Shocks and Surprises, Week Ending April 1st

• Domestic demand stirs in Japan, with partial answer from industrial sector.
• All but one report from China discovers sharp deterioration in industrial sector as cashflows and profits cramp. But the official manufacturing PMI reports best conditions of the year!
• Income and spending patterns in the US show savings ratio in retreat, with a correction/pullback in spending likely in the short term. But this is probably not the start of repeat of 2011's 'soft patch', even though regional manufacturing surveys bring bad news.
• In Europe consumers celebrate 'back from the brink' but business discovers recession. Monetary totals flatter as banks' stampede back into government bonds crowds out private lending

Japan: Domestic Demand Stirs

However unlikely it may seem, the flow of data suggests something is beginning to stir in Japan. This week brought positive surprises both from domestic demand, and also from the industrial sector. Retail sales rose 2% MOM and 3.5% YoY, and later in the week overall household spending was reported to have risen 2.3% YoY – the most rapid growth since March 2010. Then on Friday, housing starts jumped to their highest reading since last August. From the industrial sector, the Shoko Chukin SME confidence index improved beyond expectations to its least-negative since March last year (before the earthquake). At the end of the week, the manufacturing PMI came in at its strongest since August 2011, primarily on the back of a jump in new domestic orders (export orders grew only negligibly, owing to weak Chinese demand).

For Japan, this seems almost heady stuff. However, there are at least two reasons for celebrations to be muted. First, the improvement in the industrial sector has not yet shown up in industrial output, which fell 1.2% MoM and rose only 1.5% YoY – both in line with expectations. Second, and more disappointing, investment intentions revealed over the weekend in the Tankan show no sign of cyclical recovery – investment intentions for FY12 are no better than flat.

China: Industrial & Cashflow Deterioration is Contested

In China the balance of evidence suggests a quite sharp deterioration in industrial conditions – although it should be stressed that the evidence is actually contested. However, the clearest signal came at the beginning of the week, when China reported that although revenues rose 13.4% YoY during Jan-Feb, industrial profits dropped by 5.2%. A drop in profits is absolutely compatible with topline revenues growing more slowly than the c20% YoY rise in capital stock. It is also compatible with the sharp cramping in cashflows that we've tracked through the economy over the past couple of months.

Then came a spate of manufacturing surveys. The MNI Business Conditions survey was disappointing in its preliminary version: but the final version was even worse, with significant downward revisions on new orders and current production, and a real collapse in expectations of future orders and production. This was followed over the weekend by the HSBC/Markit manufacturing PMI which also recorded the fastest decline in new orders so far this year, led by domestic orders. In response to that, manufacturers reportedly are cutting both staff and purchasing of materials.

Despite all this, the official manufacturing PMI came out with the best reading of the year – an improvement far outside the range of expectations. It reported sharp rises in output and new orders (though only a slight improvement in export orders), with backlogs of work, purchases and employment all rising.

This official reading clashes with everything else being reported about China's economy.

US: Probably Not the Start of another Soft Patch

The most striking data this week was the divergence between monthly personal income and spending data. Personal income growth seems stuck at around slowed to just 0.2% MoM, leaving the 3ma stuck at 0.3% for the third month in a row. Meanwhile, personal spending jumped to 0.8% MoM, which in turn depressed the personal savings ratio to just 3.7%, the lowest rate since January 2008.

On the face of it, this is unsustainable, and we should expect an early reversal of these patterns, and in particular some short-term weakness in personal spending. However, notice also that since there appears no threat to the a rate of personal income growth which has been effectively steady for a full year, the expected oscillation of spending over the next couple of months is unlikely to herald a significant slowdown, or a re-run of the 'soft patch' we saw emerging this time last year.

In addition, it's now clear that there's a very steady downward trend in the US personal savings ratio, which has been largely uninterrupted since the middle of 2010. If this continues, it means the expected reversion to trend is unlikely to take the require the savings rate back to anything much above the 4.3% recorded in January.

But the second trend from the US this week is more worrying – a further clutch of regional manufacturing surveys which have shocked on the downside, and all of which have reported a sharp deterioration in new orders (this despite an unexpectedly positive 1.4% MOM rise in shipments of capital goods (excluding defence and air). These shocks arrived from Dallas, Richmond, Kansas and finally Milwaukee. Of the regional manufacturing surveys this week, only the Chicago PMI managed not to disappoint. Given that consumer sentiment surveys are still solid (the University of Michigan survey surprised on the upside this week), labour markets still improving, and consumer credit totals still rising, it seems harsh for the moment to interpret these manufacturing reports as heralding a soft patch. Nonetheless, they are slightly unnerving.

Europe: Relief and Recession

Signals from Europe continue to show a contrast between buoyant popular hope that the Eurozone crisis has been solved, or at any rate postponed for now, and the business realisation that the price of that stabilization is recession. Thus French and Italian consumer confidence surveys surprised on the upside (though German and British surveys disappointed), but surveys of Eurozone business confidence deteriorated worse than expected both for the general climate, and also specifically for the industrial sector.

These contradictory signals have been emerging for the past few week: in truth, a greater proportion of economic data from Europe conformed to expectations than for several weeks, suggesting that the worst of the shocks are indeed behind us for now.

Finally, no account of Europe's data this week can miss the data which showed Eurozone M3 growth accelerating to 2.8% YoY in February – an acceleration fuelled by the ECB injections of Eu1tr+ of cheap 3yr credit (Eu489bn before Christmas, Eu 530bn at end-Feb). This was the strongest M3 growth since September, and the third month of acceleration.

But the recovery is entirely  a public sector affair: liabilities to government rose 5.4% YoY, but liabilities to the private sector rose only 2.2% YoY (down from 2.8% in January).  On the asset side of the balance sheet, credits to government rose 6% YoY, driven by a 13.1% YoY jump in holdings of government bonds. By contrast private sector credits nudged up just 0.3%.

Drill down to the banking sector data, and the dynamic is obvious: in the last two months, loans to the private sector have risen Eu2bn only, whilst banks have added Eu120bn to their holdings of government bonds.  Holdings of government bonds are now equivalent to 19% of all private deposits, up from 16.9% in July 2011, and are growing at 5% a year. Loans to the private sector, meanwhile are growing at 0.5% YoY. Most of the ECB’s cheap credit has simply been re-deposited back in the ECB. But by offering huge incentives to prop up ailing Eurozone government bond markets, the ECB has also inadvertently underwritten a massive crowding out of private borrowers – one which is now intensifying Europe’s credit crunch.