Why Japan's Lousy July Trade Data Really Matters

I remain head-down compiling my quarterly global review. One of the conclusions I'm unearthing is that we need to start focussing on Japan again, because although it is making 'all the right moves' the chances of things going very wrong are rising rapidly. In the midst of these rather gloomy speculations, Japan's July trade data landed, showing exports down 8.1% yoy, and a trade deficit of Y517bn. If it passed you by, you missed something big, for truly, this was some of the most shocking data of the year. It was shocking in and of itself, and more shocking because of what it tells us about Japan's changing fundamentals. Let me count the ways. . . .

1. The slump in exports was really bad: the fall of 5.8% mom was fully 1.2 standard deviations below seasonalised trends, and came after three previous months' of sub-trend sequentials. In fact, it was the worst sequential performance since disaster-struck March 2011. It was also far worse than had been suggested by the 20-days export data, which had suggested a fall of 1.2% mom and 3.6% yoy.

2. The yoy comparisons are also alarming, because right now Japan should be gaining market share year-on-year not losing it, if only in recovery from the because of the negative hit imposed by the disasters of last year. In fact, though, Japan's share of NE Asian exports slumped to just 21.3% in the three months to July, down from 22% in the same crisis-hit period of last year.

3. The collapse in exports means the size of Japan's trade deficit is also shocking: Y517.4bn on the month, and Y5.1trillion in the 12 months to July. The long-term context strongly suggests this is not a blip, but rather the extension of a major long-term trend :
   
   
   
   
   

4. Crucially, this is happening at a time when, on a fundamental basis, Japan is getting everything right. My quarterly survey of fundamental ratios shows rates of return on capital rising, real labour productivity rising, and even Japan's terms of trade rising momentarily (up 1.2% yoy in July). Bank balance sheets also show that modest deleveraging is underway again. In these circumstances one simply doesn't expect a trade-balance blow-out, unless imports are being sucked in to finance a subsequent explosion in exports. Is that likely?

5. By extension, the disappearance of Japan's trade surplus means that Japan's private sector savings surplus is declining, sharply, even in these most favourable circumstances. By 2Q it had shrunk to just 3.3% of GDP, down from 5.9% in 2011 and 10.2% in 2010. July's trade data suggests it is still shrinking in 3Q. Since the shrinkage isn't plausibly cyclical, we can suspect there are structural forces driving it. And, of course, in Japan there's the most powerful structural force in the world offering to do the job – Japan's aging demographics.

6. But Japan's private sector savings surplus is what buys the JGBs Japan's government needs to finance itself. So how are the public finances progressing? Debt is 227% of GPD, and rising.   

All this points to an obvious conclusion - one so obvious, I leave it to you to puzzle out. But maybe a clue would not be out of order: 

Who's Got Pricing Power? Not Europe's Consumers

• Europe's terms of trade are weakening the most of any major region. This is a legacy of de facto protectionist policies which have long conspired against the consumer, coupled with a new inability for European companies to charge an answering premium for their products in international markets.

International terms of trade ought to be a zero-sum game, just as all the world's trade balances ought to sum to zero. But the world's reported data never comes close to this, which is testimony to the enormous leakages from and inadequacies in the way economic data is collected and reported.

Nevertheless , movements in international terms of trade, which record how export prices move relative to import prices, are important. They matter in the short term because a sharp rise (or fall) in a country's terms of trade can result in an unexpected windfall for traders, with the accompanying effects on cashflows and profits for the economy as a whole. Long term trends matter more, though, because they record the extent to which a country's industry is able, or unable, to price their products internationally. They are, in other words, a crude measure of how much other countries want your products.

For both reasons, they form one of the core indicators I use in my quarterly effort to understand the cyclical forces and structural challenges/opportunities of major economies. Apart from the long-standing and frankly baffling fall in Japan's index (it seems incredible that corporate Japan cannot price its goods properly) the current puzzle is the underperformance of the Eurozone. By mid-2012, the Eurozone was unique in its terms of trade being more depressed even than at the height of the 2008 commodities ramp. Every other region – even Japan – has managed to make some gains since then.

So what's going wrong? Is it that the Eurozone is unable to price its exports? Or are its import prices systematically too high?

The answer is: 'both'. Notoriously, the Eurozone's 'single market' has sprouted a proliferation of regulations which quietly raised a protectionist barrier around Europe, which has allowed prices within the Eurozone to be sustained far above (30-40% above) prices for the same goods in the US. This deformation persists. But since the crisis European exporters have not been able to command similar premiums for their exports – a loss of pricing power which is also persisting.

Consider, for example, the different histories of import and export prices since 2000 by the US and Europe. On the face of it, one would expect price changes in these two economies to mirror each other. And historically, that was the case: between 1992 and 2002 the fluctuations between US import prices and EU import prices was a minor and usually self-correcting matter: it averaged 4.2% with a 4.3% standard deviation. But in the decade since starting in 2002, it has averaged 32.5% with an 11.1% standard deviation.

Since 2002, something dramatic happened to European trading prices which has left them far higher than the US. And it has persisted: latest data puts the differential at 41.3%.

How did this happen? Starting in 2000, one can track movements in Eurozone import and export prices (denominated in dollars) relative to movements in US import and export prices. (Taking 2000 as a starting point of parity is reasonable, given the track-record of near parity of movements during 1992-2002). This is what it looks like:

The pattern tells two separate stories. The first is what happened during the period of the Euro's strength, between 2002 and 2008.

• Jan 2002 to Apr 08: The Euro gained 78% vs the dollar (from a Euro buying 88 US cents in January 2002 to $1.57 in April 2008);
• Eurozone import prices rose 49.5% relative to US import prices
• Eurozone export prices rose 48.7% relative to US export prices.

In other words, roughly two thirds of the impact of the strengthening Euro was taken by those exporting to Europe, and a similar proportion of benefit was taken by exporters from Europe. Predominantly, the strengthening of the Euro benefited the world's producers at the expense of consumers – whether those consumers were inside or outside the Eurozone. This is not a matter of European prices simply 'catching up' to US prices – things simply cost more for those inside the fundamentally protective 'single market.'

(This is not just a matter of the data. I have sat in plenty of meetings with Chinese firms and asked about their pricing policy – 30% is the usual mark-up of exports to Europe relative to their base-market prices in the US. Since European producers live in dread of Chinese competition, this informal arrangement suits everyone involved . . . . except the European consumer.)

This mattered less when European producers could also pass on similar price increases to their international customers. And this is where the data tells us its second story:  since 2008 European exporters have been unable to hold that relative pricing differential, even whilst the 'European premium' slapped on the price of goods exported to Europe has been maintained. The result is that Europe's international terms of trade are now worse than even at the height of the commodities boom.

Europe's deteriorating terms of trade are finally squeezing profit margins and cashflows, and, of course, weighing on the business and investment cycle. As the fall in terms of trade has accelerated since 2010, so this pressure has built.

Final observation: Radical (20-30%) price-cuts on imports into Europe could provide a significant unexpected upside to corporate cost-structures, and the stresses on consumption demand, in a post-Euro environment, provided the Euro's failure takes down the framework of the 'single market' customs/non-tariff barrier union.   

  

Global Trends in Private Sector Savings Surpluses

I am preparing my quarterly review of what's happening to the fundamental relationships and flows that underpin investment cycles around the world. This is my attempt to track changes in returns on capital and labour, coupled with an effort to reconcile changes in economy-wide cashflows which can be expected to result from them. With that completed (hopefully), the review moves on to 'matters arising' – which is, perhaps, the main point of the exercise. If successful, I end up either confirming or moderating the basket of prejudices I inherited from previous efforts.

Those 'matters arising' inevitably change the emphasis I place on aspects of this analysis, with the main questions now shifting away from factors of production and on to monetary velocity (ie, the impact of zombie banking systems) and public-sector debt (ie, the impact the looming 'fiscal cliffs' may have on current savings/investment choices).

No matter where you start to pull at the threads, at some point you end up looking at movements in private sector savings surpluses/deficits. This fundamental cashflow-indicator is, after all, sensitive directly to changes in fiscal policy, but also indirectly to return on capital, and to financial confidence. (And plenty more.)

What's also true is that they are going to play a central role in the options available for tackling the fiscal cliffs which most developed economies will be approaching in the coming years. This is because in the normal course of events (ie, when central banks are not 'quantitatively easing') the world's private sector savings surpluses are precisely what end up buying government bonds. But since their fluctuations also generate economic volatility, the feedback relationships between growth, savings surpluses and fiscal solvency will only become more important over time. Does anyone really claim to understand them? I think over the next couple of years Japan will be the crucial testing-ground.

In the meantime, all major economies are running private sector savings surpluses. They need to be, given the world's population of zombie-banks are in no state to fashion an artificially positive cashflow for the non-financial private sector by lending faster than their deposits rise. But the trend of these surpluses is different around the world. 

US – The Unexpected Rise of PSSS

In the US, the PSSS is unexpectedly rising above 5% of GDP, sapping domestic demand and probably reflecting a lack of confidence (fiscal cliff, just now, probably). As the savings surplus has risen, so domestic demand has disappointed in the first half of the year. But this may represent more of an opportunity than a threat in the short-term. After all, the normal determinants of ROC (and thus ultimately cashflow) look positive – asset turns are rising, returns to labour are rising, terms of trade are rising, and bond yields remain sharply below those implied by 'fair value'. Stabilization, or reversion back to the declining trend would allow a re-acceleration of domestic demand from the levels seen in 1Q12.

Eurozone – Quiet, Too Quiet

If the unexpected rise in the 1H US PSSS provides firepower for an early acceleration of domestic demand, the opposite is true in the Eurozone. One would expect that current recession and impending financial catastrophe would have resulted in the private sector restraining both consumption and investment, and thus pushing the PSSS up despite the fall in ROC and terms of trade. In fact, the ratio has remained stable over the past nine months at around 4% of GDP. The threat, of course, is that further shocks will push this ratio higher, triggering a more intense period of debt-deflation/recession. Outside the Eurozone, this danger is even more pronounced in the UK, where the surplus has fallen sharply throughout 1H12, to just 2.5% of GDP (on a 12m basis).   

Test Case - Japan

Japan's situation is without doubt the most interesting, because it is here that we're likely to learn first how the PSSS interacts with growth, ageing demographics, and the fiscal cliff. Since the bursting of Japan's bubble in 1990, Japan's private sector has generated a savings surplus averaging 8.7% of GDP. But as the population has aged, this surplus has been in gradual inexorable decline. The emergencies of the last three years (global financial crisis, earthquake/tsunami) has disguised this, but the trend is now re-emerging. 

In the 12m to June, Japan's PSSS fell to 3.3% of GDP. Absent spectacular gains in profitability, the demographics are likely to continue to erode this surplus. Already, this surplus is no longer enough to buy the JGBs the Japanese government needs to sell: in the year to June, the PSSS totalled Y15.72tr, whilst the stock of outstanding JGBs rose by sold Y27.76tr JGBs. The immediate impact on JGB yields has been nullified by Bank of Japan's quantitative easing program. But the lesson is not lost on Japan's fiscal planners: Japan's fiscal cliff is looming.    

The key problem here is that at this point, a surge in the PSSS is likely to be achieved only by renewed domestic demand recession – which in turn is likely to put further pressure on Japan's fiscal and public debt position.

So far, the world has largely ignored how these problems are once again concatenating in Japan. After all, we all know Japan runs a large savings surplus, so the problems are domestic.

Trouble is – that historic truth is rather rapidly reversing.  

China - PSSS As Policy Footnote

Finally China: last because, for now anyway, least interesting. China's PSSS is flat at around 3.5% of GDP, but probably rising at the margin, contributing to the slowdown in domestic demand during 2Q and later. The double-digit surpluses of the early 2000s were an expression of the financial repression (lack of savers' choices, undervaluation of the currency) which went with China's exogenous growth model. That it is coming down now is an expression above all of the slow easing of financial repression as China attempts the extremely tricky traverse towards an endogenous growth model. Furthermore, in the short term, any shortfall in internal cashflows which accompanies this (as is indeed happening) can and will be offset by lowering the extraordinarily high reserve ratios imposed on China's banks (more financial repression). Unlike in the US, Europe or Japan, the PSSS for the time being can be seen as a footnote response to policy, not a central factor determining and circumscribing it.

Shocks & Surprises - Week Ending 10th August

·        World trade contracted in June and July, as precautionary dynamics dominated. Globally, industry is clearing the decks, and its suppliers are clearing distribution channels. Hence the sharpest trade contraction is coming from industrial supplies and intermediates, rather than consumer or capital goods. This shows up in the details of trade data, and also in producer pricing indexes and in US wholesale numbers.

·        It’s a popular narrative, but the contraction is not simply or even mostly a case of exports falling because Europe is in recession. Rather, this contraction identifies and punishes those economies restructuring the slowest relative to their underlying challenge: those economies where policy implicitly anticipates a return to pre-Crisis ‘normality’.  So trade balances have deteriorated most sharply in China, UK and France, whilst rewarding with improved balances those furthest along the financial restructuring road (the US, Italy), or, in Germany’s case, those finding protection in an artificially weak currency.

·        Overall, there were more shocks than surprises for a third successive week, and the six-week trend is now plainly deteriorating. The deterioration is most obvious in Asia, but is also newly present in the US. Not an encouraging environment for equities.

This is an excerpt from the four-page Global Shocks & Surprises weekly summary. It maintains the brevity of the Shocks & Surprises service, but relaxes discipline just sufficiently to allow  short commentaries on the meaning and impact of shocks and surprises on the US, Europe and Asia.  If you would like to take a look, please email me: michael.taylor18@btconnect.com.

The Long and Short of US Savings

June's personal income and spending data told us the US personal savings ratio jumped 46bps to 4.4% - a sharp acceleration of the modest rise that's been underway since November 2011. 

• This echoes what I've previously written about the ongoing rise in the private sector savings surplus. 
• But reactions to it need to accept what's happening both on a short-term scale, but also, more importantly, on the long-term timescale.
• If personal savings ratios are set  to inch up for the next 10-15 years, this will compromise growth but underpin bond markets. 

The 0.5% mom rise in US personal income during June wasn't quite a surprise, and the fact that personal spending didn't rise at all wasn't quite a shock either. But taken together, they tell us that the US personal savings ratio (savings as % disposable income) jumped by 46bps mom to 4.4% - it's highest reading since August last year, and a step up which steeply breaks out of the modest upswing seen in this ratio since November 2011.

This is one of those indicators which it pays to look at over different timescales. On the short time scale, the rise since April is very sharp, and demonstrates some of the mechanics behind the current the 'soft patch'. On the short term, this is a surprise - just as the 'soft patch' is a surprise.   

But when you look at it over a long time-period, it barely seems shocking at all – rather, it would make more sense to ask why the ratio fell so suddenly below 4% during November 2011 to April 2012. On a long-term timescale, oscillations of savings behaviour look much clearer:

1. 1960 to 1975 – Steadily Building: personal savings gradually rose,
2. 1975-1985 – Statis Without Stability: serious oscillations in savings ratios accompanied and abetted the business cycles. From this distance, however, we can see the basic statis.
3. 1985 to 2005 – The Long Decline: personal savings ratios were eroded from a peak of 12.2% to a nadir of just 1% in April 2005.
4. From 2005 to ?? - Recovery: after a period of panic-saving (2008-2009) savings patterns have retrenched, but to levels above the previous lows.

How long will this period of gradually rising savings ratios last? The three previous cycles lasted 15 years, 10 years, and 20 years respectively.

The Short Term Impact of Rising Savings Ratio.  

Savings rise more slowly than savings ratios, and similarly, the impact of a higher savings ratio on actual spending is not always as obvious as it might seem. For example, although savings ratios are now rising again, the absolute amount of personal savings being made was 7.7% lower in June 2012 than in June 2011. The amount of personal savings made during the first half of 2012 was an annualized US$447bn, but this was 22% lower than during the same period last year, even though personal disposable income rose by 2.7% during that time. By contrast, personal outlays were up 3.7% yoy in June, and up 3.9% yoy during the first half.

Running the maths, if the underlying sequential growth in disposable income is maintained at the levels of 1H, and the savings ratio is maintained at 4.4%, this is what happens in 2H:

1. disposable income rises 4.2% yoy (up from 2.7% in 1H)
2. personal spending rises 3.8% yoy (down very slightly from 3.9% in 1H)
3. personal saving rises 13% yoy (reversing the 21.2% fall seen in 1H).

Remember, these are nominal data – the nominal slowing of personal spending is about the same as the expected slowing of the Core PCE Deflator. In real terms, the rise in savings co-exists with the current growth in spending.