Britain's Private Sector : Net Creditors!

On this side of the Channel, we're so used to international comparisons finding we're the most feckless, drunken, ineducable, absent-mindedly pregnant slobs that we sort of assume we must also be the most financially irresponsible deadbeats too. Particularly when compared to our clean-living near-neighbours, who we view as Germanically cautious like Mrs Merkel, or Catholicly-financially-repressed like all those Italians who are still living with their mothers past the age of 40. No wonder they can save, if they're still lapping up Mama's pasta.

It was also the message we got when Mr Soros bounced sterling out of the ERM back in 1992: 'You can't come in here dressed like that, sonny.'

Like many caricatures there's a painful element of truth. Back in the mid-2000s, the UK private sector was in net debt to its banks to the tune of around Eu350 billion, whilst the Eurozone's private sector owed a net  Eu 900 billion or thereabouts.  In other words, the Brits owed a net Eu 5,720 per head of population, which was more than double the Eurozone's Eu2,735 per capita net debt. Feckless or what?

But the mid-2000s isn't where the story stops. By the later 2000s, even the Brits got a bit worried about carrying so much debt, so even at the peak of late-2007, the net debt per capita had expanded to only Eu 6,854. But over the Channel, the party really started only in 2005, and by 2007, the Eurozone per capita net private bank debt had risen to Eu 4,475. Catching up!

And then, when the crisis hit, the Brits reacted hard and fast, repaying an astonishing net Eu 540 billion between October 2007 and March 2011. And now? The latest figures (for March 2011) show we're now in credit to the tune of Eu 116 billion, or Eu 1,880 per head.  By contrast, across the Channel, our Eurozone counterparts, though they have repaid Eu 815 billion since their peak net-debt of September 08, still find themselves net debtors to their banks of approximately Eu 1,643 per head.

And as a corollary, the British bank loan /deposit ratio has fallen to around 95% (from a 2005 peak of 121% - what was the FSA thinking of?), whilst the Eurozone LDR is still  running around 105% (dribbling down from a 2006 peak of 117%).

None of which is to imply that we Brits aren't the slack-jawed morons you can find sicking-up on the streets of Manchester/Newcastle/Cardiff on any night of the week.   It's just that, rather surprisingly, it turns out we can afford it.  So I'm off for a martini.

Spain Still Has a Fighting Chance

In January this year I was invited to a CapitalWeek conference in Beijing to talk on the likely trajectory of Europe's financial crisis. Recall, if you can, those carefree days of January when Portugal could get 10yr money for sub-7%, Ireland for 8% and change, and even Greece's bonds sometimes dipped below 11%. Well, Europe was a bit off my geographic focus, but it seemed important, so I hashed out a simple methodology, under which I calculated a hurdle rate for nominal GDP growth, which, if a country hit it, it could stabilize its sovereign debt, but beneath which, the already-heavy debt burdens could only grow. That hurdle rate was essentially debt/GDP multiplied by market rates for 10yr sovereign debt.

Working out the likely trajectory then became a matter of judging whether it was plausible that a country could hit its nominal GDP hurdle rate any time in the foreseeable future.  Here's how it looked (then) for Portugal:

Back in January, you had to believe that Portugal could sustain nominal GDP growth of 6.2% to work down its sovereign debt burden.  Since the introduction of the Euro, Portugal has only very rarely managed that hurdle rate of nominal GDP growth, and it was inconceivable to me that it was going to do so any time soon. So the conclusion was obvious - sooner or later, the sovereign debt burden would break Portugal.  As it subsequently has. And as this reality sank in, so bond yields rose and pushed up the hurdle rate - at today's yields, it stands at 8.5%. Anyone think Portugal's going to grow at 8.5% nominal?

On this methodology, there were other victims: Greece (obviously),  Ireland (less obviously), and . . . Italy (I'm afraid).

But Spain - the current focus of market attention -  was a close call. It had a hurdle rate of only 3.7% - well within its recent historic experience, and, with a 20%+ unemployment ratio, damned easy if you closed the gap with potential output. And the curious thing is,  even though Spain is under the market cosh, the hurdle rate has risen only to 3.9%, whilst its 1Q GDP rose by a nominal 2.6%. More, since its capital stock is contracting by around 2.8% a year, Spain's ROA must be climbing structurally - which suggests short/medium term cyclical support. Here's how it looks now:

My conclusion is this: even if/when the People's Party is going to spend the next weeks finding stacks of IOU's down the back of the municipal sofa, Spain's sovereign debt has still got a fighting chance.

An Obvious but Unsettling Observation

Just back from a week in China, so a bit shagged out. Still, there's one thing that's absolutely worth conveying, since I've seen no-one on the street admit it. It's this: the power shortages which are afflicting Zhejiang are not happening by accident, are not the result simply of a perverse pricing policy for electricity and coal, are not the result of a lack of hydro-power, or even the result of heavy industry starting up again after its enforced 'environmental' layoffs of 4Q.

Guys, it's policy.

It really is: China's planners have tried everything else they know to curb what they see as wasteful energy-intensive export industries and now. . . . well, they're switching them off.  Hard landing, soft landing, overheating, has nothing to do with it.  It's policy.

We're so used to resources being allocated by price it seems almost incomprehensible to us in the market that there's another, and rather cruder, way of doing things  Right now, it's before our eyes, but we simply can't understand the message.  I hope I helped.

(If you want more details of the how and why, email me. . . . )

China's April Data - The Short Conclusion

Excluding the social housing campaign, you can sum up April's data like this: contrary to popular belief, China’s economy is  being rescued by the upturn in the global economy – not the other way round.  

China's Transition - Installing Complexity

I'm off to China at the end of the week, and I've no doubt everyone will still be telling me that China's transition is underway. Certainly if you look at the Street's forecasts for China, you'll see everyone is dutifully sketching in the transition from investment & export led growth, to consumption-led growth, whilst the underlying growth rate and savings/investment balance barely skips a beat.

Let's hope so.

But I can't help noticing that in dealing with the challenges posed by China's current economic situation, the recourse to administrative measures in every way favours those parts of the economy which are most susceptible to state direction, which systematically making life difficult for China's freebooters and SMEs. Consider, for example, the choice to curb money supply growth by applying credit controls either directly (by raising reserve requirements, patrolling bank loan/deposit ratios, and directly discouraging lending into certain sectors), rather than by simply raising interest rates. What happens? Well, since the banking system isn't able or encouraged to price for risk, it'll simply lend to its 'safest' customers - the SOEs. The rest - that's the SMEs and the private sector - will soon learn not to bother applying for loans.  And so today the Chinese press tells us that kerb market rates in Guangdong, Zhejiang and Jiangsu are running at 10% a month.  When one part of the economy continues to misallocate, the other part gets squeezed hard.

It's not just money either - it's also electricity. China's got brownouts now, partly because of longstanding coal/electricity mispricing, but also partly owing to the powering-up of those energy-intensive industries which were shut down temporarily at the end of last year in order to meet environmental targets. And in Zhejiang, guess what?  When electricity is allocated, SOEs survive but private enterprises and SMEs are correspondingly  badly hit: enterprises using less than 2,000 kW per day have been shut down every other day since last year.

Now these sorts of policy choices and actions can in the short term mean targets (growth, inflation) will be hit. But by reinforcing an allocation of resources to that part of the economy which knows above all else how to invest big time now and worry about the end-market later,  the choices are surely not bringing forward the day when China's economy is driven by consumer demand, rather than the capex plans of the SOEs. Nor are they  likely to reverse the underlying downward trajectory of China's ROC and cashflows (see here).

As I've already observed, making the transition from exogenous growth models to endogenous growth models is damned hard, if only because the wild success of the financial repression/investment intensive and export-the-surplus model constantly reinforces precisely those lessons which ultimately need to be unlearned and discarded.

If the transition is to be made, all of us, investors, observers and policymakers, had better resign ourselves to a far greater complexity, and probably a far greater volatility, in the Chinese economy than we currently observe.  For, as the great Kevin Kelly says:

You can't install complexity. Networks are biased against large-scale drastic change. The only way to implement a large new system is to grow it. You can't install it. After the collapse of the Soviet Union, Russia tried to install capitalism, but this complex system couldn't be installed; it had to be grown. The network economy favors assembling large organizations from many smaller ones that keep their autonomy within the large. Networks, too, need to be grown, rather than installed. They need to accumulate over time. To grow a large network, one needs to start with a small network that works, then add more sophisticated nodes and levels to it. Every successful large system was once a successful small system.

Flow Essentials for the Big Beasts - 1Q11

Today I'm publishing my Flow Essentials booklet for the world's largest economies during 1Q2011.

What's is that?  At the root of my macroeconomic analysis is an attempt to understand the factors which go to determine the shape and strength of trade and investment cycles, and in addition measure and track the cashflows which go with it. My experience is that if you understand this, you're unlikely to go far wrong in your economic and investment judgements.

This, I guess, is the legacy of starting from a philosophical disposition that favours microeconomics, followed by a career ensconced in equity research departments, sometimes cloistered with the brilliantly  intuitive David Scott.  I attempted to systematise on a macro levels the sort of insights given on the micro-level by Dupont analysis, looking at return on capital (via asset turns), labour productivity, margins, leverage, and then the savings and cashflows which result from these cyclical determinants.

Each quarter, I use the national accounts to work out proxies for these various ratios, and today I'm publishing the 1Q booklet for the US, Eurozone, China and Japan.  It's the cycles in these countries which make the weather for everyone else. You can download it here:
 Flow Essentials 1Q - The Big Beasts

The lessons? The investment cycle looks best-entrenched in the US, and most at risk in China.  Banking systems are allocating capital badly everywhere. The rise in commodity prices has brought a reset back to 2008's painful levels for the Eurozone and Japan, but not for the US or (apparently) China.  Every single economy is running significant savings surpluses - but in the US and China, they are now in decline. On current trends, we'll have to think seriously about these around 2013 - but my guess is the 'on current trends' clause will lapse pretty quickly.

US Bond Markets, and the Novelty of Saving

The truth is, the US financial community isn't used to their economy running a private sector savings surplus - which is hardly surprising because until the financial crisis came along, it hadn't run one since the early 1990s. One result is that there are plenty of people in the US financial industry who don't instinctively understand the link between that surplus and cashflow/balance sheet movements in the banking industry.

Two strands of recent popular economic contention illustrate the point. First, when the Fed stops hoovering up government debt (sometime in June), will that result in a major bond correction? Second, now surveys show US loan conditions beginning finally to ease, are we about to see banks forced into selling off their bloated portfolio of government securities in order to fund new private sector credit?

Behind both worries lurks the same (probably unanswerable) question: why is US government debt trading above its fair value, with 10yr bonds changing hands at around 3.2%, rather than nearer the 4% that underlying conditions (policy rates, inflation, growth) would imply?  Will either of these two near-term worries upset the apple-cart.

Once again, I turn to the US private sector savings surplus.

The key point about the private sector running a savings surplus is that it represents the direction of cashflow between the US private economy and the financial system. If there is a surplus, then the financial system, after it's done all the lending and investing it can with the private sector, remains a net receiver of cash, day in, day out. And since by definition it can't deploy that cash in new private sector lending, it must necessarily end up buying either government debt or foreign assets.  When there is a deficit, by contrast, the financial system faces an urgent need to generate the cash it needs to give to a private sector which otherwise would have to make its own adjustments. And what are the two main ways for banks to raise cash? Liquidate its government bond position and/or take on net foreign liabilities. 

So when we look at the emergence of a private sector savings surplus in the US since mid-2008, we can understand why  holdings of securities have jumped by just under half a trillion dollars, and why, at the same time, net foreign liabilities of the banking system have shrunk by just under US$700 billion. What else could possibly have been expected?

Whilst the private sector continues to run a savings surplus, these flows will - must - continue, regardless of the curtailment of the Fed's buying, and/or the improvement of credit conditions.

For those worrying about the fair value of US government bonds, then, the question should be: how long will the US private sector continue to throw off surplus savings.  There are two techniques for determining this. The first is to model the numbers line by line. So far as I can tell, no-one on the Street is doing that (and neither am I, before you ask). The second is to eyeball the trend. This gives you two alternative answers. First, if the steep decline seen in 1Q is maintained (which, I suspect, can be translated as 'if oil prices continue to rise') then the US will get through its surplus by mid-2012.  If, on the other hand, the more modest trajectory of normalization seen over the last two years is extended, the surplus will endure until around mid-2013.  My guess? Even by mid-2013 the US will still be running a savings surplus, and the rest of the economy will adjust around that fundamental choice. Quite simply, it's what defines the 'New Normal'.

Luckily, by that time, less unorthodox economists than myself will be explaining it far better than me, and the Street will understand it instinctively.
   

May Tactical Allocation Games

Time for my monthly allocations game.

OK, first things first - always bear in mind that these long/short allocation settings are only a game: the choices made are purely those thrown up by rather crude mathematical models. Those models measure four important aspects of money in each market, track  how they are changing, and try to work out how the relative movements have been related in the past to relative movements in asset prices. Each month, I make long and short choices, which are then kept untraded for three months. It's not rocket science and it certainly isn't judgement.  Nor, I should add, do the results influence portfolios I'm involved with. Follow it entirely at your own peril. 

When I aggregate my monetary conditions indicators for the US, Eurozone and NE Asia I produce the  global monetary conditions indicator you see below.  It tells us we're past the time of maximum positive improvement in conditions,  but we're not yet looking at a downward inflection point. There's no simple relationship between global markets and these conditions, but I keep an eye on this because I do feel that eventually sour monetary conditions will find themselves reflected in markets.  

This month's allocations - to be kept until end-July are: 

Developed currencies: Long Euro, Short Yen.  This is the same as last month, which came in up 2% on the month. This model is up 3.2% on the year. 

Developed equity markets: Long Japan, Short Europe. Last month's Long US, Short Europe didn't exactly work out, I was down 0.6% on month, up 6.2% on the year, or 9.2% with currency model. Still my long only choices were up 22.8% YoY, or 26.5% with currency model added. That's compared with an average for the indexes I'm choosing between of 9.8%, or 15.9% for the MS World Free Index, so I forgive myself.

NE Asia: Long Japan, Short Korea.  No, I don't get it either. What's more, the NE Asia model has flunked so badly during the last year that I've had a very sticky visit from some trustees.  Perhaps I should take in washing? 

SE Asia: Long Malaysia, Short Indonesia. Nothing to report on last month's l/s position, since the model was busy short-circuiting itself, going both long and short Indonesia. Still, the long position was up 3.8% on the month, and 28.6% on the year, which is slightly better than the market average of 23.2%. 

BRICS: I was long Russia last month, and I'm doing the same again this month. It didn't work last month (the Micex was down 4%), and it means that for the year, I'm up only 4.8%, against a market average of 9.2%. 

US 1Q GDP: Returns, Velocity, Oil & Savings

Judging from the 1Q GDP data, the US economy continues to thread its way between the Scilla and Charybdis of Fed-incubated and oil-price fertilized inflation, and economic recovery. Even though the headline GDP growth rate slowed to an annualized 1.7% in 1Q, from 3.1% in 4Q10, don't expect the Street to start revising forecasts down significantly. In fact, it wouldn't surprise me to find some of them revising up.

The main thing to notice is that the fundamentals driving the US business cycle remain unusually strong. Even after the 6% YoY rises in investment spending during 1Q, capital stock is probably still slightly shrinking (assuming a 10yr straight-line depreciation of all investment spending), so there are big operational leverage gains still to be made by any company that can secure some topline growth. And since nominal GDP is still growing by around 3.9% YoY, that means most everybody. So, as a rule of thumb, US asset turns are rising, and so too therefore are returns on assets - which in the absence of monetary policy tightening, suggests the investment spending cycle still has a long way to run.

But its not just the return on capital that's rising - so too is return on labour, or labour productivity. Adjusting for the (shrinking) amount of capital per worker, the 1% YoY rise in employment goes hand in hand with a 3.6% YoY rise in nominal output per worker.  That remains at historically extremely high levels. So we should also expect labour markets to continue strengthening.

So with returns to capital and labour both rising, you'd have to have a powerful opposing factor to expect the cycle to abort any time soon.  Could the price of oil be that factor?

Not yet. The second thing to notice is that consumption demand rode out the rise in oil prices, rising 4.4% in nominal terms (vs 3.8% YoY in 4Q10), and 2.8% in real terms (vs 2.6% in 4Q10). Within this, spending on gasoline rose by US$63.7 billion, or 17.5% YoY,  out of a total rise in consumption spending of US$453 billion. Even though gasoline represents only 3.6% of consumer spending, the worry has been, and to some extent, continues to be that the rise in oil prices represents simply a tax on consumption, and that money shelled out at the pumping station is also money that can't and won't be spent elsewhere on Main Street.

Yet it hasn't worked out that way - or more precisely, this factor evidently did not trump other factors working in the consumer's favour. In fact, on my analysis, what happened was that the rise in oil prices simply quickened the erosion of the extremely high private sector savings surplus which the US economy now runs. By my calculations, that private sector savings surplus came in at around US$142 billion during 1Q11, which was down by US$174.7 billion from 1Q10. On a 12m basis, it sank to a still-robust 5.8% of GDP, down from the 7% averaged during 2010.  The lesson is that the US economy can continue to sustain consumer spending growth at these sorts of levels, despite the rise in oil prices. But only if the private sector remains sufficiently confident about the medium/long term prospects for their financial situation to allow them to scale back excessive saving. Financial confidence, (ie, bull or bear markets), remains an extremely important part of the picture.

My third observation is less cheery: there's still no sign that the relationship between the financial system and the economy is really on the mend. On way of checking this is by looking at monetary velocity. Normally when rates of return on capital are rising, monetary velocity (GDP/M2) tends to rise, as loans deployed end up generating greater cashflow. Now although velocity bounced last year off the previous year's historic lows, the rise was not sustained, and velocity actually fell back slightly during 1Q11. So the banking system remains a serious drag on the economy. On the other hand, if velocity stays down here, then the consensus that the US has little to fear from inflation, despite the Fed's best efforts, is going to be right.