Tuesday, 23 August 2011

Flow Essentials: Scaffolding for the Cycle

Today I publish my Flow Essentials booklet for 2Q for the US, the Eurozone, China and Japan. It tracks those fundamental ratios which are scaffolding for my view on the cyclical state of these economies, and their likely near-term future. The pdf file can be downloaded here.

The charts look at return on capital, labour productivity, banking system leverage trends, private sector savings surpluses/deficits, and terms of trade. They also look at the changing relationships people and their money (liquidity preference), and between money and the economy (monetary velocity).

I believe how these ratios and indicators change tell us a great deal about what's really happening in these economies, above and beyond the noise of the monthly data-tide. Moreover, they uncover cyclical potentialities and perils which would otherwise be largely hidden. Given the extreme financial risk-aversion we're currently suffering, and the underlying economic scepticism and/or fear they reflect, an examination of the roots of the world's leading economies' business cycles feels unusually timely.

Here's what they reveal:
In the US, the charts shed a light on the profound divorce between current cyclical indicators, and financial fears. If you look at what's happening to the factors of production, it's pretty clear that both ROCs and labour productivity growth are still very positive – having survived the 1H downturn with ease. But – and this I find astonishing, if only in retrospect – something profound happened in 2Q. For the first time in 12 quarters, the US private sector ran a savings deficit during 2Q. This deficit was equivalent to 0.9% of GDP, and compares to a surplus of 6.1% in 2Q10, and a 12m savings surplus of 4.3%.

In one sense, this is a shocking reversal of cashflows – for the first time since 2Q08, the US private sector has had to attract a cashflow from the financial system in order to maintain its current level of consumption and investment. And it's no illusion: precisely during the same period, the US banking system's net foreign liabilities increased for the first time since the end of 2008 – precisely what you'd expect if the banking system were having suddenly to find cash, rather than allocate it. Against this background, the weakness of the dollar is hardly surprising.

But in another sense, this is merely a restoration of normal seasonal patterns, after three years interruption-by-crisis. I calculate the PSSS using non-seasonalized data for the current account and the fiscal deficit, and it's those seasonalities which caused the 2Q plunge into deficit. We can be almost certain that a surplus (probably declining) will be resumed in 3Q and 4Q, and that the equilibrium between the US private sector and foreign savers will be effected on easier terms as the year wears on.

The other factor which is very striking is the way monetary velocity has collapsed back almost to levels seen during the worst stretches of 2009. I am inclined to believe that this represents the continuing substitution of deposits for 'riskier' financial assets – nonetheless, the less-efficient allocation of savings that implies must surely be a drag on growth. Looked at in a positive light, however, it seems unlikely that monetary velocity will fall much further – which in turn argues that nominal GDP growth is probably bottoming out just about now (at around 3.7% YoY).

As in the US, so in the Eurozone the cyclical growth factors were actually improving during 1H – ROC was rising gently albeit not yet to pre-crisis levels, and this was allowing a modest expansion of capital stock. There is much better news from labour productivity: real output per worker, adjusted for capital per worker, is now rising for the first time in recent Eurozone history, so labour markets are likely to be more resilient than might immediately be suspected. However, deleveraging is painfully slow, with bank private sector LDRs only dribbling down to around 105% (vs c82% fdor the US). Over 10% of gross foreign liabilities have quit the Eurozone banking system, with the result that even a reasonably large private sector savings surplus (about 5%) isn't delivering sufficient cash to allow much lending-growth. Added to which, monetary velocity has flatlined in Europe now since the end of 2008, with no sign of a pickup. As a result, with deposit growth slowing to under 4%, it seems unlikely Europe's nominal GDP growth will outpace that of the US any time in the near future.

For all the handringing and introspection, the story told by China's fundamental ratios is one of more of the same. Most ratios are disappointing, but not so much as to precipitate either a crisis or a major policy change. Thus, ROC is probably slightly worse in 2011 than 2010, whilst growth of capital stock is probably slightly higher in 2011 than in 2010. Monetary velocity is flatlining, as it has been for 18 months now. Terms of trade continue to decline, albeit gently.

Together the unaddressed inefficiencies are undermining China's cashflows – China's 12m PSSS probably declined to around 5.6% in 1H11 from 6.3% in 1H10 – but the pace of decline makes no dent at all in the financial sector's cashflows. In fact, by July, the banking system's LDR had fallen to 66%, which is actually down from 66.5% in July 2010. This underlying liquidity was, of course, sucked out of the system by PBOC's repeated raising of reserve requirements: once these were taken into account, the banking system's effective LDR was shunted up to just under 84%, it's highest rate since early 2004. The stress, though, is entirely policy-induced. China's real cyclical challenges are political, rather than financial or economic. (That probably makes them more real, more consequential, not less).

There's a challenge in interpreting the ratios for Japan. That challenge is first to separate out the impressive early recovery from the March 11 catastophe, from the real lasting damage done to Japan's economic infrastructure, and then secondly, to remember that even had March 11 not happened, Japan's economy would in any case be only in a mediocre position to prosper cyclically.

The disasters of March have taken a sharp toll on the factors of production: the rise in ROC was abruptly snuffed out, and previously sharp-gains in labour productivity were scaled back. Monetary velocity also collapsed. We can expect all these to bounce back to some extent during the rest of the year. But other problems cannot be attributed to March 11: for example, the unabated collapse of terms of trade – the effects of which are excacerbated by the rise in the Yen. This is also reflected in the slow decline of the private sector savings surplus, which started well before March 11, and has continued after it. The real problem is that this economy still looks fundamentally deflationary, and whilst monetary velocity will probably bounce back in 2H, there remains no reason to think it will or can return to pre-2008 levels. In which case, the long-term contraction of nominal GDP must be expected to continue in the medium to long term.

Finally, there's no real encouragement anywhere for operating margins: terms of trade have fallen sharply everywhere. In the Eurozone and Japan, they have fallen right back to the previous lows of 2008. Things aren't quite so bad in the US and China – but in both cases, comparisons are going to get tougher throughout the rest of this year.  

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