Friday, 2 December 2011

Flow Essentials - Hidden Strengths, Hidden Vulnerabilities

Today I (finally) publish my Flow Essentials for 3Q, taking in the bulk of the developed economies: US, the Eurozone, China and Japan. This booklet charts the ratios I believe to be fundamental to understanding how an economy is performing, and what implications that growth has for the financial system. The charts look at:
  • returns on capital, and growth of capital stock;
  • changes in real labour productivity, and growth of employment
  • changes in terms of trade
  • movements in leverage, and changes in the net foreign asset/liability position of the banking system
  • size and movement of private sector savings surplus/deficit
  • changes in monetary velocity and liquidity preference.

Those of you who spend time analysing equities will recognize a deep affinity between this form of macroeconomic analysis and Dupont analysis. You should also recognize the concern with cashflow. You can download it here:

Is there a Big Message for the world economy here? Superficially, the answer is 'yes, the world economy is in better shape than it usually seems.' First, return on capital is rising everywhere, except post-tsunami Japan. In the case of the US it is rising very sharply. Second, with the exception of China, there's very little in the way of growth of capital stock, so the risks to asset-turns based earnings are fundamentally still tilted towards the upside. By which I mean that continued topline growth is likely to do more good for the bottom line than a slowdown in growth is likely to do damage. Third, every major economy is running a significant private sector savings surplus: the US at 4.3%; the Eurozone at 4.9%; China at 4.2%; and Japan at 9%. Everywhere except Japan these surpluses are falling steadily – this is fuel for continued growth in private domestic demand.

Rising ROC and falling savings surpluses everywhere! Why, then, are we worried? The problem is that the flip-side of these large private sectors surpluses and almost equally large public sector budget deficits. Were this not the case, these big economies would all be producing far more than they are consuming, and deflation would be rife. (Or, more likely, profits would dry).

Worse, there is almost an economic identity in which the large private sector savings surpluses – or at least the part of those surpluses which are represented by profits - are conditional on those public sector deficits. In those parts of the world in which the underlying public sector debts are so huge as to require fiscal deficits to be pruned or reversed, there's a very predictable threat to profits growth, and therefore to the investment cycle.

We guess at this instinctively, but we can also demonstrate it at a macroeconomic level. Take two national accounting identities:
Y = C[onsumption] + I[nvestment] + G[ovt spending] + eX[ports] minus iM[ports], and
Y = W[ages] + P[rofits] = T[axes] + O[ther income]
and solve for Profits:

Profits = (C-W) + I + (G-T) + (X-M) - O

Now lets use that to look at the relative breakdown of profits from three major sources
  1. Consumption minus Wages
  2. Government spending minus Taxes
  3. Exports minus Imports.

First, look at Japan.  
As you can see, the macroeconomic attribution of Japanese profits in the aftermath of the financial crisis of 2008/09 is very different, and crucially, very much more dependent on continued fiscal deficits, than before it. In 2007-08, Japan's profits were finally no longer principally dependent public sector largesse – rather, the profits were coming from the spread between consumption and wages, and to a lesser extent, net exports. During 2010 and 2011 that all changed, and we're back to the old state-dependent structure. Moreover, the situation has been exacerbated by the continued collapse in Japan's terms of trade, so net exports barely make a contribution any longer.

Now, take a look at how the US picture has changed (I've smoothed to 5yr averages here. In this case it reveals a pattern otherwise difficult eyeball, owing to its volatility).
Each line has a story to tell. First, the top line is stagnant: it looks as if the proportion of profits generated by the surplus of consumption minus wages finally plateaued in 2Q08 at the onset of the financial crisis. There is no sign that this is about to rise higher. Second, and most obviously, the proportion of profits attributable to the fiscal deficit has risen from a low of around 5% in 2002 to an all-time high of 25% now, and it continues to rise sharply. This is the 'corporate welfare' one reads about, and it is the single biggest factor behind rising profits right now. And finally, since the financial crisis the modest closing of the trade deficit has offset the peaking of the consumption-wages profit element.

This type of analysis shows plainly enough what is at risk during coming year: that the scramble to close fiscal deficits, whether made voluntarily or under pressure from markets, will make a sharper impact on profits, returns on capital, private sector savings surpluses (cashflows) and the investment cycle than is immediately obvious. Just another way of saying: price equities on the basis of unexpected earnings volatility.  

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