What Have the French to Be So Happy About?

It's easy to get inured to the grotesque when tracking European leaders 'tackle' the crisis of their own making and sustaining. But not today. Because today  I  read of the trials of Bankia. This is a Spanish savings bank, which, sadly, not longer enjoys access to the money markets.  Consequently, it joins the queue at the ECB's lending window of last resort. When it gets to the head of the queue and explains its predicament, the ECB's man at the window says: 'And what collateral can you offer me?'  Bankia rootles around in its exquisite leather briefcase, produces a piece of paper and say, triumphantly, 'Well, I've got this!'  And 'this' turns out to be the £80 million loan Bankia made to Real Madrid to allow it to buy Portuguese dribble-wizard Ronaldo from Manchester United.  In truth, the Bankia is offering to the ECB is nothing more or less than Ronaldo.  

So even if the ECB can't rescue the Eurozone, it still should have a sporting chance at the World Central Bank Football Cup, to be held in Basel (or Beijing) in 2015.

But back to France. What have the French to be so happy about? (except the wine, cheese, weather, light . . . oh God, the list goes on). Earlier this week, as Europe's financial foundations crumbled, French consumer confidence was measured as its most joyeux of the year.

The Franco-German relationship is au fond the point of the European Union: back in the 1950s the European Iron and Steel Community was initiated precisely a de-fang the strategic industries of the Ruhr (principally Krupps - read William Manchester's 'The Arms of Krupp' for details), so that they could never again subvert democratic governments into making war on their neighbours. The Krupps did magnificently out of the Franco-Prussian War, and also World War One, and the Krupp family spotted Hitler's potential, and funded his rise in the early 1930s - so you can see how powerful the analysis would have been. When President Mitterand announced that 'L'Europe, c'est la paix', that's how he understood it.

Notice, however, that even at this stage, the point of the pan-European institutions was to provide a countervailing institutional force to the enduring dissimilarities between France and Germany.  So when we look at the Euro, the really crucial question is not whether Greece or Portugal or Spain (or even Italy) is a viable part of a common currency zone, but whether France and Germany can coexist in the same economic, financial and fiscal state.  The introduction of the Euro finally seemed to answer that question with a triumphant 'Oui'. Now look at this:

That's the spread between French and German 10yr government bond yields. I've averaged it over the last month to make it easier on the eye - and as a result it mildly underestimates the current spread. As of yesterday's (Friday's) close, the spread was 68bps. The Greek 'rescue' packages, whether ultimately successful or not, seem irrelevant to the development of this spread. 

I'm conflicted about how to read it. One could say that it represents the market's correct judgement that France's fiscal foundations are somewhat flimsier than Germany's, and so the market is working. Or one could say that the emergence and endurance of a noticeable spread represents the market's view that should push come to shove, German tax payers won't be in the business of paying French state pensions. In short, that Franco-German fiscal union will never happen. 

Whatever the reason, unless one really believes in the possibility of Franco-German fiscal union one should expect the spread to widen over the medium and longer term.  Because when it comes down to it, the French and German economic models - ie, the way they grow - are now radically different. And for historic and structural reasons, that difference is going to be far more pronounced in the next decade than it was in the previous decade.  

The next couple of charts explain how and why. The first shows the different trajectories of return on capital in France and Germany, based on an indicator measuring the flow of GDP as a return from a an estimated stock of capital. (Nb, this is a directional indicator only, not a direct measurement of ROC.)

As you can see, Germany's ROC was climbing sharply before the financial crisis (as it economically digested East Germany), and has rebounded to near record levels since. No guesses for which way it's likely to continue to go.  France's ROC record, on the other hand, has been one of sustained and enduring erosion. More, only now is it beginning to show some recovery from the financial crisis. Germany's historically low ROC surpassed that of France in late 2007 and has never looked back (perhaps coincidentally, just at the time that the yield gap also opened up). The gap between the two has widened, is widening, and there's no reason to think that won't continue.

France's growth strategy meant that is didn't notice much, because it compensated for a slightly lower relative ROC by building its asset base faster than Germany. So in the years immediately prior to the financial crisis, French capital stock was growing 5%-7% pa, whilst Germany's was, well, hardly growing at all.  France grew by growing its asset base whilst its ROC fell; Germany grew by sweating a relatively static pool of assets. Taken together, the two models resulted in pretty similar growth rates.

But, as the economically observant of you will already have noticed - these were two growth rates passing like ships in the night. Regardless of the crisis eroding the fringes of the Eurozone, there are very different economic futures beckoning for Germany and France. Germany's higher and rising ROCs invite and justify further expansion of its capital stock - something that will become only more attractive as German labour markets tighten. All in all, then, we should expect a fundamentally-based acceleration in German GDP growth sustainable over the medium and long term. For France, the opposite it true: stagnant ROC will likely continue to weigh on investment spending, growth of capital stock and ultimately growth in the medium and longer term.

To sum it up, Germany's medium and long term economic future looks rather different (and considerably brighter) than France's, in a way which reveals a fundamental difference in the growth models of both countries.That difference has been masked throughout the short lifetime of the Euro by the costs imposed on Germany by its absorption of Eastern Germany. No longer - the mask is off, and Germany's underlying outperformance is going to become more and more obvious.

All of which raises two questions. First, can France change its growth model? And second, what have the French to be so happy about?

Sic Transit Gloria Euromundi

It's Monday, the day-after-the-rescue-before, Greek 10yr bond yields are up 11bps,  and both Spain and Italy's are up 25bps, and the EuroStoxx 50 is down nearly 1.1% on the day.

For me, the best commentary on last week's package is from J.P. Morgan's David Mackie, and I hope he will forgive me quoting him at length:

'Many commentators assume that because the Euro area’s consolidated fiscal position is better than the US’s, then a Eurobond that simply aggregates Euro area sovereign debt with a joint and several guarantee will be rated the same as US treasuries. But this may not necessarily be the case. The creditworthiness of US treasuries depends on the power of the US government to tax citizens and control public spending across the entire country. In a simple Eurobond without any change in governance, the creditworthy countries only have the power to tax citizens and control public spending in their own jurisdictions. They would not have the power to tax citizens and control public spending in the less creditworthy countries. 

Thus, if we get to a situation where Spain and Italy lose access to capital markets, a Eurobond as a simple piece of financial engineering would not solve the problem. The creditworthy half of the region would not be able to bear the burden of the less creditworthy half. Only a move to a fiscal union where either governments in the creditworthy half had the ability to tax citizens and control public spending in the less creditworthy half, or alternatively where the creditworthy countries had the ability to control debt issuance by the less creditworthy countries, could save the region. Thus, when a common Eurobond is most needed, say if Spain and Italy were to lose market access, it would be the least effective unless accompanied by huge governance reforms."

US Consumer, and the 2Q Slowdown

Barrels of analytical ink have already been spilled over the disappearance of US growth in 2Q.  The line generally taken is that it is explained mostly by bad luck: first the weather was foul and inventories were building a bit; then oil prices spiked because of the Arab Spring (and then Libya); and then the global auto industry discovered just how utterly dependent it was on a few parts plants in Tohoku, Japan, knocked out by earthquake/tsunami/power-outs.  All true, no doubt, but the best economists on the Street reckon even this combination doesn't account for much over half the slowdown.

Something else was going on as well. Can we understand it, and by tracking it get a heads-up on the likely direction for the rest of the year.

I think we can. In an economist's ideal world, national flow of funds tables would be published on a weekly basis, so we could track just what's happening to balance sheets. In that way, we could hope to get a better fix on cashflows.  But alas, the Fed serves them up on a quarterly basis. Still, they still have a story to tell.

And the most important, epoch-making story they tell is of a great restoration of 'normality' to US household balance sheets. Take a look at the following chart - it shows the net position of the US household sector with credit markets (including banks) between 1970 and 1Q2011.

Actually, this chart is one of the two mainsprings of the world over the last 50 years (the other being China's emergence). And it neatly divides into three parts. The first part is 1970-1991, during which time the US household sector behaved exactly as household sectors are historically expected to do: i.e., they save, bank the savings,  and the banks then allocate those savings to industry. (Well, that used to be the theory.)  By 1991, these net deposits amount to just under US$1.5 trillion - the equivalent then of 25% of GDP.   But that year is the pinnacle: for starting in 1991, we have an absolutely startling change in financial behaviour: the US household sector starts to run down its net bank savings systematically and increasingly rapidly. By  1999, it's spent the lot, but, being 1999 the party continues.  In fact, the recession of the early 2000s merely accelerates the trend, and by 2Q2007, the US household sector owes credit markets a net US$2.97 trillion, equivalent to 21% of GDP.

And that's it - that's the bottom.  Since then, the sector, voluntarily or otherwise, has improved its net balance with credit markets by US$1.5 trillion, and as of March 2011 its net debts had contracted to US$1.42 trillion, or 9.5% of GDP.

The chart tells you that one way or another, this is a fundamental, one-in-a-generation change in financial behaviour.  It is also the central fact that is dominating US economic growth, and, most likely will continue to dominate it for years to come. This household deleveraging - which, incidentally, is as much a function of diminished appetite for financial risk as represented by equity investment as it is of blunt debt-repayment - is the financial driver of the 'new normal'.

When we track its evolution via the flow of funds tables, we can make a very good guess at what the missing element was that sabotaged US growth in  2Q, coming so hard on the heels of comparative over-achievement in 4Q10 and 1Q11.

Take a look at this chart, which tracks changes in this net debt situation on a quarter-by-quarter basis - i.e., it gives the fine grain detail to the broad sweep of the first chart.

It doesn't look much, does it - another damned dull chart, in fact. But stifle your yawns, take a moment, and  you'll see that although this deleveraging seems to have a marked seasonality, with most net changes taking place during 1Q,  this year the deleveraging barely occurred. During 1Q2009, the household sector's balance improved by US$454 billion; during 1Q2010 it improved by US$288 billion; but during 1Q2011, it improved a paltry US$55.6 billion.

When I model US domestic demand momentum against underlying financial conditions (a model that's fraying heavily at the edges, to be honest),  we saw a marked and inexplicable over-performance in 4Q10 and 1Q2011.  My belief is that that over-performance was the result of a lapse in deleveraging behaviour which, by 2Q2011 was being noticed, regretted, and reversed.

Until the 2Q2011 flow of funds tables are issued (Sept 16, mark your diary!) we won't be able to prove it. As I say, ideally flow of funds tables would be published every week. They aren't - but bank balance sheets are, and we can use those to give us a good idea of what has happened since.  I do this by simply looking at how many deposits are coming into US banks, vs how many new loans are being made - in ridiculously simplistic terms, this is a cash in vs cash out measurement.  Here's what it looks like, up to early July:

And the picture does indeed tell the same story as the flow of funds charts: perennial negative cashflow (more loans going out than deposits coming in) is replaced in 2008 by massive and sustained deleveraging. The pace of that deleveraging declines (though remains positive) throughout 2001 and into the first quarter of 2011.  And then. . . . well, the pace is picked up again in 2Q, and appears now to be stabilizing. 

In terms of the domestic demand, that means a strength of demand in 2010 and into 1Q11 which runs slightly ahead of underlying 'organic' growth (which is also why we get a mini inventory-cycle), followed by a correction in 2Q2011. 

End of the earth? End of the cycle?  By no means - but growth with deleveraging is the new normal in the US, and that's not going to change.  Anytime it looks like it has abated, assume it hasn't. And watch carefully the swings in banks cashflows - at least until they get round to publishing flow of funds tables on a weekly basis. 

Will China Implode? Not Just Now

So to recap, the world economy was swinging along nicely, despite the collapse in confidence, when it ran across  three potential catastrophes:

1. The possibility that the US recovery is stalling (a complex nexus of causes and effects which includes the impact of a profoundly divided political establishment on economic and financial confidence); 
2. The existential crisis of the Eurozone;
3. The possibility of a hard land for China. 

Today I'm going to look at the third - China.

(But first, note that the debt crises in the US and Europe are actually historic reflections of each other. The US Treasury market was a war-child - between 1861 and the end of the Civil War in 1865 government debt  mushroomed from US$65 million to US$2.756 billion. Out of desperate need to finance a war to finally settle the historic States/Federal political question, was born a single dominant Federal debt market. We watch now as that debt market becomes hostage to precisely the same question of State/Federal rights and powers (which is what, ultimately, the Tea Partiers are on about). Meanwhile, over in Europe, the attempt to try and retain a full fiscal panoply of State Powers whilst sharing a single currency has delivered bankruptcy to at least one State, and probably more. The result, more likely than not, will be the construction of a single dominant Federal debt market.)

I remain sanguine about China's immediate future.  This is not, I hope,  because I don't recognize China's problems, or the threat they pose. But for the most part they are not new. Take, for example, the worry about the debts of local government financing platforms. Now, there is no doubt that they are far bigger than they have been, and far bigger than they should be - whether you accept the National Auditor's lowball figure of around 9.5 trillian yuan, or the higher estimates, which range up to around 14.5 trillion yuan.  But in the end, these debts represent the accumulated fiscal deficit of provincial and lower levels of government. Since in China taxes flow upwards to Beijing, but responsibilities flow downwards to the regional authorities, how to finance these layers of government has been a perennial problem for China for as long as I can remember. Indeed, I'd say that how to finance lower-tiers of government has been the problem for China, possibly exceeded only by problems of water and agriculture (to which, of course, it is linked).  Monetising this problem away was the underlying reason why China used to be inflation-prone , and which ultimately brought Zhu Rongji to power in the 1990s.  About his first act was to re-set the split of China's tax-take between national and provincial governments. Anyway, here's the big bad secret which China's (not) been hiding all these years - if you're fiscally squeamish look away now. . .

As you can see, between 1995 and 2009, Guangdong and the Yangtze Delta can lay claim to fiscal respectability.   But most of the rest of China can't. The capital region (Beijing-Bohai) has finances which, were it not the capital, would be among the most disastrous in the nation - but we can perhaps give it a pass on account of its unique position in China. But the Industrial Northeast, which ran a fiscal deficit of over 12% of provincial GDP in 2009, has a distinctly rust-belt fiscal legacy. And in the Central Provinces - China's heartlands - the deficit was running at near 8% of GDP in 2009. In short, the fiscal position of China's provincial governments is a mess, and has pretty much always been a mess.

So although the situation is now news, it's not exactly new. Nor are the ways in which it has been solved. First, the central government rebates the vast majority of taxes back to lower levels of government. And secondly, local governments supplement their budgets by land sales and by using near-deniable near-provincial-sovereign financing platforms.  When times are tough, or when provincial countercyclical spending has been particularly ferocious,  there will be an extended tussle about who, ultimately, gets to pick up the tab.

With a bit of luck we will not be witness to the grisly infighting which will eventually produce a settlement.  But we can be pretty sure that it's a question of 'who's going to pay', rather than 'where on earth are we going to get the money from', because we can track the underlying cashflows of the whole China economy via the private sector savings surplus. And here is my estimate of it, up to June this year:

The key point of this chart is that although the private sector savings surplus is in decline, it's still massive at around 5.6% of GDP, or 2.4 trillion yuan a year. And that surplus is effectively the net cashflow into China's financial system after the banks have done all the lending they can do to the private sector (which for these purposes includes the local government financial vehicles). There's nothing for this money to go on except either central government debt, or foreign assets. This persistent deluge of cash into the banking system is the reason why China's banking system has a collective loan/deposit ratio of only 66%. It's the reason why bank lending can growth at mid-teen levels persistently even though the government has commandeered and disabled 20%+ of the deposit base as reserves.  And, of course, it's also the reason why China isn't going to run out of financial or fiscal options any time soon.

Misery and Spending, Spending and Misery

Yesterday's post looked back with a broad and affectionate eye at the monthly trade and demand data for the world economy, concluding that  although here in the financial industry we are peering into the abyss, around us the world goes on pretty much as normal - people go on shopping, goods get made, shipped and sold. And when you total up all that quotidian coming and going it is strangely hard to notice that we're on the edge of a multiple crises.  Rather, the world economy looks pretty robust, trending (normalizing on IMF data) for global GDP growth of around 5%. 

In my experience, though the really big economic/financial crises shake the seismograph, they don't arrive like earthquakes out of the blue - rather, there's a steady and enduring stream of disappointment lasting usually years before the cashflow and balance sheet consequences become unendurable.  In the late 1990s, SE Asia's terms of trade were quietly falling apart for years, eroding cashflows and current accounts, before the consequences became clear in  1997/98. In the US, new home sales peaked in mid-2005 and spent the next three and a half years grinding relentlessly lower before finally bad debts (or rather, the attempt to 'insure' them by the CDS market) brought the Reaper's sickle to the banking system.  

It's not a rule, but it is a tendency. And so to today's topic: the danger implicit in a perceived collapse in consumer confidence. This, after all, is what is now dominating the headlines - just this morning we had the Nielsen global survey which concluded that we are at our most miserable since early 2009. Last week we had the Uni of Michigan US consumer confidence shocker also serving up the same conclusion. But because the really serious problems grind slow but grind small, I tend to view short-term movements in consumer confidence readings with considerable caution. Are they cause, or are they effect, or are they, indeed, anything truly measurable in the first place?

First, let's look at what is happening to measured global consumer confidence. To create this global index I've used subindexes in the US, Eurozone and NE Asia (including China), and as usual weighted them according to 5yr GDP averages. 

The first thing that strikes me is that although global confidence has certainly taken a knock, we're not really back at early 2009 levels. The Uni of Michigan may or may not be accurate in that story, but it's not one which yet has purchase in the  Eurozone  (105.1 in June 2011 plays 70.6 in March 2009), or in  NE Asia (97.2 in June plays a low of 81.7 in Jan 2009). 

Now let's look at the relationship between confidence and demand momentum.  Using the great statistical method of smoothing to a 6m purl and then eyeballing, it seems that usually there's a pretty good fit between the consumer confidence measured, and direct measurements of domestic demand. 

But one needs to go considerably beyond eyeballing the smoothed data to explore any seeming relationship. What we are looking for is evidence that a change in consumer confidence has a useful correlation between a change in domestic demand momentum - with no smoothing or averaging allowed. I've looked at the change occurring over three months (ie, the changes in both measures between, say, December and September) between 2000 and now. This shows there's a correlation coefficient of 0.24 between the changes in these two over 134 observations - sailing past the 1% significance test.  But the coefficient gets even stronger if you view consumer confidence as being a lagging indicator: it rises to 0.256 on a one-month lag, and 0.349 on a 2 month lag (this is its peak).

If you treat confidence as a leading indicator, however, the coefficient rapidly dribbles away to insignificance. 

The moral? Those surveys we're watching - the Nielsen, the Conference Board, the University of Michigan - they're more likely to be lagging indicators than leading.  Perhaps we're miserable because we're not spending, rather than not spending because we're miserable.  

But if that's true (and it's not a nice thought) it suggests there's a more powerful reason that mere transient misery why we're not spending, if we're not spending.   And so on we go, down the analytical trail. 

A Prelude to Possible Armageddon

'Be forward-looking'. Right now, I'd rather not. And that's not only cowardice speaking, but a claim that in times like these, the blazing inferno of our forthcoming possible catastrophes is at the very least likely to blind us to our present actual condition.  Today, and tomorrow, if I have time, I intend to look back - to establish at least where we stand, even if several of our paths onwards lead over the precipice.

What present itself in the data - even up to May and June data - is the sheer buoyant health of the world economy, and its sheer normality. Let's remember what's actually happening in world trade, and what's happening to world demand.

First, the link between G3 demand and NE Asian exports is as tight as it has ever been, and, what's more, so far as we can tell, both have been interruptedly buoyant now since the middle of 2009.  Looking at G3 import data in dollar terms, by May US imports were rising 20.7% YoY, Eurozone imports were up 32.6% YoY, and Japan's imports were up 27.5% YoY. Overall, then, G3 imports were growing 26.9% YoY. What's more, sequential momentum remained positive, with the MoM growth in the three months to May rising 0.8 SDs faster than the historic seasonalized average, and the 6m of this momentum indicator riding at 0.92 SDs.  This is not immediately signalling the developed world economy is dangerously anaemic.

And, of course, NE Asia's exports machine is answer the call: by May NE Asia's exports were growing 14.8% YoY (China up 19.3%, Korea up 22.4%, Taiwan up 9.5%, and even Japan  managed a 1.8% YoY rise, despite the worst that earthquakes/tsunamis/nuclear accidents could throw at them. By June, my best guess is that NE Asian YoY export growth will come in again around the same (China up 17.9%, Korea up 13.6%, Taiwan up 10.8% and, based on the first 20 days, Japan up 9.2%). As the chart below shows, there's been a downward inflection in the 6m momentum trendline, but we're still ranging deep in positive territory.  And that's despite the multiple catastrophes suffered in the region's second-largest industrial economy.

Up to May and June, then, if you had to choose a description of the world economy judging from its trade data, it would be fair to use words like buoyant, or - if you're determined to be a grizzled pessimist - steady.

So it should be no surprise that you'd probably end up using much the same vocabulary if you looked at domestic demand data.  A word about how I do this. In each country, I look at what I consider to be the obvious monthly data-points for domestic demand: retail sales; auto sales; labour markets (employment and wages); construction and, where possible, service industries activity.  For each of these indicators, I develop the seasonalized historic expectation and measure monthly deviations from that pattern, expressed in terms of standard deviations.  For each country, I will then take a flat average of those deviations. When looking across countries (ie, for NE Asia, or for Europe, or for the world) I weight according to a 5yr average of dollar GDPs.

Here's how the situation looks up to May:

This ought to ring some bells: momentum accelerating throughout 4Q10 and 1Q11, followed by a sharp fall-off in April and May, with the beginnings of a recovery visible in June (probably - we've only partial data so far).  On a 6m trend basis, we have the same thing we saw in the trade data: an inflection point downwards in April, but still defiantly positive underlying sequential momentum. (Details: for 6m to June, the US is up 0.49; Europe is up 0.21; and NE Asia is up 0.05. For June itself, the relative strengths (on the data we have) are almost exactly reversed - ie NE Asia is up 0.78; Europe up 0.13; US down 0.26). 

Once again, one would conclude from this data that although the world economy's future may turn out to be catastrophic for several popularly identifiable reasons, its OK so far. (As the man said as he flew past the 30th floor window on the way down.)

Naturally enough, when an economist goes to the considerable trouble of constructing these indicators, he likes to use them to get a quick grab on likely GDP growth.  In the case of this demand model, the newly-normalized model (yes, shameless, I know) runs to an r-squared of 0.9 over the last 12 years when regressed against the IMF's global GDP result.  Last year, the IMF says the world economy grew by 5.01%, whilst this demand indicator suggested 5.2%. This year again, it's again telling us to expect the world will grow by around 5.2%. 

Unless, of course, the immediate future is dreadful.  Which it might be - it demands no highly-developed imaginative powers to envision it.  But as you ponder the possible trajectories, do at least remember that for all the analytical ink spilled, and for all the weaknesses already printed in the world's data, during 1H 2011 the world was growing quite nicely at a clip of around 5%.