pressures have to be contained, and they are stronger than consensus wishes to acknowledge. A previous post explained how the absence of viable savings products and vehicles was driving surplus savings into real assets, notably real estate and commodities, in a way which was already producing speculative bubbles. This highlights the need to accelerate financial reforms, including effective regulation. But these speculative bubble are also hinting at the likely emergence of wider inflationary pressures.

This is only just beginning to surface in the data. April’s CPI stayed steady at 2.3% yoy, and the current deflections against trend suggest that it will stay above 2% throughout the year. This will be a surprise to a consensus which still expects it to fall to around 1.8% by 3Q. A more worrying straw in the wind was China’s PPI, which fell only 3.4% yoy in April, with consumer goods down only 0.2% yoy. Not only was this less deflationary than expected, but looked at more closely, the index rose 0.7% mom, which was the steepest rise since Feb 2011, and was 2.9SDs above historic seasonal trends.

But this may be only the tip of the iceberg. Historically, the relationship between China’s CPI and monetary policy has centred on growth in M1, with inflections in M1 growth coming usually around six months before inflections in CPI. In momentum terms, M1 growth bottomed out in the middle of 2015, and has been accelerating moderately at first, but quite vigorously since the latter part of 2015. By April, M1 growth was running at 22.9% yoy and the underlying momentum was still accelerating sharply, with April’s monthly gain 0.9SDs above seasonalized historic trends. Unless the relationship between M1 And CPI breaks down, we should now be expecting inflation to pick up by 4Q to nearer 4% than 2%.

Will it be different this time? Currently, the consensus apparently thinks so. That’s where the risk lies.

What would an unexpected outbreak of accelerating inflation do to China’s policy choices? It would produce the worst of all possible world for China. To be very blunt, it would compel exactly the combination of necessary credit crunch and subsequent hard landing, followed by far-reaching structural reform, which China’s leaders are so keen to avoid. Perhaps it is this realization which is behind the dramatic gyrations of monetary policy.

China's Balance of Payments - The Gaps Telling the Story

noreply@blogger.com (Michael Taylor) — Tue, 10 May 2016 11:05:00 +0000

China has published its 1Q balance of payments data, and it’s fairly obvious that the most interesting element of them is the billions of dollars missing. In fact, the gap between what’s claimed in the balance of payments and what’s revealed in the movement of China’s foreign reserves would itself be the biggest single line-item in the presentation. And there is an even bigger gap between the cashflows implied by the private sector savings surplus - which is partly calculated via the current account - and the cashflows reported by China’s banks.

In fact, movements in these gaps during 1Q tell us a great deal about China’s current position and policy choices. They are suggesting that:

China has had a degree of success in stemming the outflow of cash which peaked in 3Q15 and 4Q15, but also
With most domestic savings avenues currently closed or discredited (equities, deposits, wealth management products, P2P vehicles), the flow of excess private savings are necessarily being pushed out of financial assets and into real assets, including real estate (again) and commodities (again).

If so, the conclusion is clear: the need for financial sector reform in order to deal with the savings surplus remains urgent, because the lack of viable savings vehicles not only generates bubbles in non-financial assets, but simultaneously puts pressure on PBOC to supply the liquidity private savers no longer wish to entrust to the vehicles available.

Last week brought two pieces of news from which to judge whether the flow of cash out of China seen since the middle of 2014 has been successfully checked. First, foreign reserves rose by US$6.4bn in April to US$6.4bn to US$3.219tr, the second consecutive monthly rise following 18 months of nearly-uninterrupted decline. Second, China’s 1Q current account balance was announced to have been a US$48.1bn surplus, which was roughly in line with what was expected in the light of 1Q’s US$125.7bn trade surplus, although down by US$37.2bn yoy.

The balance of payment data ought, in theory, be the place to start to assess whether the rush of cash out of China has been checked. And on the face of it, the situation is encouraging: China reported a current account surplus of US$48.1bn in 1Q, with a goods trade surplus of US$104.9bn partly offset by a services deficit of US$57bn, and with net international income receipts of US$1.9bn almost fully offset by the US$1.7bn recorded in net transfers out of China. On this accounting, the current account surplus was equivalent to 2% of GDP in 1Q, with 12m surplus retreating go 2.7% in 1Q from the 3% recorded in 4Q15.

But the preliminary estimates also reported that the capital and financial accounts ran a US$48.1bn, completely offsetting the current account surplus. As a result, we should have expected no change in China’s foreign reserves during 1Q. But the reserves data shows China’s reserves fell US$117.8bn in the 3m to March.

The gap between the balance of payments data and the movement in reserves can be seen as one measure of the size and direction of movements of cash and capital into and out of China without attracting the attention of China’s central authorities. When China’s economy is under stress, this gets glossed as ‘capital flight’; when times are good, it tends to just get called ‘hot money’. In most countries, these differences tend to get logged under ‘errors and omissions.’ In China, however, the amounts involved are now so large that such ‘errors and omissions’ would be the biggest line item in the balance of payments.

Between 2005 and the middle of 2014, this difference was almost always sharply positive; since the middle of 2014, when the dollar surged, the difference has always been sharply negative. This reached a peak in 3Q15 and 4Q15, with deficits ot US$243.1bn and US$225.1bn respectively. In that context, the US$117.8bn missing from the accounts in 1Q16 is an improvement. But the unacknowledged outflow is only moderated, not yet checked or reversed.

The mild rises in foreign reserves during March and April suggest that the situation continues to improve.

With all its faults, if one takes China’s current account data at face value we can do a second check, by comparing movements in China’s private sector savings surplus to the net flow of cash into (or out of) China’s banking system. The theory here is that if the private sector is generating a net flow of savings after having done all the consumption and investment it intends, the result is must be a flow of cash into the financial system. By definition, the financial system can use that cashflow only to buy public sector or foreign assets.

During 1Q, the current account showed a surplus of 2% of GDP, whilst the government was also running a fiscal surplus equivalent to 0.6% of GDP (down from 2.4% in 1Q15). As a result, China’s private sector surplus can in a 1.4% of GDP, up from 1.1% in 1Q15, and stabilizing the 12m PSSS at 6.4% of GDP.

In Rmb terms, the 1Q PSSS surplus amounted to Rmb 220.8bn, and the 12m surplus came to Rmb4,400bn..
In 1Q, banks saw a net inflow of deposits of Rmb 813bn, but during the 12m, there was a net outflow of Rmb4,731bn.

In the 12m to March, the gap between the surplus savings generated (Rmb 4,400bn) and the net outflow of cash from the banking system (Rmb4,731bn) came to Rmb9,131bn. Taking an average Rmb rate of 6.32 for the period, that is an amount equivalent to US$1.445tr. Meanwhile, the amount ‘missing’ from difference between the balance of payments and movements in reserves comes to US$653bn. In other words, the balance of payments and reserves data may yet be understating the extent of capital outflow, quite considerably.

This is not the only explanation, however: deposits can rise in the absence of bank lending if the private sector becomes a net seller of non-financial assets (such as property) and banks the proceeds. Conversely, deposits can grow more slowly than lending if the private sector becomes a net buyer of non-financial assets, such as property or commodities. During 1Q, the turnaround in real estate markets in first and second tier cities has been marked, and the recovery in China’s commodity markets has been strong enough to prompt concern among regulators of China’s commodity futures’ market.

At this point, it is surely clear that it is dangerous to reach firm conclusions. However, the balance of evidence suggests that the peak of capital outflow from China has probably been reached, but that China’s savers have yet to be persuaded that the products and services available to savers (deposits, equities, bonds, wealth management products) offer acceptable rates of return. Consequently, the hunt is redoubled for real domestic assets in which to invest the surplus savings the economy continues to generate.

The case for continued financial reform could hardly be more obvious.

Britain's Long Upward Grind is in Trouble

noreply@blogger.com (Michael Taylor) — Tue, 26 Apr 2016 16:50:00 +0000

The recent weakening of Britain's employment and retail sales data isn't a coincidence, but rather a sign of sliding productivity. With little in the way of credit expansion, the growth of payroll income has been the mainstay of the long expansion, supplemented recently by the private sector running down its savings surplus to a modest deficit. So in the absence of any other props, the long grinding expansion is entering a soft patch.

The UK and the US exited the Great Recession at about the same time, in the second half of 2009, but in both cases the recovery has been feeble compared to the recession, and has lacked in the usual cyclical accelerators. Rather, it has been a long upward grind, frequently threatening to ebb away out of inanition, rather than excess. In both cases, what has driven the expansion has been a slow and steady rise in employment, which in turn has been based on harder work - modest gains in output per worker achieved even in the absence of increases in capital per worker.

The hope was that eventually this grinding expansion would be sufficient to draw forth the sort of investment spending and/or credit expansion which usually act as accelerators on the upswing of the business cycle. In Britain, that hope has not yet been realized. By February 2016, bank lending in sterling to the private sector was growing only 3% yoy, but this was the highest since at least 2010, and the total loans outstanding were still 3.9%, or £60.6bn, below their total five years earlier. As far as investment is concerned, in nominal terms investment rose 4.4% yoy in 4Q15, and, depreciating all investment over 10yrs, capital stock was growing only 3.8% yoy in nominal terms, compared with a real GDP growth rate of 2.4%.

Without the usual contributions from these supports, the expansion continues to rely on gain in employment. However, the grounds for expecting continued employment growth are currently being undermined by falling productivity. After accounting for changes in capital stock per employee, real output per worker fell 1.3% in 2015, the biggest decline since the Great Recession, and extending a deterioration which had begun the previous year. As the chart shows, employment growth does tend to respond, albeit with a lag, to changes in this measure of labour productivity.

This is the background to the weakening of Britain’s employment data, and consequently domestic demand indicators, which emerged in the data for February released this week. First, there was a sharp deterioration in employment gains, with only a net 20k new jobs added in the 3m to February, with 9k lost in February alone. There was no comfort in the details: the number of employees fell 23k, whilst the number self-employed rose 25k, the number of full-time jobs rose only 17k, and the number of vacancies were unchanged in the 3m to March. In addition, average weekly wage growth slowed to 18% in the 3m to February, with wages rises concentrated in construction (up 8%) and wholesale/retail/hotels/restaurants +2.7%. In other word, wages were rising fastest in the most pro-cyclical sectors of the economy even as the employment foundations of the expansion were being undercut.

And in turn, that was reflected in March’s retail sales, which showed ex-petrol sales volumes falling 1.6% mom, whilst petrol sales rose 0.5%. In value terms, sales fell 1.4% mom and fell 0.1% yoy, with a monthly movement which was 1.6SDs below historic seasonal trends. This was a sharp enough fall to drag the 6m momentum vs trend to minus 0.4SDs, which is the biggest deflection against trend since the beginning of 2010.

Not only are the employment foundations of Britain’s current expansion weakening, but so too are the financial foundations which would allow household consumption to outpace the growth of payroll earnings. First, by the end of 2015, Britain’s private sector was running a small savings deficit, equivalent to approximately 1.1% of GDP. That deficit means that the private sector must be - and is - running down its net deposits with Britain’s banks. In fact, in the 3m to February, whilst bank lending was growing at 2.5%, sterling bank deposits rose only 1.1%. The result is that the private sector’s net deposits with Britain’s banks had fallen by an average £25bn yoy in the 3m to February. By February, those net deposits had fallen to £79bn,

Most likely the current slowdown in retail spending signals the unwillingness to see the decline in net deposits continue or accelerate, particularly at a time when labour markets are souring. In short, whilst Britain’s long expansion may have been fundamentally acyclical, the spurs behind the current slowdown are developing their own cyclical features.

China's 6.7% yoy 1Q GDP - The Price and the Cost

noreply@blogger.com (Michael Taylor) — Tue, 19 Apr 2016 11:08:00 +0000

China’s 1Q GDP result was good news, but was bought at a cost. If China is to maintain progress towards its stated structural goals, as I expect, then the front-loading of government investment and monetary accommodation which built this positive 1Q result will be reversed shortly after it becomes clear that the global trading environment is warming.

The 6.7% yoy GDP growth reported by China for 1Q16 neatly met the universal expectation, so sends the signal ‘nothing to see here’. So as polite guest commentator on China’s economy, I will ignore it, and turn instead to the much more interesting nominal growth.

Nominal GDP growth accelerated to 7.1% yoy, up from 5.8% in 4Q, and with a very slight gain on underlying momentum. This was actually more impressive than it might seem, because the trade surplus is no longer a major contributor to growth. In 1Q China’s trade surplus amounted to Rmb 823bn, and rose only 8.3% yoy, adding only 43bps to the nominal GDP growth rate. That compares with an average contribution to nominal GDP growth of 235bps during 2015. Subtract the trade surplus from China’s nominal GDP and we get some idea of what happened to domestic demand: it rose 7.1% yoy, which was the quickest nominal achieved since 2Q14.

This is the point at which to emphasize that even a modest growth in nominal GDP growth at this point is far better news than is generally acknowledged or realized. That is because the legacy of China’s extraordinary surge in investment spending during 2003-2011 has in its fifth year of retreat, allowing one to see on the horizon the long-lost possibility of profits growth. If one depreciates capital investment over 10yrs, one finds the growth of China’s capital stock is slowing fast: .on this basis, I estimate that in 2015, China’s capital stock was growing by approximately 10% yoy in nominal terms, rather than the 15%-20% pace we’ve been used to since 2003. My expectation is that capital stock will be growing even slower by the end of 2016. So if China’s nominal GDP sustains the very modest gain against momentum seen during 1Q, we begin to reach the time where nominal GDP is at least keeping pace with capital stock growth, and possibly overhauling it. At that point, asset turns are rising, dragging with it return on capital and profits. For many investors, this will be something they have never seen before.

So there is genuinely good news: but it was bought at a real cost, paid by fiscal policy, monetary policy, industrial policy, investment policy and overall strategic direction. Acknowledge these costs as real, but, crucially, do not be fooled into thinking that China’s authorities have abandoned their strategic goals. Rather, assume those goals will pursued with renewed intensity when the authorities think a suitable economic environment is encountered.

The first cost is a further downturn in the efficiency of finance. In the 12m to March 2016, each increase of 100 Rmb in bank credit was associated with a gain of only Rmb 33 in nominal GDP - that’s down from Rmb 44 during the same period last year, and is approaching the lows associated with the credit splurge of early 2009. It gets worse: every Rmb 100 of new aggregate financing was associated with a gain of only Rmb 24.5 in nominal GDP in the 12m to March, down from Rmb 30.1 in the same period last year. Improving the efficiency of financial allocation is absolutely at the heart of China’s longed-for structural reforms. It took a sharp backwards step during 1Q16.

The other obvious cost was the deterioration of the public finances. So far we have fiscal data only for Jan-Feb, which showed only a modest deterioration yoy (a surplus of Rmb 621bn in 2016 vs a surplus of Rmb 685bn in 1Q15). However, the underlying trends were worsening steeply, and if they were maintained during March, I expect the surplus one normally expects in 1Q will have all-but disappeared. If so, the published data suggests China is already running a budget deficit slightly above the 4% of GDP floated as a possibility in PBOC’s research.

It is not difficult to see how central this fiscal spending is to the 1Q recovery. Also released today was Jan-March urban asset investment: stripping out March on its own, investment rose 11.2% yoy, but with private investment rising just 4.9% whilst public sector investment jumped 23.4%. And it shows also in the industrial breakdown: the big gains were primary industries +25.5% yt, led by public facilities +31%, water production +26.8% and power & heat +20.9%. Meanwhile, secondary industries - that’s manufacturing - rose only 7.3% ytd.

That’s not the sort of efficient investment pattern China needs if it is to make the epically-difficult traverse from a financial repression/capital building/surplus production model of economic growth to an efficient saving allocation/return on capital/consumer spending model. It is, in fact, a relapse.

The danger, however, is to believe that China’s authorities have therefore forgotten or abandoned their strategic goals, or don’t appreciate how the rescue act of 1Q has put those goals in jeopardy. It is much more likely that they view the 1Q retreat as necessary to safeguard the political environment needed to pursue those reforms in the medium to long term. If so, when the global economic temperature warms, expect the stimuli which supported 1Q to be withdrawn and reversed.

US Wholesalers' Data Reflects Structural Change, not Cyclical Pressures

noreply@blogger.com (Michael Taylor) — Mon, 11 Apr 2016 11:37:00 +0000

If the wholesale trade is the cyclical indicator it is traditionally held to be, then the US business cycle is in deep trouble. But fortunately (if you're not a wholesaler), what the sustained weakness of the wholesale data shows is not so much a cyclical downturn in the US economy, but rather major structural pressure on the wholesale industry as a sector.

During February, wholesalers' sales fell 0.2% mom, the fourth monthly contraction in succession, whilst their inventories fell 0.5% mom, the fifth monthly fall in a row. In fact, things are a whole lot worse than that for wholesalers: sales have been gently sagging since towards the end of 2014, and the continued rise in the inventory/sales ratio suggests that wholesalers have been unwilling or unable to adjust their business strategies and balance sheets to reflect that fall. As a result, the inventory/shipment ratio has continued to rise practically unabated since the end of 2014, even though total holding of wholesale inventories peaked in September 2015.

To understand what's going on, it pays to contemplate the role of wholealers in an economy. The point of wholesalers it that they absorb (buffer), and finance, the temporal frictions between suppliers and end-customers, with both ends of the bargain content to pay a fee to ensure more predictable supply, more predictable demand. Such a role cannot abolish business cycles, but will smooth frictions within the cycle. Indeed, it is precisely when wholesalers are faced with changes in business conditions which they can no longer absorb/finance, that they themselves become key indicators of a business cycle inflection point. The inventory/shipment ratio rises, and wholesalers move to cut their risk, passing on the market’s bad news to the manufacturer. This is a familiar feature of business cycles, seen both in 2000/01 recession and again, more spectacularly, in 2008/09. (It has its corollary in NE Asia when manufacturers’ inventory/shipment ratios are a regular bellwether for NE Asia’s export prices and industrial cycle.)

But as the first chart shows, wholesalers’ inventory/sales ratio has been rising almost continuously since the middle of 2014, and is now the highest it has been since early 2009, and above the peak levels seen during the 2000/01 recession. And yet there is no recession (despite the poor profits outlook), and the sustained strength of labour markets makes it very unlikely we’re about to see one now. Moreover, unlike in 2000/01 and 2008/09, the problem is not an unwanted build-up of inventories (they’ve been flat since the middle of 2015), but rather the sustained fall in sales.

There is a further reason to think something structural, rather than cyclical, is afoot. The second chart expresses wholesalers’ sales as a proportion of manufacturers’ and retailers’ sales combined. What is shows is that wholesalers’ market share of total sales has been flat since mid-2011, and has been in steady decline since the middle of 2014. In January, wholesale sales’ market share fell to its lowest since December 2010. No such extended period of market-share loss was seen either in 2000/01 or in 2008/09. No such extended decline was seen during the wild commodity gyrations of the last 15 years.

So wholesale ain’t what is used to be. Quite possibly, wholesalers’ difficulties are not this time a key cyclical indicator. Why? Once again, remember, the wholesalers’ role is to absorb and finance the frictions between supplier and end-buyer. If that role is under challenge, it is likely to be either because frictions have become easier to manage (ie, to predict and anticipate) and/or because they have become easier to finance. Or both.

If information technologies are sufficiently distributed and trusted to cut the friction between supply and demand, and at the same time, financing conditions have improved post-crisis, the need for and role of the wholesale trade becomes smaller. If that is what is happening, today’s shocking fall in wholesale sales is poor news for the wholesale trade, but perhaps not quite so dreadful for the US economy as a whole.

Japan's Exporters Face Double Whammy - Currency & Margins

noreply@blogger.com (Michael Taylor) — Thu, 07 Apr 2016 14:11:00 +0000

The two key factors which have allowed Japanese manufacturers to thrive despite the sharp deflation in their export prices are going into reverse. First, currencies movements against the dollar and the Rmb, are eroding Japan’s competitive position and will intensify the pressure on Yen export prices. Second, at the same time, the stabilization of commodity prices threatens to reverse the terms of trade gains which have compensated for loss of pricing power, and been the motor for margin gains over the last 18 months.

Large manufacturers have noticed: Bank of Japan’s 1Q Tankan survey of 1,087 large-scale manufacturers reported their outlook index falling 4pts to 3, which was the lowest since 1Q13. Only 11% expecting a favourable outlook, compared with 8% expecting an unfavourable outlook and the vast majority, 81%, thinking the future was ‘not so favourable’.

This fall in optimism does not yet fully incorporate the scale of the currency whiplash now underway: today the yen is trading under 111 to the dollar, whilst the Tankan’s respondents still expect the yen to average 117.5 during FY16.

But the combination of a resurgent dollar and an Rmb determined to hang onto its coat-tails, which has handed Japan’s exporters considerable competitive advantage since 2H14, has reversed. Not only is China explicitly no longer willing to peg its currency to the dollar, but in addition, the US Fed gives every indication it does not wish the dollar to strengthen. Japan’s exporters are the principal competitive victim in these two policy reversals.

Let’s put some numbers on it:
i) between September 2012 and May 2013, the Yen lost 24.1% against the Rmb
ii) between July 2014 and June 2015, the Yen lost a further 19% against the Rmb. Between September 2012 and July 2015, the yen had depreciated by 39.2% against the Rmb.
iii) However, between June 2015 and April 2016, the yen has appreciated 17.9% back against the Rmb, and it has now lost virtually all the gains made during the 2H14 dollar rise

For Japan, this simply means both far tougher international competition from China, implying faster market-share loss and sharper downward pressure on Yen export prices.

Which brings us directly to the second problem large manufacturers are worrying about: margins. Looking at the detail behind the fall in the Tankan outlook index, there was no change in expected domestic demand/supply conditions, with the economy expected to remain solidly oversupplied, slightly offset by a small improvement expected in overseas conditions. Rather, it is margins that are the worry. Currently a net 8% of large manufacturers are seeing their input prices fall, but this isn’t expected to last: only a net 1% expect input prices to keep falling. But the same moderation of deflation isn’t expected for output prices: currently a net 15% report output prices are falling, and a net 13% expect them to keep falling. Result, margins are going to fall.

Ministry of Finance’s massive quarterly survey of private sector p&ls and balance sheets reveal just how central this is likely to be. The survey allows us to analyse how Japanese ROE has been sustained (and even raised slightly) over the last few years. The answer is simply that operating margins have risen from 3.2% in 2012 to 3.8% in 2013, 4.1% in 2014 and 4.5% in 2015. This has been enough to offset continued decline in asset turns (from 0.95x in 2012 to 0.89x in 2015) and financial leverage (from 2.82x in 2012 to 2.62x in 2015).

Moreover, we can then disaggregate what is driving those margins. Over the last year, the story has been overwhelmingly one in which a 0.8pp decline in cost of goods sold/sales compensated for deterioration in other aspects of margins (principally SG&A expenses), which cut the margins gain to just 0.4pps.

And that decline in the cost of goods sold/sales ratio is, in turn, a direct reflection of the rise in Japan’s terms of trade, generated by import prices falling faster than export prices.

The final chart demonstrates how the trade-off between falling export prices and surging terms of trade has worked during the last 18 months. The very specific problem is that the combination of currency movements and commodity prices which generated this useful trade-off has gone into reverse. During the coming year, we can expect to see the red line (export prices) fall even steeper, but the grey line (terms of trade) also to fall. That in turn will begin to push up cost of goods sold/sales ratio, which in turn will drag down margins and return on equity. The deterioration in large manufacturers’ outlook captured by the 1Q Tankan only begins to acknowledge that times are about to get a lot tougher for Japan’s exporters.

Dollar Regime Change and Southeast Asia - Who Benefits?

noreply@blogger.com (Michael Taylor) — Wed, 30 Mar 2016 17:13:00 +0000

During the last 18 months, for most Asian economies, the curtailing of cross-border financial flows associated with the rising dollar has trumped domestic cashflows in setting overall monetary and financial conditions. Now the immediate pressure on cross-border financing is abating, it’s time to look again at Asia’s domestic cashflows.

Private sector savings surpluses are key indicators in identifying the size and direction of the flow of cash between the private sector and the financial system, and so in turn also are important components in determining movements in bond yields. The more developed the financial system, the more buffers are in place to mute the impact of changes in private sector savings habits. So let's look at the balances for Southeast Asia and India.

Conclusions? Whilst in Indonesia and Malaysia, domestic trends are pushing the private sector savings balance towards inflection points which international finance are likely to notice and react to, the broader beneficiaries of a general relaxation in cross-border financing conditions are likely to be found precisely in those economies where competing pressures are not currently felt, which means the Philippines and India. Meanwhile, in Singapore and Thailand, the huge savings surpluses already maintained means changes in international financial conditions are unlikely to be noticed greatly.

Not every Southeast Asian economy has a similar savings surplus/deficit profile or trajectory, so the opportunities raised by the weaker dollar and relaxation of cross-border finance flows are not shared equally.

Indonesia and Malaysia are the economies most obviously exposed to the change in the international financial environment, since both countries are approaching the inflection points in the balance of private sector savings and deficits. For Indonesia, it seems possible that the improvement seen in 1Q’s trade position will allow the private sector to break into savings surplus for the first time since 2012. Indonesia has been running a savings deficit since 2012, which peaked at 2.7% in mid-2013, but which had recovered to a deficit of just 0.7% of GDP by end-2015 and may well have broken into surplus during 1Q16.

It has been a slow and frustrating process getting to this inflection point. But if it occurs, it will mean that Indonesia’s private sector is no longer fundamentally seeking cashflow from the financial sector in order to maintain its current levels of consumption and investment, but rather that those consumption and investment choices are sufficiently modest to allow for net savings/profits which the financial sector needs to redeploy into public sector or foreign assets. This domestically-generated financial tailwind is likely to be strengthened by any relaxation in cross-border financing conditions.

Malaysia potentially represents the opposite situation: the country has been gradually working its way through a savings surplus which peaked at 16.6% of GDP in mid-2009 to just 2.7% in 2015. Stabilization of this negative trend has seemed possible on three occasions, but in each case the negative trend has resumed. What a relaxation of international financing conditions would offer Malaysia is a softer landing if the private sector does eventually lapse into savings deficit.

By contrast, Singapore and Thailand already run such huge private sector savings surpluses that their domestic financial conditions are unlikely to be constrained by internal cashflow issues in the first place. So for both Singapore and Thailand the relaxation in cross-border financing conditions is unlikely to have a significant impact on domestic economic or financial activity. Singapore has run a massive savings surplus for as long as anyone has been counting, and by end-2015 it was running at 18.8% of GDP. Thailand, meanwhile, has recovered from a marginal deficit in mid-2013 to a surplus equivalent to 11.1% of GDP by end-2015. This dramatic build-up really took off after the military coup of mid-2014, suggesting it is the result of a rise in precautionary saving responding to political uncertainty. If so, the savings surplus is likely to be maintained, and act primarily as a damper on domestic demand.

What binds Singapore, Thailand, Indonesia and Malaysia together in this analysis is that domestic private savings surpluses or deficits trends are already in place which will tend to be the decisive influence, with a significant relaxation of cross-border financing availability offering only to qualify those conditions, rather than to supersede them. Counter-intuitively, it is those economies in which currently the private sector savings surplus/deficit situation or trend puts no clear pressure on domestic financial activity, or offers no obvious new opportunity, that the impact of improved cross-border financing conditions is likely to have a more decisive directional influence. Two economies which come into this category are the Philippines and (outside Southeast Asia) India.

Philippines has a surplus of 3.8%: this ratio has been falling gently since 2013, but may now be stabilizing or even growing once again. This week, India announced its 4Q current account balance showed a deficit of US$7.07bn or 1.1% of GDP (the trade deficit narrowed US$3.4bn qoq to $34bn, whilst the surplus of invisibles rose US$0.2bn to $18.1bn), which in turn suggests India is running a private sector savings surplus of a steady 2.5% of GDP. In neither case does movement of the ratio present any immediate difficulties or offer any significant opportunities; in both cases, therefore, the absence of such immediate prompts means any improvement in international financing conditions are likely to be felt more obviously.

US 4Q: Profits Fall as Wages and Dividends Rise

noreply@blogger.com (Michael Taylor) — Tue, 29 Mar 2016 11:12:00 +0000

The third revision of US 4Q GDP growth arrives garnished with details of how national income was shared between workers, companies and shareholders. The message emerging is that even though growth is slowing, the tightening labour market means employees are managing to secure a slightly greater proportion of the marginal growth. But in addition, as the overall profits picture also deteriorates, so companies are prepared to pay out a higher proportion of their profits in order to keep their shareholders happy. This combination is hardly sustainable, and adds more detail to the internal dynamics of the US's profits recession.

US 4Q GDP grew by an annualized 1.4%, according to the third (and final) estimate, double the rate initially estimated, and better than consensus expected. Growth of private consumption was upgraded to 2.4% from an initial 2.2%, thanks to a 2.8% jump in services. Residential investment also grew by an annualized 10.1% (rather than the 8.1% initial thought), and net exports stripped only 0.14pps from GDP growth, rather than the 0.47pps initially estimated.

But not everything was upgraded: private non-residential investment spending fell an annualized 2.1%, worse than the 1.8% fall initially estimated.

The 1.4% annualized GDP growth just about keeps the economy in touch with its 2009-2015 trend growth rate of 2.1%, but there’s no hint that the economy is moving back towards its 1990-2007 trend growth rate of 3.2%.

More worryingly, despite the upgrade, this GDP expansion is not enough to sustain profits growth. In fact, corporate profits, including depreciation and inventory adjustments, fell 9.2% qoq, and generated the steepest yoy fall since the recession of 2008. Proprietor’s income fared slightly better, rising 0.5% qoq, which suggests a higher proportion of profits are being paid out in dividends. Rental income, meanwhile, rose 1.2% qoq. These three sources of income from profits together fell 3.7% qoq and fell 3.4% yoy, which, once again, was the bleakest result since 2008.

By contrast, the wages bill rose 1% qoq and 4.1% yoy. The result is that the wage bill is now rising faster than GDP in nominal terms, and wages as a proportion of GDP rose 40bps yoy to 54%, which was the highest proportion since 2009, and almost exactly in line with the 10yr average. Meanwhile, corporate profits as as percentage of GDP fell 1.4pps yoy to 8.3% in 4Q, which was 0.4 standard deviations below the 10yr average of 8.8%. If one includes proprietors’ income and rental receipts, the proportion rises to 19.8% of GDP, also down 1.4pps yoy, but still above the 18.7% average of the last 10 years.

Why US Capital Goods Orders Keep Sinking

noreply@blogger.com (Michael Taylor) — Thu, 24 Mar 2016 16:32:00 +0000

Although February's US capital goods numbers were routinely dreadful, in some ways they were not quite as bad as they first seemed, since they implied no significant disequilibrium within the capital goods sector itself. Nevertheless, with return on capital drifting lower, we should not expect any sustained improvement in the short and probably medium term: most likely orders are going to keep falling.

February's numbers were bad enough: capital goods orders (nondef ex-air) fell 1.8% mom, to the lowest dollar value since December 2013, and shipments fell 1.1%, to the lowest dollar value since January 2014, Hardest hit were orders for electrical equipment (down 2.8%) and machinery (down 2.6%); for shipments electrical equipment fell 2% and machinery fell 1.3%..

It’s not exactly good news, but it does perhaps mitigate the shock: despite the falls, there was no substantial deterioration in the balance between orders, shipments and inventories. Shipments fell 1.1% mom and inventories fell 0.3% mom, and that was enough to push up the inventory/shipment ratio by only 0.01pt to 1.76x. Any rise is disappointing, but the 1.76x ratio is actually still below the average since 2010, and implies no irresistible pressure to cut orders and start dumping inventory. Second, with orders down 1.8% mom and shipments down 1.1%, the book-to-bill ratio settled at almost exactly 1, with a fractional fall well within the margin of error. Once again, it’s not great, but it doesn’t imply that the industry is massively out of equilibrium. And that’s the good news: the capital goods sector is in retreat, but that retreat isn’t developing its own negative feedback cycle yet.

The much poorer news is that the fundamental problem depressing capital spending remains unaddressed: return on capital is almost certainly falling, and until it starts rising again, there’s good reason to expect spending on capital goods to keep falling too. In the chart below, the ROC directional indicator is calculated by expressing nominal GDP as an income from a stock of fixed capital. The stock of fixed capital is estimated by depreciating over 10yrs all non-residential private gross fixed capital formation reported in the quarterly national accounts.

The chart compares the dollar value of capital goods orders (nondef ex-air) and movements in that ROC directional indicator. It shows capital orders to be fairly acutely sensitive to movements in the ROC directional indicator. This has been particularly true since 2010, where even small deflections in the ROC directional indicator have coincided with short-lived rises and falls in capital goods orders.

As of 4Q15, the stock of capital is growing at 4.1% yoy, whilst nominal GDP is growing only 3% yoy. It would nominal GDP growth annualizing at 5.1% during 1Q16 just to stabilize this ROC directional indicator. A gain of that size would surprise consensus. However, until nominal GDP growth can overhaul the pace of growth of capital stock, the ROC directional indicator will keep drifting down, most probably taking capital goods orders down with it.

Mario Draghi as (Successful) Football Manager

noreply@blogger.com (Michael Taylor) — Wed, 16 Mar 2016 09:11:00 +0000

It is sometime said that the chief skill of a football manager is to pick to which team he should lend his magic at any one time. Much the same might be said of central bankers and their policy initiatives. For example, when Mark Carney accepted the post of Governor of the Bank of England in late 2012, it could be inferred that he was fairly confident the boat was not going down.

Something similar may be true of the European Central Bank’s latest clutch of easing measures. The combination of further interest rate cuts (including more deeply negative interest rates on banks’ deposits with the central bank; an enlargement and extension of its asset-buying program, and a new round of even-more generous long-term refinancing offers) probably can’t secure the ECB’s inflation target of near-but-not-quite 2% in the medium term. Nor can they guarantee the rehabilitation of the Eurozone’s banking system: the Japanese experience of the last 25 years shows how hard it is for even the most extreme monetary policy to resuscitate broken banking systems.

However, ECB governor Mario Draghi has pushed the new measures at a time when it is reasonable to expect the Eurozone’s current grinding and acyclical expansion to continue and accelerate modestly. If so, future commentators will congratulate M Draghi on the part he played in securing it.

In more detail:

i) the ECB’s refinancing rate is cut 5bps to zero; its marginal lending facility rate is cut by 5bps to 0.25%, and the deposit facility rate charged on banks’ excess deposits with ECB is raised 10bps to 0.5%.

ii) the ECB raised its target for monthly purchases of assets by Eu20bn to Eu80bn a month, with investment euro-denominated corporate bonds included.

iii) a new series of four refinancing operations will be launched in June, each with a four year maturity, under which banks will be able to borrow up to 30% of a specific eligible portion of their loan-book as of end-Jan 2016, with the rate set at the main refinancing rate (ie, zero).

The Eurozone is still in the early stages of a weak recovery, with 4Q’s 0.3% qoq GDP growth being the 11th successive quarter of sustained fractional growth. This sustained expansion owes nothing to credit growth, but everything to rising employment, which in turn reflects in labour productivity gains wrung out of a labour force in the teeth of a shrinking and aging capital stock. It is not exciting, but it is durable, and it looks very similar to the post-crisis expansions seen already in the UK and US.

At the heart of this grinding recovery are improvements in the return on capital, and rising labour productivity. Looking first at return on capital: by 4Q, real GDP was growing at 1.6% yoy, and nominal GDP was growing at 2.6% yoy, whilst gross fixed capital formation was growing at 3.4% yoy in real terms, and 4.1% yoy in nominal terms. Eurozone’s nominal capital stock finally stopped shrinking during the middle of 2015, and by the end of the year was growing at about 0.3% yoy. With capital stock growing only 0.3% whilst nominal GDP is growing around 2.6%, the return on capital must be rising. Moreover, unless nominal GDP growth slumps below 0.3% yoy, that rise in return on capital will continue for the foreseeable future.

How is it being achieved? The answer is: in the same way as we have previously seen in the US and the UK. This recovery is driven by a rise in labour productivity attributable to something other than rises in capital per worker (longer hours? more efficient working? upgraded skills?). As the chart below shows, real output per worker, deflated by changes in capital per worker, has been rising modestly but continuously since 2013, and by the end of last year, output per worker was rising 1.4% yoy. This laid the foundations for a similarly modest but sustained rise in employment. By 4Q15, employment was rising 1.2% yoy, with 4.5mn jobs added since the nadir of 1Q13.

That slow and steady rise in employment is also responsible for a slow but steady recovery in demand, achieved in the absence of any noticeable credit cycle, and despite the private sector’s unchanged financial caution. In fact, the private sector is running a savings surplus of just over 5% of GDP, as it has been since 2013. By definition, this savings surplus means the private sector is making more new deposits into the Eurozone banking system than it is taking out in new loans. Nothing the ECB does to interest rates or refinancing opportunities can result rises in net new lending until the private sector waives this financial caution. Even when you flood the banking system with liquidity, as M Draghi is doing, banks’ loan/deposit ratio will fall as the private sector generates net savings flows.

This continued deleveraging also means that although ECB action may be able, finally, to encourage growth in money M2, the impact of that monetary growth on GDP will be muted by an answering fall in monetary velocity (GDP/M2). What’s happening here is that whilst M2 is a count of the stock of money (essentially cash and deposits), what matters for economic activity in the short term are the activity-creating flows between those accounts. And the problem is that banks are either unwilling or unable to act effectively to re-circulate those funds around the private economy.

Nevertheless, even with savings surpluses undiminished, and even with banks’ ability to lend therefore circumscribed, the productivity-based rise in employment is sufficient to allow a steady expansion of demand, even in the absence of the sort of credit-based accelerators usually experienced in a classic business cycle. This is precisely the sort of steady, acyclical grinding recovery we have been watching for the past few years in the UK and US.

Three Ways to Track Cross-Border Credit

noreply@blogger.com (Michael Taylor) — Fri, 04 Mar 2016 12:07:00 +0000

Summary: Whilst the destruction of wealth represented by the falling stockmarkets will surely have malign economic consequences, they were not themselves responding to problems or excesses in the global economy which would be predictably resolved by a business cycle downturn. Rather, those falls were generated by a contraction of cross-border bank lending which ultimately had its roots in the surge in the dollar during 2Q14. If so, tracking the inflection in trends of cross-border financing becomes the most important task economists face currently. Here I present three ways we might be able to get on top of these trends.

I have argued that whilst the destruction of wealth represented by the falling stockmarkets will surely have malign economic consequences, they were not themselves responding to problems or excesses in the global economy which would be predictably resolved by a business cycle downturn. Rather, those falls were generated by a contraction of cross-border bank lending which ultimately had its roots in the surge in the dollar during 2Q14. The fall in cross-border financing acts on reserve money in just the same way a contraction in central bank lending to the financial system does. It is this unrecognized monetary crunch which toppled stockmarkets, with the worst impacts being felt precisely in those economies (and stockmarkets) which had previously benefitted most from the previous rise in cross-border lending. In practice that meant emerging markets, and China in particular.

The Bank for International Settlements data has the widest record of this, and it shows net cross-border claims on banks dropping by US$748bn to just $496bn between 3Q14 and 3Q15.

The impact was muted for developed country banks, net claims fell by only $185bn to $1.243tr, but for others, net claims dropped $563bn to result in a net liability of $747bn. This hit to ex-developed country banks was only partly offset by a continued rise (of US$190bn) in net claims on non-bank borrowers in the same period. Overall, however, net claims on countries outside the ‘developed’ definition fell by US$373bn - or by just over half - to US$371bn at the end of 3Q15.

A couple of things strike me visually concurrent and also what you’d expect: the direction of the flows mirrors the strength and weakness of the dollar/SDR. When the dollar strengthens mid-2011 to mid-2012, and again mid-2014 to early 2015) cross-border claims tend to diminish; when the dollar stabilizes or weakens, cross-borders lending picks up once again.

Because my global Monetary Conditions Indicator (excluding China) includes direction and volatility measures of movements of the US dollar (as well as monetary aggregates, real interest rates and yield curve measures), it is not surprising that there seems to be a good relationship then, between that and the movement of total international bank net claims on the the world (ex-developed countries).

The BIS’s data is invaluable in tracking this fundamental stress which finds expression in financial markets, but it is slow arriving - the latest data runs only to September 2015. To work out the degree to which those stresses are persisting, intensifying or retreating we need faster data. I have three suggestions:

direct observation of foreign assets and liabilities of developed-country bank balance sheets;
movements in my global monetary conditions indicator;
activity in credit default swap markets.

1. Developed Economy Bank’s Foreign Assets/Liabilities

The most direct indicator of the trends in cross border lending are, of course, movements in the net foreign assets or liabilities of developed economy banks. Although obviously less complete than the BIS’s survey, they are updated far more quickly. Looking at these balance sheets, we find two main sources for the drain in cross-border lending: the Eurozone, and, specifically, Hong Kong’s lending to China.

Eurozone Stress, the Big Unfinished Factor

As the chart shows, the net foreign asset position of the Eurozone’s banks has been in sharp and almost continuous contraction since the middle of 2014. In July 2014, the Eurozone banking system’s net foreign asset position hit a peak of US$1.917tr, but by January 2016 this had shrunk by US$481bn to US$1.437bn. There is no sign that this contraction has yet come to an end. Moreover, it is a mistake to view this contraction purely as a function of the 19.8% fall in the Euro against the dollar during this period: first, because it is a net figure and the fall in the currency affects both foreign assets and liabilities similarly; second, although Sterling has suffered a similar fall during the same period (down 15.5%), there has been no similar sustained run-down in foreign assets from London’s banks. Rather, this sustained fall in Eurozone banks’ net foreign assets represents a genuine disentanglement of Eurozone banks from ex-Eurozone finance. The data up to January contains no suggestion that this withdrawal has been completed. Anecdotal evidence and the demonstrated travails of the Eurozone banking system (loan growth of 0.1% yoy in Jan 2016) also give no obvious reason to expect an early reversal.

Hong Kong & China Finance. The second source of stress is the way in which Hong Kong’s financial system has pulled in credit lines to China - a contraction which has been far stronger than the overall fall in its net foreign asset position. I have written about this previously, but to summarise: between June 2014 and NOvember 2015, Hong Kong banks’ net foreign asset position fell US$47bn to US$253bn. This was a relatively modest reversal in trend, but hides a much more extreme reversal in its China position: between June 2014 and November 2015, the banking system’s net China assets fell US$247bn to just US$90bn. I expect by now that net total has already fallen to zero, or possibly less.

By contrast, the US banking system shows a fall in net foreign liabilities which is the counterparty of the fall in other banking system’s net foreign assets. Between July 2014 and December 2015 US banks’ net foreign liabilities fell by US$338bn to US$1.93tr, as gross foreign assets fell by US$27.6bn, but foreign liabilities fell by $395.6bn. We have data up to the end of 2015, and there is no obvious change in the trend.

Finally, we come to Japan, for which we have the data up to the end of 2015. This shows the familiar run down in net foreign assets between July 2014 and June 2015, although it was a relatively small affair - the contraction was only US$42.9bn. However, uniquely, that was subsequently reversed, and the current US$269bn in net foreign assets held at end-2015 is almost identical to the total held in July 2014. Small though the movement is, this is the only banking system I can find where foreign asset holdings are actually now rising.

2. Global Monetary Conditions Indicator

As we saw in the chart above, inflection points in my global monetary conditions indicator do seem to have coincided with similar inflection points in total cross-border financing flows. It is therefore worth noting that the decline seen between summer 2014 and sustained throughout 2015 does appear at least to have bottomed out - although it is too early to be certain it is inflecting upwards.

3. Credit Default Swaps - Weekly to end-Feb

The final indicator which may be worth watching is movements in the notional amount of credit default swaps outstanding. The data is timely and delivered weekly from the International Swap Dealers Assn, but has its own difficulties: responding to regulations which demand increased capital accounting for these products, the industry has adopted various ways of ‘compressing’ the notional outstanding balances, essentially by writing down the notional amount of matching or offsetting swaps outstanding in tranches as the cashflows materialize. As this has progressed, since the overall trend has been for the notional outstanding to fall by approximately 17% a year.

However, when detrended, the movements against trend shows the characteristic movement seen in cross-border lending, and in particular, the sharp fall against trend since the middle of 2014, which has been sustained until now.

After a particularly harsh fall at the end of the year - almost certainly in response to the approach of the end of year balance sheet - there has been something of a recovery in January and February. In fact, the middle of February saw the break above trend since December2014. Probably not too much should be read into that just yet: it may well just represent a rebound

infrom the unusually sharp falls of December. Nevertheless, I think this total is worth watching, since a sustained rise vs trend is a plausible early-indicator for a broader recovery in cross-border finance.

China: Zhou Xiaochuan Opens Up

noreply@blogger.com (Michael Taylor) — Wed, 17 Feb 2016 14:14:00 +0000

PBOC chief Zhou Xiaochuan’s c7,800 word detailed exposition of PBOC policy development and deployment pubished by Caixin this Monday is (I think) unprecedented. It is sane, sober and compendious, and cannot have found the light of day without rock-solid political support. It should buttress confidence in China’s policymaking right now, and will remain a must-read for anyone wanting to understand Chinese policymaking for years to come. It may mark the point at which the scarier China scenarios buy less market support.

On January 7th, my email message to clients started: “If China has a policy or a strategy for the Rmb, now would be a good time to reveal it. In the absence of a plausible and public strategy, the markets have conjured up enough feedback mechanisms to produce a genuine simple currency crisis.”

Five weeks later, PBOC governor Zhou Xiaochuan has produced an unprecedentedly lengthy and detailed account of policy strategy and tactics imaginable - a compendious response. Not only is it required reading for anyone involved in China now, but I suspect it will become something of a locus classicus for anyone wishing to understand Chinese financial policy development for years to come.

Governor Zhou’s exposition is contained in a c7,800 word written ‘interview’ published in Caixin, formerly seen as the house-mag of Zhu Rongji’s successors. I think it’s a mistake to attempt a precis, because such cherry-picking actually negates the key thrust of the message - that China has sufficient confidence in its policies to explain them in detail, including discussing the challenges and uncertainties which they encounter, and the mistakes made. Instead, you should set aside an hour to read it here: Zhou Xiaochuan's Caixin Interview.

China rarely really explains what it thinks it is doing, and how it intends to go about it. It doesn’t happen very often because such public assertion is impossible without rock-solid foundations of political consensus and coherence. Chinese politics is a tough game, so no-one goes beyond bland in public without having squared or neutralized any potential opposition beforehand.

This is why it is so important: such a public assertion means that what it lays out should be taken at face value. Serious deviation from these positions will be extremely unlikely whilst Mr Zhou remains in public view. The tone adopted is also important, and doubtless has been carefully calibrated. It features frequent acknowledgement of the limits of central banks in dealing with human nature (at one point, he includes ‘original sin’ as a reason for capital flight; at another, he points out that central banks are neither God nor magician). He is surprisingly clear-eyed about the compromises previously accepted in policymaking and their legacies.

So what does it cover?
• fx reform;
• capital flight and capital outflow;
• reserves management;
• the balance between tactics and strategy in policy formulation and exercise;
• PBOC’s role in communicating policy;
• legacy of policy mistakes;
• the competing or complementary roles of macro-prudential policies and macro-prudential regulation (a shot across CBRC’s bows?).

And more.

This interview is surely intended to help restore international confidence in China’s policy making, and my guess is that it will succeed.

My fundamental view is that the current volatility in financial markets is not, ultimately, about imbalances in the world economy, but rather about the historic break-down of the global oil-cartel and the fragility this has revealed once again in the world’s banks. Together these have resulted a fall in cross-border lending since mid-2014. And that has drained liquidity throughout the world in defiance of everything central banks have sought to achieve. China has been the single largest target because, as bank robber Willie Sutton explained ‘that’s where the money is’: withdrawal of bank lines (or paying down dollar debt) has formed the nucleus of the exodus of capital from China.

As Mr Zhou says at several points in his ‘interview’ this will necessarily burn itself out sooner or later. (Probably sooner, given that Hong Kong’s net exposure to China has probably reached zero by now).

There are two positive factors which currently are emerging which might help:
i) The inclusion of the Rmb into the IMF’s Special Drawing Right basket. It’s coming in October 2016.
ii) The agreement reached between the US and EU financial regulators to mutually recognize each other’s clearing arrangements for swaps and derivatives contracts. The key role of CDSs during the financial crisis, with banks belatedly discovering the terrible difference between ‘clearing’ and ‘offsetting’ made properly functioning clearing essential. But the sustained lack of recognition of ‘equivalence’ must surely have been a drag on cross-border liquidity. If this is now being removed. . .

To this can be added a third: China’s demonstration of clarity of purpose, and confidence in its goals, delivered in Mr Zhou’s ‘interview’.

China's Capital Outflow, Capital Flight, Conflicting Agendas

noreply@blogger.com (Michael Taylor) — Tue, 09 Feb 2016 14:06:00 +0000

Are Chinese people finding ways to circumvent rules and regulations in order to get their money out of the country? Yes, without doubt. Are China’s authorities currently bent on stopping them? Again, yes. To have said that, though, is to also to say ‘situation normal’. What matters is whether this capital outflow is sabotaging all other economic activity; and whether the government’s attempt to stop it has leapfrogged all other economic and policy goals. And the answer to both those is ‘not yet’.

The most important truth about China is trivial to state but very hard to comprehend: China contains multitudes. Within those multitudes it is always possible to produce stories and data proving one thing, and also stories and data disproving the same thing. When the news from China is contradictory, that’s not inaccurate reporting so much as the only possible result of fair representation.

And so to the arguments about capital flight. The important question is not ‘can we identify avenues of capital outflow?’ but ‘Is capital flight accelerating in a way which undermines China’s financial system and economy’. True ‘capital flight’ is tremendously damaging, as it represents an determination to avoid a certain penalty (major inflation, major devaluation) which overrides all the normal prompts which usually keep economic and financial activity ticking over.

Now, no doubt households and companies would like to spirit away some Rmb offshore, or convert it into dollars, and some are certainly doing so. The scheme by which Hong Kong’s insurers sold HK$21.1bn worth of products to mainland UnionPay holders during Jan-Sept 2015 attests to that. But this is obviously not the only agenda motivating households, corporates, and the financial system. For there is another conflicting agenda corporates have to address: banks are fretting about their loans, suppliers are increasingly demanding cash, and there’s only so much inventory to be turned into cash. In these circumstances, it is only the free cash at the margin that has the luxury of getting on the plane to Hong Kong. And for now, the bulk of the evidence suggests that on balance, the desire to survive the squeeze is trumping the desire to send capital abroad.

Similarly, dealing with ‘capital flight’ is only one of a number of goals upon which China’s policymakers are bent, and it’s not yet clear it has become prioritized over the strategic economic and financial goals China’s policymakers have spent years war-gaming.

In my time there have been two episodes of capital flight from China, both of which posed fundamental challenge to the financial, and later the political, system. The first was in the late 1980s, and the second was in the early 1990s. In its aftermath, Zhu Rongji was given the mandate to push through the fundamental reforms to the financial system and central planning which laid the foundations for the prosperity China has won during the last 20 years.

Although different in details, both episodes had similar primary characteristics:
i) inflationary pressures had mounted without an effective policy response, resulting in surging inflationary expectations;
ii) reserve money ballooned in response to depositors taking their money from the banking system (which in turn intensified i); and
iii) the trade balance deteriorated suddenly and sharply.

None of that is happening currently. In fact, the reverse is happening.
i) By December Inflation was running at 1.7% yoy only, and although this is likely to rise slightly during 2016, more economists are worried about deflation than inflation;
ii) Reserve money is actually falling, down 6% yoy in December. Despite that, Rmb bank deposits rate are growing at 19.2% yoy (whilst bank lending is growing at 15%) and during 2015 banks enjoyed a net inflow deposits (less loans) of Rmb1.256tr. In the last three months of the year, that net inflow was Rmb150bn, better than the Rmb237bn net outflow experienced, on average, during the previous three years.
iii) The trade surplus continues to grow: December’s US$60.09bn surplus was up 21% yoy, and during 4Q the surplus of US$175.8bn was up 17.3% yoy.

This configuration of data suggests that although at the margin people and companies are seeking ways to shelter from possible devaluation, the core aim of most economic actors is to survive the liquidity squeeze.

This also shows up, perversely, in some data which is claimed as evidence for capital flight: viz, the discrepancy in China’s account of its exports to Hong Kong and Hong Kong’s account of its imports from China. The underlying problem of the trade data is this: during December China said it exported US$45.93bn to Hong Kong, but Hong Kong reported it had imported only US$23.7bn from China - a discrepancy of US$22.2bn.

It is strange to view this as an expression of capital flight. Chinese traders have forever used trade with Hong Kong to circumvent China’s capital restrictions, under-or-over invoicing as necessary. But if you want to smuggle capital out of China, you don’t exaggerate your exports to China. Quite the reverse: if anything, you would exaggerate your import bill, since that would provide you with a ‘legitimate’ way to send money abroad.

There is an altogether more obvious reason why Chinese companies might over-invoice their exports to friends in Hong Kong. To be polite, it is a way of maximising the tax rebates paid by the government to companies on their export earnings. At the end of a tough financial year, a quick boost to these rebates will be particularly attractive. One also cannot discount the possibility that exporters might be able to win more favourable financing terms from their banks if able to show a healthy growth on their export earnings ‘outstanding’.

None of this is to say that capital flight isn’t happening, or that the government isn’t concerned by it. It clearly is happening, and clearly the government would like to stop it if possible. But that doesn’t mean it has forced its way to the top of the government’s policy agenda - rather, it has become a slightly more important member of the competing claims on government attention and time.

Different This Time? Part 2

noreply@blogger.com (Michael Taylor) — Mon, 08 Feb 2016 16:55:00 +0000

The previous post suggested that the standard explanations for the current financial volatility seem misdirected. This piece lays out the mechanics of an alternative explanation, that the world’s financial markets are struggling to absorb the impact of dollar strength.

First, though, to recap:
i) Current global monetary conditions don’t suggest the world economy is likely to plunge into recession, and globally domestic demand data remains relatively robust. In particular, labour markets remain strong in the US and UK, are clearly improving in the Eurozone, and also in Northeast Asia (outside China).
ii) Within the private sector, there has been no noticeable credit cycle, and no bubble-like investment cycle, which invites or requires re-winding.
iii). Although oil prices are falling, this reflects a supply-glut caused by attempts to resist a historic unwinding of the OPEC monopoly, rather than a shortfall in demand. (In fact, OPEC’s global demand figures suggest world demand rose by 1.9% in 2015, up from 1.5% in 2014 and 1% in 2013, although they expect a moderation to 1.3% in 2016.)

Rather, the key to the current volatility, and also to China’s ‘capital flight’ lies somewhere else: specifically, it has its roots in the dollar going on a tear between the middle of 2014 and early 2015. Between July 2014 and March 2015, the currency rallied 12.2% against the IMF’s basket currency, the SDR. Money suddenly got more expensive.

The widest-angle view of the dollar helps explain why its movements matter so much: the dollar is the world’s currency, and when you see it strengthen, it means the value of money has just gone up. But now narrow it down to the company level. Imagine your company has borrowed in dollars to fund a new machine, and the dollar has just risen against the currency of a major competitor. Tomorrow you find your competitor has dropped his dollar selling price, so you face the choice of cutting your price or losing market share. Either choice cuts into your profits and cashflow, and that makes it tougher to make your interest payments.

What’s worse, your banker knows this, and feels just a little less friendly to you than he was last week. Don’t be too hard on him though, because the chances are that the bank’s own dollar-funding opportunities are also shrinking. After all, his own earnings have also just fallen in dollar-terms. This is what happens when the value of money rises.

A rising dollar provided the background to Asia’s financial crises in 1997 and 1998, with the yen falling 33% yen against the dollar between June 1995 and April 1997 (from 84.5 to .125.5 to the dollar). At the time Japan accounted for just over half of all NE Asia’s exports, so as Japan dropped its prices, everyone else did too. It was also the background to the 2000/2001 US recession was a strengthening of the dollar, which rose 16.2% against the SDR between October 1998 and mid-2001.
Today’s worries have once again been crystallized by the strength of the dollar. This time the stress is less to do with export prices, and more to do with a loss of funding opportunities. Yes, globally manufacturers felt the chill of deflation; but Asia’s export economies are cushioned not only by the margins relief of falling commodity prices, but by the huge foreign exchange reserves, which are the prize won by the private sector running persistent sector savings surpluses. When the dollar started rising in July 2014, China had US$3.966tr in foreign reserves, and Asia ex-China had a further US$2.983tr.

China responsibly, but also rashly, decided the Rmb would remain effectively pegged to the dollar even as it rose. This caused, and is causing, some pain. But in truth, the pressure on export was not decisive - as sustained trade surpluses and the global resilience of domestic demand attests.

The tougher impact came from the impact on capital flows. The rise in the dollar reminded the world’s banks of ‘what happened last time’ and they set about cutting credits to those perceived vulnerable (including each other).The Bank for International Settlements (BIS) in Basel tracks cross-border lending, and although its quarterly reports are slow to appear, they tell a very clear tale.

Between September 2014 and September 2015, foreign lending into the US fell by $321bn, into the UK fell $544bn, and by $83bn into both France and Germany. In all, that’s a fall of just over $1tr in cross border lending into the major financial capitals of the work during the 12m to September 2015. Asia’s international finance centres were hit too: cross-border lending into Singapore dropped by $67.4bn (or 11.1%) and lending to Hong Kong fell $19bn (or by 3.1%),

But the worst hit of any country was China, where cross border lending fell by 20.9% yoy, or by $231bn in the 12m to September 2015. During the same period, China’s foreign exchange reserves fell by $374bn. So it is this net repayment of cross-border debt which accounts for the majority of China’s alleged ‘capital flight’.

When it comes to lending into China, Hong Kong plays a special role - and the HKMA produces its data (slightly) faster than the BIS. HKMA’s data tells us that Hong Kong’s net lending to China fell from US$333bn in September 2014 to just US$100bn by October 2015. On those trends, net lending into China by Hong Kong will have fallen to around US$50bn by end-January, and will have been all squared away by April. Most likely, however, the pace at which lines have been pulled will have quickened over the last few months.

This pulling of banking lines to China does seem to be the fundamental force skinning China of its foreign reserves. But if so, it has two important consequences. First, when all the credit lines are pulled, the pressure on China is likely to ease: as far as Hong Kong’s position is concerned, we’re probably nearly there already. And second, it means we must re-think those tales of China’s ‘capital flight’.

Different This Time? Part 1

noreply@blogger.com (Michael Taylor) — Tue, 02 Feb 2016 15:14:00 +0000

It’s common to hear that the most dangerous words in economics are ‘it’s different this time’. But ‘it’s just the same as last time’ run them a close second: each economic or financial crisis develops in its own way, and follows its own trajectory. If today’s financial volatility does mutate into an economic crisis, it will have very different roots from the crisis of western financial institutions of 2008, the US-led recession of 2000, or the Asian financial crises of 2007/08.

The differences are so pronounced that it’s surprising the consensus that economic chaos is heading our way has been so easily accepted.

This is where it pays to crunch quite a lot of data, rather than rely on excitable headlines or ‘gut feeling’. First, compare the difference in global monetary conditions currently developing to the situation in previous recessions. (I’m tracking them here for the US, China, Japan and the Eurozone by measuring how much money is out there, what’s the price of it, the shape of the yield curve the size and volatility in changes in international price of different currencies). Prior to the onset of recession in the US in mid-2000, global monetary conditions had been deteriorating for at least a year, with US short term rates bottoming in Oct 1998 at 4%, rising to over 6% by the time recession bit. Before the financial avalanche of 2008, global monetary conditions had been in solid deterioration for approximately two and a half years. Between 2004 and the middle of 2007, US short-term rates had risen from approximately 1.5% to a peak of 5% in mid-2007.

One could argue that both in 2000 and 2008, the US Federal Reserve was working to cool things down, and eventually succeeded beyond their most fevered nightmares. Global monetary policymakers are not (yet) making the same mistake this time. True, the Federal Reserve has tapped the brakes, but this continues to be offset by easing in China, the Eurozone and Japan.

Demand conditions are also very different from the onset of previous recessions. (My measurement here aggregates 30 different monthly measures from the US, Europe and NE Asia, with the common components being employment, retail sales and auto sales. In each case, I measure each to see how far they are deviating from a long-term seasonalized trend.) Prior to both 2000 and 2008 recessions, global domestic demand was running quite sharply stronger than underlying trend. Not now: since early 2013 global demand has shown, at best, a tortuous but persistent upward grind.

Nor is it difficult to discover the reason: the world’s banks remain loathe to lend, so it’s difficult to spot a vigorous credit cycle anywhere (with the possible exception of South Korea). With no credit boom kicking in to accelerate the cycle, the current global expansion depends largely on the slow rise in employment in developed economies.

But this is where the good news lies:

in the US non-farm payrolls have been growing steadily since 2000, with the growth accelerating to 2.1% during 2015;
in the UK, jobs growth started accelerating in 2012, since when the economy has added 2.27mn jobs, with 267k of them coming in the 3m to November;
in the Eurozone, the unemployment rate has fallen from a peak of 12.1% in mid-2013 to 10.5% currently, and in the 12m to September employment rose 1.6mn, or by 1.1%;
in NE Asia, Japanese employment rose 0.3% despite a shrinking population;, in S Korea Dec’s employment was up 2% yoy, and Taiwan’s was up 0.8%.

Normally, economists view employment as a lagging indicator, because small upturns in business conditions tend to be accelerated into fully-blown business cycles by supporting credit and investment booms, which in turn accelerate the rise in employment. When the credit and investment music stops, it takes some time for labour markets to react. But the single most salient feature of the current global expansion is precisely the absence of credit and investment booms. Those bubbles aren’t about to burst, because they’ve not yet been blown.

So for the time being, the rise in employment is likely to backstop global economic growth, even if collapsing stockmarkets temporarily knock consumer confidence, depress retail sales and raise savings ratios. If these don’t form the roots of the next financial crisis, what is the problem which Asia’s falling stockmarkets are reacting to?

End of the Industrial Super-Cycle

noreply@blogger.com (Michael Taylor) — Fri, 25 Sep 2015 17:26:00 +0000

There’s an issue, or an unstated assumption, which underlies much of the current worry about the state and direction of the world economy. One way of appreciating it is asking the question: ‘How can the US economy still be expanding vigorously when its industrial sector is in such trouble?’

Consider the evidence. US industrial output has shown consistently negative momentum since 4Q14 and this shows few signs of reversing: in August output fell 0.4% mom, and the regional industrial surveys for September have been grim, with the Philadelphia Fed survey shocking at minus 6 , the Empire State manufacturing survey grim at minus 14.7, the Richmond Fed survey showing minus 5 (worst since January 2013), and the Kansas City Fed manufacturing survey showing minus 6. At the same time, inventory/shipment ratios have risen to the highest levels since 2009, so far without improvement; capacity utilization rates have tumbled from a high of 79% in November to 77.6% in August. Exports, meanwhile, have endured consistently negative 6m momentum trends since July 2014, and by July 2015 were falling 7% yoy.

Despite this, domestic demand indicators have remained on balance positive, and, in particular, labour markets have remained robust. In the face of the most dramatic trade/industry downturn since the great recession, 2Q GDP growth came in at 3.9% annualized, largely on the back of a 3.6% annualized rise in personal consumption.

The contradiction between what is happening in the industrial sector and the trajectory of the broader US economy shows up clearly in my momentum indicators.

This divergence between the industrial sector and the overall economy is fairly obvious in the US. What is less obvious is that something very similar is characteristic of the entire global economy.

As the chart shows (*see below for details on these indicators), on a global basis, the industrial sector is clearly in trouble, but despite that, domestic demand momentum is not merely being maintained, it continues to accelerate slowly, as it has for much of the time since early 2014.

It seems to me that the most important thing about this aspect of the global economy is to acknowledge that it is really happening, and has been happening for nearly a year now. There is a deeply entrenched expectation that where the industrial sector leads, the rest of the economy must inevitably follow, from which it follows that a description of the industrial sector cycle is adequate to locate an economy’s current trajectory and potential.

Part of the reason for that is that economists (and everyone else) feel far more comfortable analysing the industrial economy than the services sector. At the most basic level, industrial output is far easier to count, movements in industrial prices are far easier to observe, balance sheets of industrial companies easier to take apart, all of which has allowed us a very good idea of how business cycles affect industrial companies. Similar analysis of the services sector fails at the first hurdle - even counting the output is so uncertain that we rely on hard-fought and contestable conventions and inferences, rather than direct observation. As for pricing, inventories, capital involved. . . .

Historically, there have been good historical reasons for the expectation that where industry leads, the rest of the cycle will follow, and what’s more, over the last 20 years new life has been breathed into those reasons by China's rise. Nevertheless, the expectation is, in philosophical terms, not necessary but only contingent - and it may be that as China has got richer, the contingency is passing.

Consider how spending patterns in the US have changed. In 1950, spending on goods accounted for 60.7% of all personal consumption spending, with services accounting for only 39.3%. However, as incomes rose, so the proportion spent on services rose, until in the 12m to June 2015, the proportions were almost exactly reversed, with 67.2% of personal spending going on services, vs only 32.8% on goods. But even that exaggerates the importance of industrial sector supply, since two thirds of spending on goods is on ‘non-durables’ such as food and gasoline. In fact, spending on durable goods accounts for only 10.8% of US personal consumption spending. This helps explain why a loss of momentum in the US industrial sector need not necessarily be pointing to a wider economic slump.

Such a pattern should surprise no-one: as a society grows wealthier, so marginal demand shifts from the acquisition of goods to the consumption of services.

One should expect to find this shifting pattern of demand not just in the US and Europe but, of course, in Asia too. And given the extraordinary rise in material comfort in China over the last 20 years, one should expect a similar pattern of shifting demand there too. Although we do not have the data to show this directly, the changing composition of China’s GDP makes it clear that this process is underway.

In 1995, secondary industries (ie, principally manufacturing) accounted for 46.7% of GDP output, whilst tertiary industries (ie, principally services) accounted for 33.6%. By 2015, the ratios had changed so that tertiary industries accounted for 48.6% of output, whilst secondary industries accounted for 42.2%. But note that as far as domestic demand is concerned, China was also running at trade surplus of approximately 5.5% of GDP, suggesting that domestic demand for secondary industry products had probably sunk to around 36.7% of GDP.

The shift in underlying demand is even clearer when one looks at marginal contributions to GDP: in 1995 tertiary industries accounted for about 29% of marginal GDP growth; in 2015 that had risen to 68%.

This shift in Chinese marginal demand away from goods to services, although predictable, is nevertheless the signal that the forces which drove the commodities ‘super-cycle’ - the sudden emergence of demand for goods from a Chinese population transitioning from poverty to material decency - are no longer the primary forces driving either the commodity cycle, the global industrial sector, or indeed, the world economy. When China first started emerging from grinding poverty to mass material decency, it was predictable that the first priority for China's population was to acquire more 'stuff'. So it made sense to buy the stuff that made 'stuff' - hence the commodities super-cycle.

But as China's population has grown richer, its marginal demand has shifted from 'more stuff' to 'better services'. Crudely put, its the shift from a new shirt to a sharper haircut. Unless industrial companies have factored in this slight slowdown in the rate of growth of marginal demand from China, the industrial sector will discover it cannot win the return on capital from its capex that it originally expected. On the other hand, demand for services will continue to grow relatively unimpaired.

In these circumstances, disappointing industrial demand and all that goes with it can easily co-exist with continued growth of employment, and overall demand in the world economy.

* (My global momentum indicators for the industrial sector and for monetary conditions take in data from the US, Eurozone, Japan and China; the global domestic demand indicator also includes data from the UK, S Korea and Taiwan. In each case, the indicator measures standard deviation movements from historic seasonal trends for key data. For the industrial indicator, this includes output, exports (local currency value and volume) and where possible indicators for inventory ratios and capacity utilization rates. For domestic demand, I include retail sales, vehicle sales, employment, wages, and selected other indicators where possible. For monetary conditions I include growth of monetary aggregates, movements of the currency vs the SDR, movements in real interest rates and changes in the shape of the yield curve. In each case, for global aggregates, countries are weighted according to 5yr average of US$ denominated GDP. No single-figure indicator will be perfect, but I am confident that these are sufficiently information-rich to not be completely wrong.)

Cargo-Cult Companies - Japan's 2Q Duponts

noreply@blogger.com (Michael Taylor) — Tue, 01 Sep 2015 16:43:00 +0000

The MOF's 2Q survey of private sector balance sheets and p&ls reveals this: more than ever before, corporate Japan's ROE depends only on the ability to source supplies cheaply, and there is little sign it wishes to change this business model or expand its reach. It is a cargo-cult approach, in which all depends on the vale of what washes up on Japan's shores.

On the downside, this confirms that Abenomics' hoped-for rejuvenation of the Japanese economy is nowhere to be seen. On the upside, in the short term, a devaluation of the Rmb will probably aid Japanese profits, rather than erode them as I initially thought.

The 2Q private survey presents a picture of extremes:

the highest operating margins since my data starts in 1980;
the lowest asset turns since my data starts in 1980;
the lowest financial leverage since my data starts in 1980.

At the moment, the gains in operating margins trump all else, raising ROE to 10.4% (just below the post-200 average) and ROA to 3.9% (1SD above the post-2000 average). So it is probably no surprise that as the key ratios which determine return on equity scale off in both directions to to previously unseen extremes, there is no sign of any change whatsoever in corporate behaviour.

And what does it all add up to? Operating profits growth running at just 7% yoy on a 12m basis, and investment in plant and equipment up just 5.5%, only just enough to cover the depreciation allowances claimed.

In 2Q sales rose 1.1% yoy (1.4% 12ma) whilst operating profits jumped 20.5% yoy (7.4% 12ma), and as a result, margins rose to 4.81% (vs 4.52% in 1Q), and 4.3% on 12m. These are the fattest operating margins for Japan since my data begins in 1980.

The reason for the rise in margins is simply an improvement in corporate terms of trade, with the cost of goods sold ratio falling 0.9pps qoq to 76.4%, the lowest since at least 1980 (although on a 12m basis, the 77.3% ratio was matched in 2Q11). There is no further improvement in SG&A /Sales, with the ratio rising slightly to 18.8% (vs 18.2% in 1Q and 18.7% in 2Q14). And there was practically no further improvement in the sales/expenses per employee ratio, as sales per employee fell 3.1% yoy whilst expenses per employee fell 3.4% yoy.

Both asset turns and financial leverage continue to decline to new lows. Total assets rose 5.2% yoy and 5.9% 12ma whilst sales rose 1.1% yoy and 1.4% on a 12ma, so annualized asset turns fell to 0.87, from 0.95 in 1Q and 0.91 in 2Q14. On a 12m basis, asset turns fall to 0.906x, the lowest since 1980s.

Whilst total assets rose 5.2% yoy in 2Q, shareholders’ net worth rose 6.5% yoy, so financial leverage fell to 2.63, or 2.66x on a 12m basis: again, the lowest since 1980 at least. The cash portion of that net worth continues to rise, up 8.6% yoy in 2Q, equivalent to 11.4% of total assets, or 11.3% on a 12 basis - the highest proportion since 1992 in the immediate aftermath of the zaiteku financing bubble years. Those cash holdings strip 4.5 percentage points from return on equity, cutting it to 10.4% from the ex-cash ratio of 14.9%.

US Capital Goods Winter Thaws in July

noreply@blogger.com (Michael Taylor) — Wed, 26 Aug 2015 15:49:00 +0000

There was enough in July’s capital goods data to remove most of the clouds which have hung over the investment cycle for the last six months. In July capital goods (nondef ex-air) orders jumped 2.2% mom, whilst shipments rose 0.6% and inventories fell 0.1% mom. The orders recovery was broadly-spread: autos rose 4% mom, computer/electronics rose 2% mom, machinery rose 1.5% and electrical equipment rose 1.3%.

The result is that the book/bill ratio recovered back to 1 for the first time since January, and the inventory/shipment ratio fell to 1.73x, also the lowest since January. Although this does not entirely remove all threats from the capital goods cycle, it does suggest the immediate pressures have been relieved.

In particular, inventories of capital goods have been kept essentially flat since September 2014, and with the inventory/shipment ratio now a full standard deviation lower than the post-2010 trend, any significant recovery in end-demand stands to be amplified by a rush to re-stock supply channels.

Still, for the capital goods sector, 2014-15 was a long long winter, and even July’s results are not stellar. In particular the book/bill ratio is still a full standard deviation below the post-2010 average. More, although orders rose a revised 1.4% mom in June and a further 2.2% in July, it still leaves the dollar total down 3.3% yoy and 6.6% below the 2010-2014 growth rate. Similarly, although shipments rose 0.9% mom in June and 0.6% in July, in dollar terms they were up only 0.5% yoy in July and are 5.3% below the 2010-2014 trend.

China and Commodities - The End of the Beginning

noreply@blogger.com (Michael Taylor) — Fri, 21 Aug 2015 17:45:00 +0000

I suspect the market is wrong about China, and wrong about its likely appetite for industrial commodities in the coming year - most likely the bottom has already been and gone.

To start with two things which should be obvious: the Caixin manufacturing PMI for August, which apparently managed to panic markets when it fell by 1.7pts to 47.1, is produced by Markit. China’s industrial data is insufficiently consistent to allow the tests, but where one can measure - Europe, UK and the US - there not the slightest scintilla of meaningful correlation between movements in Markit’s PMIs and movements in industrial output. I do not doubt these indexes power to move markets, but their information content is right up there with astrology: they are not even wrong.

The second thing which I think is obvious is that China’s willingness to devalue the Rmb is a correction of a quite serious monetary policy mistake made last year, and was a necessary precondition to re-liquefying the economy. There are clear signs that PBOC is now grasping the opportunity, adding 150bn yuan in open market interventions this week, the largest since Chinese New Year’s temporary 205bn yuan injection, and compared with the average weekly rise of just 6bn yuan during the last three months. On top of that, the week has seen PBOC extend 110bn yuan in medium-term loans to 14 financial institutions, and also pump $48bn into China Development Bank and US$45bn into China Exim Bank.

China has finally granted itself the conditions under which it can reflate the economy, and it looks like the central bank is finally making an attempt. If it succeeds, then the track record suggests that eased monetary conditions will be able to restore momentum in both the industrial sector and in domestic demand.

If so, this is the end of the beginning of China’s cycle, rather than the beginning of the end.

In which case, the current panic in commodity markets looks misplaced, since Chinese demand for industrial commodities is more likely to stabilize and/or rise during the coming year than to disappear. In fact, that trajectory may already be emerging in the relevant data, such as imports and inventories.

The place to start is with the volume of China’s imports of industrial commodities. For those commodities which are no longer growing, imports topped out early in 2014, since when they have been either stagnant or falling. But by July, that peak is beginning to pass out of the base of comparison, with the result that yoy falls are beginning to moderate and will continue to do so, even if the recent signs of modest growth disappear. In July, imports of four out of the six major industrial commodities showed a yoy rise in volume terms.

Crude Oil: up 29.3% yoy, and up 10.4% ytd
Refined products: up 28.5% in July, and up 0.9% ytd
Iron ore: up 4.3% yoy in July, and down 0.1% ytd
Copper: up 2.9% yoy in July, and down 9.4% ytd
Coal: down 7.7% yoy in July, and down 34.1% ytd
Steel Products: down 13.9% yoy and down 8.9% ytd

We can also get some clues from Australia’s trade patterns: during June exports to China rose 3.4% yoy, although in the year to June exports to China were down 17.7% ytd. Now, looking at commodities: in A$ value terms:

Iron ore down 10.9% yoy in June and down 32.1% ytd
Coal: up 13.7% yoy in June and up 1.7% ytd
Copper: down 21.4% yoy in June and down 24.2% ytd

The message is similar: although the market is soft, the later data suggests things are moderating, not getting worse.

There’s more to this moderation than simply a base of comparison effect. In addition, the inadvertent tightening of monetary conditions during 2H14 and early 2015 squeezed working capital hard enough to make China’s companies in turn squeeze their supply chains (hence the toll on Northeast Asian suppliers) and cut inventory holdings. There are a variety of measures of China’s inventories, but most agree that commodities inventories have fallen, quite sharply. Of the three separate measures of iron ore inventories, two find them down 26.8% yoy in July, and one finds them down 29.5%. Rebar inventories are down 3.4% yoy, and hot rolled coil inventories are down 8.2%. Coal inventories at China’s ports are also down 10.9%.

It is more difficult to construct wider inventory totals, but producer goods seem to have been falling steadily and consistently since 2008. That fall has moderated significantly over the last year, but still, by June, inventories of producer goods were down 7.5% yoy. It is even more difficult to reconstruct an inventory series for durable goods generally, but my attempt suggests inventories of durable goods peaked in September 2014, have fallen 18% since then and were down 0.3%yoy in June.

This combination of falling import demand and falling inventory holdings of industrial commodities is consistent with what one would expect after a prolonged period of unusual monetary discipline. What would be consistent with a relaxation of that discipline would be, at the least, a willingness to stabilize inventory holdings, which with even steady underlying domestic demand, would result in a resumption of rising demand for industrial commodities.

Which is perhaps what is also signalled by freight rates. The Baltic Dry index ended July at 1,131, up 50% yoy, and slightly more than double the Feb 2015 low. Since the end of July, it has dropped to 1,014: the average price since 2011 is 1128, and the current price is 0.3SDs below that average. Interpretation? The index was anticipating some pick-up in demand, and still is, although it now has slight doubts. Perhaps it too places its faith in Markit’s PMIs.

China Post-Dollar Policy - Coordination or Frustration?

noreply@blogger.com (Michael Taylor) — Fri, 14 Aug 2015 11:00:00 +0000

With faultless timing, the BIS’s Financial Stability Board published its once-every-five-years peer review of China, assessing the authorities’ administrative ability to foresee, recognize and react in a timely manner to financial instability. Its message? That whilst great strides had been made, there are still a plethora of regulatory agencies with mandates sufficiently loosely drawn that their efforts sometime overlap and nullify each other.

Or, as they put it: ‘Enhancing inter-agency coordination and developing an integrated risk assessment framework will promote a common understanding of objectives and risks, which will in turn facilitate joint policy actions and public communication.’

Whilst the FSB was focussing on the agencies with a claim to oversee various parts of China’s proliferating financial sector, they could have extended their review to highlight the way the different agendas of the Ministry of Finance and PBOC have hampered effective monetary policy development in the run-up to the stockmarket collapse and subsequent yuan devaluation.

The tension between the two arises because government has 3.6tr yuan deposits with the central bank, amounting to 11% of its total assets, or, excluding fx reserves, about a third of the implied domestic assets of PBOC. By raising or lowering those deposits, the Finance Ministry can affect private sector liquidity: when it lowers its deposits, it pumps money into the private sector; when it raises deposits, it takes money out of the private sector.

Over the last year, the average monthly movement of these deposits (addition or subtraction) has come to 373bn yuan.

During the same time period, the average monthly addition/subtraction to liquidity made by PBOC has been 85bn yuan. But open market activities are not the sum total of PBOC’s interactions with the domestic economy. We can estimate those by looking at the change in PBOC’s total assets, minus the change in the fx reserves kept on that balance sheet. Currently, these implied domestic assets amount to 11.28tr yuan, and they increased by 2.71tr yuan, or by 32%, in the year to July, with the average monthly addition/subtraction coming to 418bn yuan.

As we can see, the Finance Ministry has a swing factor averaging 373bn yuan a month, and PBOC has a total swing factor of 418bn yuan. Those are big numbers, and if deployed in a consistent and coherent way, they could have a serious impact on domestic liquidity. But they are also so similar in size that they each separately could frustrate and cancel out each other’s policy intentions.

So what’s actually happening? The following chart shows the 6m momentum change vs in government deposits and PBOC’s implied domestic assets, expressed in SDs vs historic seasonal trends.

And what it captures is that the default position over the last year has been for PBOC and Ministry of Finance actions to pretty much cancel each other out. During the second half of 2014, as the dollar began to rise and China’s foreign exchange reserves began to fall, PBOC responded by rapidly expanding their domestic assets. This was a reasonable response to the tightening of conditions implied by the forced-march rise of the Rmb. But the impact was negated by the rise in government deposits made by the Finance Ministry - what PBOC put in, the Finance Ministry took out.

Early this year, when it was clear that the economy was in worse shape than anticipated, the Finance Ministry abruptly changed its tactics, running down its deposits in PBOC, with the effect of pumping liquidity into the domestic economy. Unfortunately, just at that time PBOC also changed its policy, cutting back sharply on the growth of domestic assets: 72% of the rise in domestic assets made in the year to July was made during between July 2014 and Jan 2015. Result? Both policy initiatives were cancelled out once again.

The hope is that, with monetary policy no longer constrained by the need to shadow the dollar, both PBOC and Finance Ministry can agree on coordinating a mutual approach to fiscal and monetary policy which can be sufficiently accommodating to make a positive impact on the economy. The data for July - the latest available - hints that something like this may yet emerge.