Germany's Seasonal Adjustment Failure

Most of the time seasonal adjustments are useful because one really wants to know what is happening from month to month rather than from year to year - and seasonally adjusted series let you see that. But from time to time they go wrong, because they adjust only slowly to structural shifts in the pattern of economic behaviour (spending, saving, investing, ordering etc). And sometimes, particularly under the pressure of economic or financial crises, those structural shifts can be abrupt.

For much of the world, the period since 2008 has been one of very rapid structural adjustment. As a result, some seasonally adjusted data is proving more fallible than usual. 

Take, for example, this morning's September retail sales data from Germany. According to the seasonally adjusted data, sales rose an impressive 1.5% mom - far stronger than anyone had expected.  But if you look at the raw data, sales fell 3.1% yoy, which was far weaker than anyone expected. What's more, sales fell 1% mom in September, which contrasts with the 1.9% mom averaged in the previous five Septembers. That's a disappointment which is 0.9 Standard deviations below the series. 

So which is right? Were Germany's retail sales stronger than expected in September, or weaker than expected?  Clearly it matters, and your judgement on it will depend on your trust in Germany's seasonal adjustment process. 

Now, at its most basic, the idea of seasonally adjusting is to reallocate monthly sales in such a way as to compensate for the sometimes violent seasonal fluctuations (the peak in December, the crash in January, for example). This has the consequence that the acid test for whether the process is working properly is whether over a 12 month period, the adjustment process becomes statistically invisible. In other words, the 12ma for a seasonally adjusted series must be near-identical to the 12ma for the non-adjusted series. If it isn't, there's something wrong.  Here's how the two series yoy 12ma for German retail sales, adjusted and non-adjusted look. 

The graph makes the point: there's something wrong - Germany's seasonal adjustment process doesn't meet even the most basic test of coherence. Although Germany's seasonal adjustment process was working fine all the way up to mid-2010, since then it has increasingly diverged from raw data, with the seasonal adjustment producing systematically stronger-than-justified readings during mid-2010 to mid-2011, and subsequently producing seriously weaker-than-justified readings from mid-2011 to August 2012.

By happy chance, the 1.5% mom reading for September - far stronger than seems justified in its own right - has brought the 12m average back to the correct level.  But given the adjustment process's failure since mid-2010, it would require a leap of faith to believe this is anything other than a happy coincidence.

The conclusion? On this series, at the moment you can not  trust the seasonally adjusted data.  And a second conclusion? Germany's September retail sales were not surprisingly strong, as today's headlines proclaim: they were (almost) shockingly weak. 

US Industrial Vulnerability, Germany's Contradictory Confidence Readings - Two From Last Week

Last week's data provided more than two things to ponder, but the two I've chosen to highlight are:

1. The continuing weakness of US industrial data, turning up in regional surveys for October
2. The contradictory state of Germany confidence indicators: business and industrial surveys are showing severe deterioration, whilst consumer confidence surveys report continuing improvements. This divorce between industry and consumers won't last.

1. US Industry Surprises from the US in the last few weeks have tracked the recovery of consumer confidence, vehicle sales, housing market, and, on balance labour markets. But October’s regional manufacturing surveys from Kansas and Richmond provided a reminder that the industrial side of the economy remains very weak. In particular, Kansas’s survey was the weakest since mid-2009, driven mainly by a steep fall in new orders (minus 11 vs minus 2 in Sept), orders backlogs and more steeply falling exports. In the Richmond survey, although the headline result (minus 7) wasn't particularly unusual, all broad indicators were in retreat - shipments, orders, employment and capacity utilization. 

The underlying problems is that the momentum of industrial production remains more robust than that of sales and inventories combined, and there is little support from export markets to take  up the slack. In non-recessionary times, manufacturing and trade sales typically grow at a yearly rate about 5 percentage points higher than industrial output. By August, however, on a 3m basis, manufacturing and trade sales were running at 3% yoy, whilst output was growing 3.8%. For capital goods (non-defence, ex-air) shipments  have fallen in mom terms for each of the last three months. 

With neither a vigorous inventory cycle (total business inventories rose 5% yoy 3ma in August) or exports growth (they contracted 1.6% mom sa in both August and July) to soak up the difference, the likelihood is for repeated bouts of industrial weakness. The chart displays the problem in momentum terms: the last two times this mismatch between output and sales momentum opened up, recession followed.

2. German Confidence The week brought contradictory readings of German confidence.  On the one hand the October GfK Consumer Confidence rose to its strongest level since pre-crisis mid-2007, primarily on the basis of a rise in income expectations. But this was offset by a continuing fall in the Ifo Business Climate Survey to its lowest point since the start of  2010, led by a fall in the manufacturing climate. 

The findings were confirmed in this morning's European Commission October survey of business and consumer sentiment. Germany's industrial confidence index fell to minus 18.3 (from minus 15.9), and its service sector confidence evaporated (0.7 in Oct vs 5.4 in Sept). But at the same time the consumer confidence reading improved to minus 9.3 from September's minus 10.3.  

Now it is unlikely that this divergence in view between consumers and industry will or can be maintained for long. Historically, German income expectations have tracked (and, on the upside, anticipated) changes in employment. But for the last two months, Germany’s measured employment has been flat, with increasingly negative momentum, and October’s Manufacturing PMI also found renewed job cutting. 

Conclusion? The reported strength of German consumer confidence is vulnerable in the short term, and with it German retail sales (up 1.2% yoy in August) and vehicle sales (down 10.9% yoy in September). 

China's Inflection, US Risk, British Jobs: Three From Last Week

Three things worth your attention from last week's data-flow:
1. The inflection in China's September monetary and domestic demand data. It's not that things are changing/improving at a fundamental level - it's just that there's more money about, which is unblocking cashflows. 
2. Yes, the global balance of shocks and surprises is reaching its peak of the year, after a third very 'surprising' week (globally 28.3% of releases surprised, 13.3% shocked). But don't ignore the fact that US bond markets seem to be indicating that financial risk appetite is about as positive as historically it gets. The message therefore is one of vulnerability. 
3. The rise in British jobs, extended again in August, looks a real phenomenon, rather than a statistical one, and is a sustained trend, rather than, say, an Olympics-related spike.  Of course, since it contradicts poor GDP data, it implies falling labour productivity.  But by no more than the 1998-2008 trend would have expected.
  
1. China Money and Domestic Demand Taken together, September’s money  and domestic demand data make a convincing case that China’s economy has reached an inflection point. M1 of 7.3% yoy surprised, as did M2 growth of 14.8%.  Similarly, retail sales growth surprised at 14.2% yoy, and was nearly a full standard deviations better than seasonal trends; and there was a surprise too from urban fixed asset investment growth of  20.5% ytd yoy. 

It is revealing that even as the growth of monetary aggregates surprised, they suggested no underlying change in the way China's consumers, investors and savers are behaving. For example, there was no uptick in liquidity preference (M1/M2) of the sort you'd expect if people were suddenly more keen to spend money on  goods, services or investments. Similarly, monetary velocity (GDP/M2) is still in decline, suggesting no underlying gain in banks' efficiency in allocating resources.  

In turn, this tells us that the upward inflection of the economy is not the result of an underlying improvement in the factors determining  cyclical behaviour, but simply a result of there being more money available to allow companies and individuals to maintain their previous behaviour. It is simply a direct result of a loosening of credit conditions.  

Whilst most commentary tends to focus on China’s trade data, what determines China’s domestic demand is changes in the availability of credit and (probably more importantly) cashflow. So the key event supporting this upward inflection point is probably the growth in financing that is not straight ‘bank lending’, but rather is everything else which is included in the much broader ‘social financing aggregate’ total (explained here). The monthly addition to social financing came to Rmb1.65tr in September, which was almost four times the addition in Sept 2011. In the three months to September, new ‘social financing’ came to Rmb 3.94tr, up from Rmb 2.04tr in the same period last year. The central difference between simply relaxing bank credit vs expanding the broader financing options of social financing is precisely that it tends to address the cumulative cashflow problems of China’s economy without privileging asset markets such as real estate.

2. US Surprises and Risk Premium  The 6wk global balance of shocks and surprises is approaching its most positive of the year so far. The improvements made in September (largely in Asia, but shared more modestly by the US and the Eurozone), has been accompanied by a rise in the US capital risk premium levels to pre and post crisis highs. This capital risk premium is calculated as the difference the yield on 10yr Treasuries and 10yr TIPS. The higher the premium, the greater the appetite for financial risk. Currently it stands at around 2.52% (Treasuries at 1.8%, TIPS and minus 0.715), which is a level last seen in March-April 2011, and before that June-July 2008. On both those occasions, this was the peak of risk appetite, and the retreat from that peak was accompanied by falling equity markets.  

There’s no certainty that anything similar will happen this time, but it does suggest that fixed income markets are now discounting a continuing stream of good news, and so are more vulnerable to disappointments than at any time for the last 18 months. 

 3. British Employment  The rise in British employment is one of the statistical mysteries of our time: in the 3m to August, the number of jobs rose by 212k qoq, with 162k new employees and a further 35k newly self-employed.  Moreover, the number of those economically inactive also fell by 138k during the same period. As the chart shows, this means that the number of British jobs is now 84k now than at the pre-crisis peak of early 2008. 

Quite often, surprise improvements in unemployment rates can be traced to strange movements in the denominator. Not in this case: the improvement looks quite genuine. But the improvement is in stark contrast to two things: first, GDP data which tells us the British economy is currently 3.8% smaller than it was at its pre-crisis peak. Second, it is also a great contrast to what is happening in the Eurozone, where in 2Q employment levels had fallen by 4m, or 2.7% from early 1Q2008 levels, with no sign of recovery.

In fact, the divergence between GDP and employment may be less surprising than it immediately seems. Certainly, if all the data is correct, it implies an erosion in labour productivity. However, once real output per worker is discounted by changes in capital per worker, it becomes clear that declining real labour productivity  has been the norm since at least 1998, and that, after steep cyclical productivity declines in 2008/09, current productivity levels have simply recovered to the (falling) 1998-2008 trendline.  The sharp rise in employment since 2010 ran alongside the recovery back to that (falling) trendline. From here on in, we should expect 'normal' employment patterns to be resumed. 

Two Fatuous Policy Debates / Displacement Activity

Policy debates are occupying editorial columns in the US and Europe: it's displacement activity.

1. How fast should the US be recovering? Reinhart & Rogoff (slowly) vs Bordo & Haubrich (much quicker than this)
2. Egregious Institutions: The IMF's little 'Fiscal Multiplier Error'

How Fast Should the US Be Recovering?

So is the US recovery post financial crisis exceptionally slow or about normal? On an academic plane, this public debate pitches Reinhart and Rogoff (who's read of economic history suggests slow recovery is, roughly speaking, the norm), versus Bordo and Haubrich (who's read of economic history finds that US bouncebacks from financial crises usually feature periods of very rapid recovery). But this is a full-spectrum argument, being waged not just by rival academic papers, but subsequently by newspaper columnists, because, of course, the verdict bears directly on the Presidential election. If Reinhart and Rogoff's history is correct, President Obama need not apologize for the sluggish recovery. If Bordo and Haubrich are right, his policies are at best ineffective, and at worst they are retarding the recovery.

In the end, the argument comes down to which data-set one uses. But that in itself is interesting, because it reveals that the real argument is about what a financial crisis really is, and that in turn means you cannot escape talking about the structure and role of financial institutions.

And here, I believe, is the real problem. For it seems clear that what happened in 2008 was radically different from any financial crisis I've witnessed before. In fact, I believe that what happened this time wasn't so much a financial crisis as a crisis in financial institutions. Ultimately the systemic financial crisis had surprisingly little to do with saving and investment decisions made by the non-financial sector, but everything to do with the leverage within and between a relatively small number of financial institutions themselves.

The popular narrative of the crisis would have us believe that it was the weight of mortgage and credit card debt which triggered the crisis. Certainly they were the catalyst, but the seizing up of interbank and inter-financial institution credit in 2008 had relatively little to do with that. Rather, what did the damage it was the sudden fear of unfeasibly large contingent liabilities surfacing in the CDS market – which, not incidentally, were discovered to be effectively non-fungible. How much? By mid-2007, outstanding CDSs had a notional value of $62.17 trillion.

The world's financial institutions made the terrible and belated discovery that writing a new CDS to 'offset' an unwanted bilateral position was not the balance sheet equivalent as commercial banks' clearing each others' cheques at the end of the business day. That single simple-minded banking error potentially stood to bankrupt every major player in the CDS market, and an unknowable number of their clients. That was the deadly poison of the 2008/09 financial crisis.

As a result, the normal 'boom and bust' trajectory in the real economy should not be expected. The normal (Austrian-inflected) story of financial crises and business cycles has the following outlines:

1. Excessive leverage results in unwise investments:
2. As returns on those investments slow, so the cashflows to sustain new investment diminishes.
3. Consequently, credit availability dries up, mal-investment is discovered and eventually liquidated.
4. Cashflows are restored as savings are reallocated to more profitable opportunities.

For those of us who watched the 1997/98 Asian crises, this is a profoundly convincing narrative – indeed, with only small adjustments for individual countries, it has been demonstrably true.

But it's a template you'd struggle to fit over the data for this crisis. First, where's the systemic over-investment? By my calculations (based on depreciating all investment over a 10 year period), in 2007 US capital stock was growing at a paltry 5.3%, which is lower than the 7.9% in pre-recession 1999, say, or the 11.5% in pre-recession 1981. Indeed, growth in capital stock of just 5.3%, is 0.6SDs below the average of 6.7% sustained between 1980 and 2007. And yes, that data includes residential investment.

Secondly, so far as the non-financial sector is concerned, the rectification stage of the cycle has been rapidly achieved. My return on capital indicator bottomed out in 2Q99, recovered to 2007 levels by 2Q10, and by 2Q12 was the highest since 1999. And partly in consequence, a 2Q07 private sector savings deficit of 4.6% of GDP was turned into a savings surplus of 9.9% of GDP by 2Q09. And this was very visible: the corporate sector amassed cash, and the household sector fully paid off its 2Q07 $2.214tr net debt to credit markets by 1Q2011.

To summarize: the non-financial sector's initial 'credit-fuelled over-investment' was unspectacular in the run-up to the financial crisis, and its financial reaction to the crisis has been a) in form, as one would expect; b) rapid and c) huge.

If this crisis fit the (Austrian) description, the US would indeed be growing very vigorously by now on the back of rapid and extensive balance-sheet restoration. Soaring ROC would produce hearty investment-spending; banks awash with depositors cash would seek out new financing opportunities; newly-strengthened balance sheets would restore consumer confidence.

But this is not happening because that's not how this crisis was caused, nor how it erupted, and it is not how it will be conquered. I suggest that what we have seen, and are seeing, is less a financial crisis than a crisis in financial institutions. What does this crisis consist of? First, the realization that the institutions are profoundly undercapitalized for the business they wish to pursue. Second, the realization that since every financial institution in the developed world has the same problem, these are no longer national problems: Europe's financial/political crisis is – as well as everything else – a reflection of this. And third, behind all this lies the same unresolved structural crisis that has ultimately been the driver behind everything – the likelihood that the bond bull market which ran so profitably from 1982 to the present day (albeit only on QE life-support) is finished. After all, it was the desperate chase after yield in an otherwise fully-arbitraged bond world that bred the CDS market in the first place.

I could add to this list indefinitely were I to consider the still-unclear political fall-out from the mass failure of the western world's financial institutions.

But for now, the crucial thing to know is that when a financial institution lacks capital, it no longer has the ability to buy or create financial assets. What this means is that the private sector can restore its balance sheets as rapidly as it may – but the dollars it places in the financial institutions aren't going to come back out again in the form of loans or other financial assets. The dollars go there to die.

We can measure this by looking at monetary velocity, which is GDP/M2. Let's first have a look at what happened to Japanese monetary velocity before and after the Bubble burst in 1990.

There is a danger of this being a little abstract. The key point is this: Japanese banks' loan books peaked out in December 1993, at Y525.4 trillion. As of September 2012, they stood at Y397.7 trillion – down by a quarter. And deposits? Up by around 26% during the same period.

Now consider what's happening to monetary velocity in the rest of the world.

And the conclusion? That the US recovery is hobbled, and will be hobbled, by the problems inherited by a set of financial institutions which have failed, but still with us. The recovery will not be aided by financial institutions: it will have to carry them. A new set of institutions will emerge, or will have to be improvised.

This is not, incidentally, a condemnation of any particular set of named institutions, or a slur on the good people who work in them. Rather, the problem is the very form of our financial institutions – commercial banks are forms of commercial activity which were a sensible response to, say, 17^th century European experience. They are geniunely irrational and dangerous in the 21^st century.

I could go on, but the key text is by Jesus Huerta de Soto: “Money, Bank Credit, and Economic Cycles'. New forms of financial institutions are desperately needed, and will, I expect, emerge over the coming years. I would also recommend supplementing it by looking up the work on mutual fund banking by Randall Kroszner, who's been developing his ideas on this since his stint as an intern at John Greenwood's GT in Hong Kong in the late 1980s.  

IMF - Let's Pretend the Fiscal Multiplier is the Error

Meanwhile, Europe is being entertained by the IMF's discovery that it underestimated the fiscal multiplier effect of government spending cuts in Southern Europe, thus sending the wrong policy prescription, and miring Southern Europe in spiralling depression.

The core passage reads: “earlier analysis by the IMF staff suggests that, on average, fiscal multipliers were near 0.5 in advanced economies during the three decades leading up to 2009. If the multipliers underlying the growth forecasts were about 0.5, as this informal evidence suggests, our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession.  “

Where does one start? The IMF's mea culpa would be more impressive – no, let me rephrase that – would be less egregious if its implemented policy recommendations for Southern Europe hadn't inexplicably overlooked two much more important problems:

1. Ruling out devaluation out of the Euro (ie, lending its support and our money, to propping up the Euro project)
2. Failing to grasp the different dynamics underpinning the administrative capabilities and relationship between the public and the govenrment in Northern Europe to Southern Europe. (Measured and explained by the World Bank, and precised by me here.)

The IMF's re-working of its fiscal multipliers is no explanation and scant apology for these two obvious and fundamental howlers, but rather an attempt to disguise their disastrous consequences as a mere calculation error by their econometricians. Rather than a contribution to a policy debate, it looks to me like an attempt to dodge responsibility. To argue its merits is to grant the IMF's recommendations a degree of credibility which, frankly, they do not deserve.

Growth or austerity? 'OK, the patient is dead: now, what's the best way to encourage him to tap-dance?'

The second reason for not engaging in the 'policy debate' is this: all major central banks are now committed, one way or another, to 'quantitative easing'. Let's be clear what quantitative easing is: it is the policy of despair; by deliberately over-riding pricing as a mechanism for allocation savings, it is the subversion of economics. Why should one take seriously blitherings about fiscal policy when the real policy is simply to print more money and give it to the banking system to give to the government?  

Three Surprises From Last Week

The world's economic data continues to break positively: on a strictly numerical basis, last week was the most positively ‘surprising’  since mid-July, and leaves the 6wk tally 0.32 SDs above ‘normal’ – also the most positive score since late-July, and a positive background for financial assets.

Meanwhile, here are three surprises from last week which are worth bearing in mind: 

1. US Confidence indicators are surging, primarily reflecting an expectation that things will get better, rather than that they have got better. It's important to the extent that it curbs the rising private sector savings surplus. 

2. China's Financing.  Loan growth disappointed in September, but this disguised a reliquefying of corporate cashflows which is being achieved through other forms of finance than bank loans. 

3. Eurozone Industrial Production. Notice that the surprise rise in August production was the work mainly of those Southern European countries suffering to achieve internal devaluations. Might it possibly be working?  

 1. US Confidence  The central shock of the US economy this year has been the resurgence of its private sector savings surplus (rose to 5.3% of GDP in the 12m to June, up from 3.9% in 2011), which in turn has leached strength from domestic demand and growth. One can identify various reasons for this renewed outbreak of financial caution at different times throughout the year – none of which seem grounded in the fundamentals of the US cycle itself. 

But two surveys of October consumer confidence suggest this might be passing: both the University of Michigan’s consumer confidence survey, and the IBD/TIPP Economic Optimism survey both recorded really sharp improvements in economic expectations. The Uni of Michigan survey is particularly dramatic: the subindex for ‘economic expectations’ jumped to its highest level since 2007. More, as the chart shows, it is now within 0.2SDs of the 2001-2007 average reading. On the face of it, confidence in the future has very nearly returned to pre-financial crisis levels!  

If the survey is truly representative, and if its findings are sustained, this renewed confidence can be expected to result in surprising levels of domestic demand growth during 4Q, including an acceleration in the recovery of housing markets. Whilst equity markets would be delighted, there will be a price to be paid in the bond markets.

2. China Financing  At the heart of China’s surprisingly robust September monetary aggregates (M1 up 7.3% yoy, M2 up 14.8%)lies a large-scale but quiet reliquification of China’s industrial companies.  Analysts have been fixated on fluctuations in new bank lending, on the basis that it would be here that any general policy-loosening would show up – as it did in late 2008-early 2009. 

But even up to September, there has been no such loosening – September’s Rmb623bn in new lending was below the range of expectations. Instead, the loosening is being done outside normal bank lending totals, using large issuance of bankers acceptances, fx loans, trust loans. As a result, total ‘aggregate financing’ jumped to Rmb 1.65tr in September 2012, compared with just Rmb 428bn in Sept 2011. 

The rise in BAs – Rmb 216.3bn were newly issued in September - is particularly important because they are a direct response to potentially cascading cashflow problems in the corporate sector. But at the same time, there is only limited opportunity for these funds to inflate politically-sensitive property markets. For the banks,  these alternative financing instruments can side-step official ceilings on direct lending, and on loan-deposit ratios. Indeed, despite the surge in aggregate financing in September, banks could report a net increase of Rmb 1.65tr in deposits during the month  - exactly the same number as new aggregate financing – which led to a fall in the loan-deposit ratio.  

The bottom line is that as China sequences its way to financial liberalisation, Goodhart’s Law will apply in spades: we (and China’s policymakers) will inevitably end up tracking the wrong thing. Like bank lending, for example. 

3. Southern Europe Industrial Production Regardless of how its financial/political diplomacy plays out, the Eurozone will not survive – and will not deserve to survive  – if it condemns Southern European economies to an impossible competitive disadvantage to its Germany competitor. The ‘internal devaluations’ being forced upon Southern Europe can be justified only by the belief that eventually the pain will be justified by a competitive gain that will allow its industries to flourish. 

August’s industrial production data gave some hint of what that would look like: the Eurozone’s output rose 0.6% mom, but mainly because of Southern European countries’ growth (Italy 1.7% mom, Spain 12.3%) whilst Germany contracted 0.4% mom. Is this the start of something? 

Probably not: as the chart shows, since 2008, Southern Europe’s industrial output has contracted by around 20%, whilst Germany’s has risen around 12%. The divergence has been particularly stark since the second half of 2009. August’s reversal in growth patterns breaks that trend by 1.2 SDs, but so far it remains just a ‘blip.’

  

  

In Love With Hong Kong Again?

Yes, Hong Kong's climate eases up in October, and the Kowloon neighbourhood where I was staying with friends is a fine place to live, West Kowloon is shaping up really well, and it was great to be back for the first time in a couple of years. But I lived in Hong Kong for a long time, and left with ambivalent feelings about it. So is this simply nostalgia working on me, or is the old excitement coming back – the joy of the economic chase which Hong Kong does so incomparably?

When moods like these overtake me, I reach for my analytical tools to straighten me out. How is Hong Kong really doing? And what's happening to its growth model? This delivers two contrasting conclusions:

1. On a short-term cyclical basis, Hong Kong is exposed (responding to: monetary slowdown; weaker labour markets; likely short-term reversion of private sector savings deficit)
2. On a longer-term structural basis, Hong Kong looks in good shape, with positive readings for growth of capital stock, return on capital, services prices, services terms of trade, monetary velocity and . . . . confidence.

Cyclical Vulnerabilities

Among the professionals I met (largely lawyers) the mood was downbeat, as the realization slowly dawns that the next global (and Chinese) growth cycle is unlikely to be much like what Hong Kong (and China) has enjoyed since the 1990s. And in the short term, there are several reasons to expect Hong Kong's cyclical downturn to intensify.

First, consider the evidence of the monthly data – and in particular the link one expects between changes in monetary conditions and changes in domestic demand momentum. The chart below tracks Hong Kong's monetary conditions (movements in monetary aggregates, currency, real bond yields and the yield curve) and domestic demand (retail sales, auto sales, employment, tourist arrivals, residential property deals). Broadly, the story is that Hong Kong's domestic demand is doing rather better than the decline in its monetary conditions would suggest: in August, employment was up 2.2% yoy, retail sales up 4.5%, vehicles, tourist arrivals 20.5% yoy, sales & purchase agreements up 51.4% yoy, and car sales down only 0.9% yoy. By contrast, monetary conditions have been deteriorating now for a year, and on a 6m basis are now at their least-friendly since early 2009.   

In Hong Kong, changes in monetary conditions and domestic demand tend to go hand in hand, so a further weakening in domestic demand is already about six months overdue.

And it is not difficult to spot the vulnerabilities which could bring this about. First, the decline in real labour productivity (real output per worker adjusted for changes in capital stock per worker), is now about as severe as in 2009, but this has only now begun to provoke a noticeable slackening in the number of people employed. Only in July did hiring fall below seasonal trends, although in August this became more pronounced: we are more likely at the start of the weakness than the end of it.

The second vulnerability is connected with a likely correction in savings and financial leverage.The buoyancy of Hong Kong's domestic economy since 2009 has been underwritten by a financial confidence which has allowed the private sector savings surplus to erode from a peak of 12% of GDP (in 12m to June 2009) to a savings deficit of 1.7% of GDP in the 12m to June 2012. This willingness to run down savings surpluses is not necessarily a bad thing – it shows confidence – and whilst it continues it bolsters demand. But the danger now is precisely that if confidence dwindles, the private sector will re-build its savings surplus, and in the process depress domestic consumption and investment.

Intimately linked with this are shifts in the leverage of Hong Kong's private sector, which we can track using the loan to deposit ratio of Hong Kong's banks. If the private sector decides to go into savings-surplus mode, we will see the banks' loan/deposit ratio fall. And this is already underway: in August, HK$ loans rose only 3.6% yoy, with sequential movements 0.2SDs below seasonal trends, whislt HK$ deposits rose 8% yoy, with the sequential movement 0.7 SDs above seasonal trends. On a 3m basis, the loan/deposit ratio peaked a year ago at 85.7%, but the latest data suggests a new down-wave is arriving right now.  

Structural Strengths

There are good reasons to expect the current cyclical slowdown to intensify from here. But when it comes to Hong Kong's structural fundamentals, its ability to make its way in the world, things look a lot brighter. Indeed, on several measures, Hong Kong looks in better shape now than at any stage since the 1990s.

First, its growth factors look in good shape: HK's stock of fixed capital is growing around 7.4% yoy currently – the fastest since the pre-handover bubble. Returns on that capital peaked out at the end of 2011 and are now falling (and will continue to fall as the cycle deteriorates). However, they are still at historically high rates for Hong Kong. Hong Kong's underlying investment proposition remains more attractive than it was throughout the 2000s.

Second, this indicator finds an echo in the stabilization of Hong Kong's monetary velocity (GDP/M2). Unlike most of the rest of the world , Hong Kong's monetary velocity is no longer falling – rather it has been stable since late 2009 and is now gently trending higher. This suggests that the allocation of savings by Hong Kong's banking system is no longer fundamentally deteriorating in terms of the amount of GDP growth generated by each deposit in the banking system. A banking sector which is not acting as a systemic drag on growth is rather a rarity in the world: the US, Europe, Japan and China - in each case monetary velocity is falling. (In the chart below, notice also the sustained high levels of liquidity preference (M1/M2), which suggests sustained retail and speculative confidence.)

Third, and probably most important: despite the slowdown, and unlike in 2008-2009, Hong Kong is still able to price its services internationally. Working from the GDP deflators, the price of Hong Kong's services exports rose 0.3% qoq and 4.7% yoy in 2Q, whilst the price of its services imports fell 0.1% yoy.

Consequently Hong Kong's services terms of trade are surviving: indeed, quite possibly they are improving for the first time since the 1990s.

Now this truly matters for Hong Kong's future, and, of course, for its property market (and thus the balance sheet confidence of the private sector, and the balance sheet of the banks). So long as Hong Kong can continue to price its services internationally, its future looks bright.