US Household Deleveraging: Finance vs Fear

Three charts today which show how far US household sector deleveraging has already gone – back all the way to the realms of ‘normality’ and, in some ways, beyond. It leads to a powerful conclusion: deleveraging is no longer about the sustainability of balance sheets or even current spending patterns. Rather, it’s now about fear of what the future may bring. Or to be more precise: fear of unemployment.

This first chart tells us about the overall size of US net household balance sheets in comparison with the size of the economy.  At the end of June US households had net financial assets of US$32.38 trillion, equivalent to 235% of GDP. That size looks about right, with little or no further adjustment needed, by two counts. The first measurement is made simply by extrapolating the gradual rise in the household sector’s net financial assets as a percentage of the economy between 1978 and 1994  - ie, in those years after the conquest of inflation but before the roaring bull markets of the mid/late 1990s and the asset bubbles inflated after the financial crashes of 1997/98.  (For reference, the S&P ended 1994 at 459.) If things had simply gone on like that, we’d expect household net financial asset to have reached around 226% of GDP – vs the 235% we see currently. To get there would take a fall of 3.6% in net household assets and no change in GDP – personally I’ve no doubt we’re already there.  The second measurement is simply the average around which this ratio has oscillated so wildly since 1995 – it comes out at 233%.

I think it reasonably safe to believe that, cyclical fluctuation notwithstanding, the  structural adjustment made in the size of US household balance sheets relative to the economy has substantially been made.  Or more bluntly, the US household sector is about as wealthy as you’d expect.

But what about the mortgage debt? How heavily is that likely to be weighing on households savings/spending decisions?  The second chart looks at mortgage debt in proportion to the total holding of net financial assets. If this is very high, one might anticipate a reluctance on behalf of households to raise mortgage debt faster than their overall balance sheets.   And indeed, we see that this ratio has crumbled from a 1Q peak of 40.9% to 28.2% at end-2Q11 – a level which was sustained unchanged between 2002 and 2007.

It may therefore seem reasonable to see this as a point of stability, at which the urgency of cutting mortgage debt is relaxed somewhat in the minds of householders. If not, and we are looking for a full retreat to the pre-1992  financial norms, then the ratio needs to come down further, to 22%-23%.  If so, then at the post-crisis rates of adjustment, we can expect that to be completed within four quarter – ie, by June 2012. 

The third chart looks directly at the US household mortgage debt service ratio, which expresses payments on mortgage debt, home insurance, and property taxes, as a percentage of with disposable personal income. At end-June 2011, this ratio had fallen to 9.5%, the lowest reading since 2003, and down from a peak of 11.3% in 3Q2007.  More, this is now lower than the 1980-2011 average of 9.6%, or the average since 1995 of 9.7%.   It is also lower than at the start of the period of aberrant financial behaviour (when households started running down net deposits, rather than building them up) in 1991. 

There is a simple and irresistible conclusion to be drawn from these charts: by the standards of the financial history of the last 30 years or so, we ought now to be coming to an end of US household sector deleveraging.  Demonstrably:

1. the household sector’s net financial situation is about where history suggests it should be;
2. mortgage debt as a percentage of net financial assets has already retreated to recently ‘normal’ levels, and on current trajectories will have returned to long-term ‘normal’ levels within a year. And
3. mortgage debt service ratios are already below long-term averages.

And from this one can draw one further conclusion: that continued and sustained debt deleveraging by the US householder is based not on the discomfort of the current situation, but fears about deteriorating future prospects.  Jobs and job safety, in other words.

Shocks and Surprises, Week ending September 24th

The week's news and markets were once again dominated by the Euro-crisis – a Three Act Tragedy in which I think we're in the middle of Act Two, where the Princes of Europe continue not to notice that the palace they have built over the last 50 years is on fire, and the portcullis still down. It's in the nature of these dramas that Act One is largely taken up with the technical business of scenery setting, Act Two is largely taken up with argument, and Act Three is all about the body count.

Outside the Euro-palace gates, the noises-off continue to be discouraging. There was a parade of nasty shocks where things turned out worse than Euro-economists had expected: these ranged from industrial orders (down 2.1%, and dreadful downward revisions from Italy), consumer confidence (worst for two years), French consumer confidence, and PMI readings for both manufacturing and services, and, outside the Eurozone, UK orders. Actually things could have been worse – readings from Germany were at least no worse than expected, and neither was the fall in the Eurozone Composite PMI (though it showed an actual contraction at 49.2, and the new orders reading fell the steepest since July 2009). But everyone's now waiting for Act Three.

Nonetheless, Europe is not the whole world, thankfully, and there were significant surprises out the US last week which got sucked under to oblivion in the tail-wake of the Euro-crisis. One cannot judge the likely near-term course of US household deleveraging cycle without taking into account the housing market, because that's at the centre of the whole issue. And last week, there were two major upside surprises: sales of existing houses jumped by 7.7% MoM, which was almost double the most optimistic reading in the normal level of expectations, with purchases of single-family homes up 8.5%. Now, it's true that prices are still falling (down 1.7% MoM and 5.1% YoY), but when you're looking for the bottom of the market, it's volume that matters. Builders also seem to feel some sort of a bottom is being reached: building permits jumped 3.2% MoM, which again was outside the range of expectations by some considerable distance. In fact, expectations for MoM results remain immovably negative even though three out of the last four months have shown significant growth (May up 8.2%, June up 1.3%, July down 2.6%, August up 3.2%).

So tomorrow's new housing sales data, also for August, will therefore be worth watching. Consensus is looking for only 294k, a fall of 1.3% MoM, still conservative. Even so, it would represent a rise of 5.2% YoY. The balance of last week's data suggests we can't rule out an upside surprise on this one. So to do bank balance sheets, where the Fed data tells us closed-end residential loans rose 5% YoY in August, after rising 5.3% in July.

In Asia, the main 'shock' is that the strength of the yen is catching up with Japan's exporters. As usual, the J-curve effect, in which the initial lack of trade balance response to a sharp currency appreciation is suddenly and dramatically reversed, caught us us economists out. We can walk the J-curve drill in our sleep, but it still gets us every time – I have no idea why. Well, the data for August showed export growth achieving less than half the bottom end of analysts' expectations, whilst import growth exceeded even the top end of the range of consensus. China looks to be the main beneficiary – exports to China rose only 2.4% YoY, but imports from China leapt to 16.3% YoY, and Japan's trade deficit with China almost tripled on the month.

And the data from China this last week suggested it will welcome all the benefit from the strong yen it can get. I think there were three data-series from China which were distinctly disappointing this week: the MNI Flash Business Sentiment Survey, the HSBC/Markit Flash Manufacturing PMI, and Taiwan's export orders. Since there's only a published consensus on Taiwan's export orders we'll start there: they rose 5.3% YoY in August (vs 11.1% in July), which was below the bottom end of expectations. The main reason for the slowdown was growth in orders from the US, which fell to 9.1% YoY from 16.8% in July, but orders from HK/China didn't help – they fell 0.4% MoM, and grew only 3.4% YoY (vs 6.5% in the previous month).

The shock from the HSBC/Markit Manufacturing PMI is less in its headline (it fell to 49.4 from 49.9 – but this just takes us back to July levels) than in the details – sharp falls in new orders, particularly export orders, and stocks of purchases all suggest more slowdown is on its way, whilst inflation in both input and output prices continues to accelerate. Similarly, the shock from the MNI Flash Business Sentiment Survey isn't immediately obvious – it rose to 59.27 in September from 55.4 in August. Not bad – except that this reading of how listed firms are feeling isn't seasonally adjusted, and that 7.9% MoM rise is frankly pallid compared with, say, the 11.9% recorded last September. In fact, on a YoY basis, the reading was down 14.8% YoY (vs a fall of 10.9% in August).

Euro-Deposits on Both Sides of the Pond

A quick follow-up on a couple of stories I've been following. First, the flight from foreign banks operating in the US. The US Fed's data tells us that between the end of May and September 7^th, foreign banks operating in the US lost US$233.3bn in deposits – that's 20.3% of their total – with nearly half of that exiting since the beginning of August. As I reported earlier, they remain super-cautious, holding US$943.2 bn in cash, which is slightly more than they'd need were every single depositor to demand his money back today. And yet in response to this shrinking deposit liabilities base, they have not yet started shrinking their loan book: rather they are supporting their loan book by a) selling other securities and b) taking in US$174 bn of net liabilities from branches overseas. But clearly, sometime soon that loanbook (currently standing at US$619 billion) is going to start shrinking.

Back across the Atlantic, what's happening at the ECB? Well, it continues to pump in money. Its holdings of Euro-area securities rose a further Eu8 bn in the week to September 16^th, and its total balance sheet expanded by Eu 48.3bn on the week. The overall balance sheet continues to add leverage: total assets were 26.2x the size of the ECB's capital as of Sept 16 – the highest leverage ratio the ECB has enjoyed/endured since June last year.

But I don't think that's the main story for the ECB just now. Rather, I think the thing that needs watching is the build-up of fixed-term deposits on its balance sheet. These fixed deposits have jumped from a steady Eu74bn in mid-August, to Eu143 billion at the latest reading. 

 What are they? They are exactly what they say they are – fixed deposits. What's happening? Well, earlier this week, the FT reported that Siemens had withdrawn Eu500m+ in cash deposits from large French banks and transferred it to ECB, partly on lack of financial confidence, and partly because ECB is paying higher interest rates. In total, Siemens now has Eu4-6bn parked in ECB, mostly through one-week deposits.

In other words, not only are American depositors are quietly withdrawing deposits from foreign banks, but European corporations are also quietly withdrawing deposits from Eurozone banks. The Eurosystem of central banks and the ECB really do seem to be acting as a banker of last resort. Since mid-August, the build-up of time deposits held in ECB has risen at a fairly steady Eu14 bn a week. So far, it 's a pinprick – just half a percent a month of the Eurozone's total private sector deposits. But with an average loan/deposit ratio of 105%, the Eurozone's banks need every Eurocent in deposits they can muster.

IMF and CDS both Finger China's Banks

Which banks have been de-rated the most since the latest Euro-explosion at the beginning of August? Easy question, that – European banks, of course. But China's banks are running them an uncomfortably close second.

The latest bout of Eurocrisis broke raging from its cages at the beginning of August – I know because I was worried I was flying into a banking collapse in Cyprus for my holidays - and since then the average CDS price fo 5yr European bank bonds has risen by 150bps to 517. Despite rating agencies' downgrades, we're seen only a pale echo of that rise for US banks: during the same period CDS rates rose only 90bps to 225. There has been roughly the same rise for Asian banks (including China) – they've added 93bps to 250.

But CDSs for China Development Bank have risen 149 to 305, and for Bank of China they've risen 142bps to 288. This re-pricing isn't generic, and isn't typical of the market – it seems it is specifically pointing to a previously unacknowledged leveraged vulnerability in China's banks to the risks posed by the Eurozone. Since neither of these banks is known or expected to have anything significant in the way of direct exposure to the Euro-threat, it needs some explanation.

And yesterday, we got the clearest possible explanation from the IMF in its latest Global Financial Stability Report. A good deal of that report wraps itself around Europe's problems, of course, but China's situation gets a full page box all of its own (here – Chapter One, Page 40). It's a must-read. 

It points out that during 2009-10, China experienced one of the highest rates of credit expansion in the world, as authorities boosted investment spending – in fact, an accompanying chart shows it surpassed only by Vietnam and Belarus. (Interesting factoid: since then, the Vietnamese Dong has fallen by 15% vs the dollar, the Belarus Ruble has lost 60%, and the yuan has risen 8%.) 'Many of those investment projects are thought to lack longer-term commercial viability, putting the repayment of the underlying debt in doubt.' Recent policy tightening has slowed headline loan growth, but other forms of credit have surged. . . . These include;

• bank acceptance bills and trust loans, now also regulated more tightly;
• inter-corporate lending and credit from small loan companies; and
• funding from banks based in HK and offshore bond markets.

'Based on the authorites total social financing data, the stock of domestic loans reached 173% of GDP at end-June. This places China well above the levels of credit typically observed among countries at the same income level. . . . '

'A long-running real estate boom . . . adds another layer of risk. . . . In this environment, the authorities' current efforts to cool the market might induce a sharper-than-expected correction in prices, depressing collateral values. A weaker property market could also put further pressure on local governments, which rely heavily on revenue from land sales.'

What to do? I think the IMF's conclusions are absolutely on the money. 'While they believe it will be costly, most analysts consider that the likely fallout from China's credit boom will be manageable. One key source of confidence is China's strong fiscal position, including a large stock of public-sector assets and low central government debt. Nevertheless, even those buffers do not preclude significant bouts of uncertainty as to how losses will ultimately be allocated among the banks' private investors and local and central government. To the extent that the government needs to step in, the consequence could be a substantial worsening of China's public debt metrics and a narrower scope for future fiscal stimulus.'

Those two last points – about the scrap to avoid holding the losses, and the extent to which the hangover from 2008-2010 will constrain Chinese government policy choices over the next 18 months – should be carved in stone above every asset-allocators desk.

 

US Now vs Japan 1990s - Part II, Real Estate

This week's river-drift of data from the US is all about the state of the property market – so it's time to post the second part of how the US's deleveraging cycle looks fundamentally different from that of Japan in the 1990s.

It's no longer breaking news to anyone that the US has embarked on a private sector deleveraging which constrains its business cycle, and from there it's easy to conclude, as some very smart analysts have, that the US is at the end of its debt super-cycle. (Though what's a debt super-cycle anyway? Is it just a demographic cycle in heavy disguise? Discuss later.) And from there it is but a short step to seeing the US now in much the same state as Japan in its immediate post-bubble years.

But I think that's a step too far. Debt deleveragings come in at least three different flavours: corporate debt de-leveraging, household debt deleveraging, and government debt deleveraging. These must necessarily play out in different ways. Unless the bond markets have you by the throat (a la Eurozone currently) policy choices define the scope and pace of government debt deleveraging. With politicians calling the shots, this means they are usually achieved without noticeable pain, via growth outstripping the pace of government spending. Quite often, countries don't even notice they're doing it.

Deleveraging led by corporate deleveraging is far more painful, particularly in capital-intensive economies. As long as it goes on, corporate deleveraging will necessarily depress returns on capital, and thus delay the arrival of a new business/investment cycle. That isn't the whole of the story of Japan's lost decade(s), but it is probably the single most important plotline.

Thankfully, as we've seen, the US's deleveraging isn't driven by the corporate sector, but by the household sector, and, associated, by the financial sector which abetted the build-up of debt in the first place.

I've run this chart many times, and doubtless I'll be updating it next week when the US's latest flow of fund tables are published. It makes two simple points: first that there was a dramatic change in financial behaviour by the household sector starting in 2001, when the traditional desire to build up net deposits with credit markets reversed. Second, that this behaviour reversed dramatically in 3Q07, since when the US household sector repaid over US$1.5 trillion in net debt. During the same period, the banking system's loan to deposit ratio has fallen from a peak of 102% to 82% now. That's the lowest rate of bank leverage since the mid-1980s.

Now the key driver of household debt deleveraging (and the associated bank deleveraging) is the housing market, since mortgage debt is the biggest single financial liability any household is ever likely to take on. (This is also why the waxing and waning of this 'debt super-cycle' may turn out to be inextricably linked to the underlying demographics.)

So it is to the housing market that we must turn for evidence of the state of the cycle, and comparisons between the US now and Japan in the early 1990s. The next chart looks at the growth in volume of housing construction starts in the period before the financial crashes of 1Q90 (for Japan), and 4Q08 (for the US).  

The experience of Japan then and the US now are utterly different. In Japan's case, the realization that the housing market was in trouble really didn't become active until a year before the crash (hardly surprising this – in Japan, the leverage was concentrated in the corporate sector). In the US, the housing market had been in stall for fully 12 quarters before the financial collapse arrived. Consequently, whilst in Japan, the bursting of the housing bubble was met with a disbelief which died very long and very hard (I remember meeting Japanese property investors in Hong Kong in the early 1990s looking for a market 'like Japan, where prices never go down'), there's no such illusion in the US now.

Both countries discovered culturally specific ways to delay dealing with the consequences to the financial system of bad mortgage assets; the Japanese by a long period of extended government and bank collusion in denial; the US by discovering a Gordian knot of legal and regulatory malfeasance which at one point threatened to strip away any clear concept of ownership or liability.

Nevertheless, after five years during which housing construction has fallen by around 75% in volume, and – with a lag of a year – prices have fallen by around 25%, the main feature of the housing market is depressed stability. New home construction has been running around 600,000 since the beginning of 2009, sales of new homes have been similarly static (give or take the a-seasonal impact of housing-related tax breaks arriving and departing) during that time, as have the prices paid for them.

Most crucially, it no longer matters very much: residential housing investment has fallen to just 2.5% of GDP, the banks have deleveraged, and so has the household sector. The housing sector's already done the damage it's going to do. If it ever picks up, it will be a pleasant surprise at the margins. If it doesn't – well, I guess we'll have to look to the corporate investment as the key cyclical driver (it's about 10.4% of GDP).

Which leads to a final point: there's absolutely nothing incompatible between household debt-deleveraging and sustained consumption growth, just as there's nothing incompatible between government debt-deleveraging and GDP growth. In terms of the maths, there's likely to be a big jolt on consumption when households change from adding debt to paying it down, with an echo heard in Year Two's data. By Year Three, the other normal cyclical factors return to dominate patterns of marginal consumption – ie, the state of the investment cycle, and the impact that has on labour market conditions.

In short, the US right now doesn't really look much like Japan in the early 1990s.  

Shocks and Surprises, Week Ending September 17

Summing the shocks and surprises this week is pretty easy: the financial world may be teetering on the brink, but industrial sectors around the world are holding firm, even as developed world trade and current account balances continue to improve. The world doesn't need to downgrade its expectations of the US, Japan's recovery is stabilizing, China isn't crashing, and we've stopped worrying about inflation threats for the time being.

So all we need to worry about is the financial and political implosion of Europe. For neurotics, that's plenty.

There were few shocks or surprises out of the US this week, as bulk of the major indicators of the real economy arrived in line with the depressed consensus: industrial production (up 0.2% MoM), capacity utilization (77.4%), the Phily Fed survey (-17.5), business inventories (up 0.4%), retail sales (flat), and three confidence indicators (the U of Michigan, the Bloomberg consumer comfort index, and the NFIB Small Business Optimism Index).

What shocks and surprises there were therefore made little impact on markets, and are unlikely to demand much of a trimming of views from the Street. The Empire State manufacturing index declined very slightly again, to minus 8.8, but the details were equivocal, with a sharp fall in shipments offset by much better news on unfilled orders, for example. Probably the worst news continues to come from the labour market, with both initial and continuing claims rising beyond the range of expectations. But there were similarly marginal nice surprises, from the current account deficit , and from the IBD/TIPP economic optimism index, both of which printed slightly better than consensus expected.

There are obviously no shortage of political and financial shocks and surprises in the Eurozone this week, but in contrast to this, the economic and industrial data provided something of a refuge. As with the US, the industrial economy is holding up reasonably well, with eurozone industrial production up 1% MoM – mainly on the back of Germany (up 4.1%) and capital goods (up 3%). Germany's still rising output offset falls of 1.7% MoM from both Spain and Italy. On the fringes of the eurozone, UK average weekly earnings rose faster than expected (by 2.8% YoY), and this allowed retail sales to fall no more than the depressed consensus expected (0.1% MoM).

Again echoing the US experience, external balances are improving. The US current account deficit continues to shrink slightly faster than expected, and the Eurozone's trade balance surged into a surplus which, for some reason I find statistically inexplicable, sprang a surprise on the posse of Euro-economists detailed to get this right.

But economists in stabilizing Japan seem to have found their range, where industrial output, capacity utilization, machine tool orders, business confidence surveys and even Tokyo condo sales all managed to come and go without disturbing the consensus or the markets.

China's monthly data tapestry was woven mostly over last weekend, and we remarked last week that the trade outcome for August was far better than expected, with exports up 24.5% YoY and imports up 30.2% YoY. Around the rest of Asia this week brought faint echoes of this positive surprise, both in a rise in Korea's terms of trade (yes, you read it right, a rise in Korea's terms of trade), and a surprise 8.3% YoY jump in Singaporean non-oil domestic exports. Don't get too excited about that, since the surprise seems to have been generated by exports of ships – more representatively electronics exports fell 19.4%, and pharma was down 7.1%.

Back in China, the monetary data contained both surprises and shocks to balance each other out. The positive surprise came in the 548.5b yuan in new loans made in August – some 16b yuan above the range of expectations. But this was offset by a slowdown in M2 growth to 13.5% from 14.7% - below the range of expectations. China's M2 growth has swung quite wildly from June to August, the best explanation for which lies in the scramble for deposits in June – during which expiring wealth-management products were channelled very briefly into on-balance-sheet deposits. In July those deposits scarpered once again, and August's 0.9% MoM growth probably represents a return to the underlying seasonal patterns.

Finally, whilst central bankers around the world try to work out how high they need to build the buttress of printed money in order to keep the Euro-cathedral from collapsing under the weight of its own dogmas, they were at least not disturbed by any significant inflationary shocks this week: Eurozone CPI , US CPI, US PPI and US import prices, UK CPI and even Japanese corporate goods prices all behaved as expected.  

Why the US Now Isn't Japan Post-Bubble

In November 2009, I was talking to a hedge fund conference in London about the Japanese post-bubble experience, trying to answer whether Japan's posts-bubble experience was coming America's way.

It took 45 slides for me to conclude 'probably not', on the grounds that there was a big difference in how deleveraging cycles played out, depending on whether your debt overhang was concentrated in the corporate sector or the household sector. And I still think that's important. In Japan's case, the debt overhang was in the corporate sector, and as corporate Japan deleveraged, the process inevitably crushed corporate ROEs. The result of that was that the capital investment motor to the business cycle spluttered indefinitely without ever really coming to life.

In Japan's case, too, the complex and all-pervading financial repression which had been such a vital structural support to Japan's corporate debt habit at first delayed the message getting through to corporate Japan, and also, of course, discouraged the sort of household spending which could have moderated the impact of corporate deleveraging.

In the US case, I said, the debt overhang is in the household sector, which can come down very quickly. Meanwhile, unlike in Japan post-1990, ROCs in the US were rising sharply, so we could and should expect to see an investment cycle begin to kick in.

Well, that's what I thought, and two years later, the same questions are still being asked, and the assumption that the US might well be in for a Japan-type experience is becoming ingrained. And I still think 'probably not.'

So here are three charts comparing the underlying cyclical trajectory of Japan, starting 1Q90, and the US, starting 4Q08.

The first shows the difference between the direction of ROC, calculated in my normal manner of expressing GDP as a flow of income from a stock of capital estimated by assuming 10 year straight-line depreciation on all gross fixed capital formation. The problem for Japan was that even 17 quarters after the Bubble burst, ROC was still declining, and when it stopped declining, it barely ticked up. That, overwhelmingly, was the impact of sustained corporate deleveraging. Meanwhile, in the US, the decline in ROC bottomed out within a year of the financial crisis, and continues to rise quite vigorously. One should expect this rise in ROC eventually to give rise to a recovery in capital spending, which in turn becomes a motive source for a positive business cycle. Confidence may ebb and flow, but if ROC is rising, it's very safe to assume that capital spending will too.  

In fact, that's what's happening – in sharp contrast to Japan.As the chart shows, it took corporate Japan a couple of years to reverse the build-up of capital stock, and start a long drawn-out slowdown from which it has barely recovered. For the US there was less corporate delusion from the get-go, with the stock of capital shrinking within 18 months, and very quietly beginning to show signs of sustained recovery.

And the third chart helps explain why: the average age of the US capital stock was already significantly higher than Japan's then (or Europe's now). As capital ages, the argument for re-tooling becomes increasingly urgent.

Now the US has its problems, and household sector deleveraging isn't a painless experience. But, crucially, it does not by itself take out the capital-spending cycle – a key accelerator of any business cycle. However the US's deleveraging plays out, it's not going to be a carbon copy of Japan's experience.

  

ECB - What A Mistake to Make

You'd think the ECB would tread carefully, given that they're dancing around a Doomsday Machine. But, as I'll show you, they haven't been. Rather, they've been stomping around the market to clumsily that history may well regard them as a direct catalyst for this latest and most dangerous round of financial destabilization.

If you've seen it mentioned before by the press or by the Street, I apologize – I must have missed it. Possibly it's just too awful to mention.

To understand what happened, you need to reacquaint yourself with the timeline of the meltdown of peripheral European sovereign bonds. Here, then, is what happened to the average premium of 10yr bonds for Eurozone vulnerables (for this purpose: Greece, Ireland, Portugal, Spain, Italy), relative to generic 10yr Euro sovereigns.

What was happening as those premia surged higher? Cast your mind back to late-June to mid-July – it's a quaint and safe time compared to the horrors we confront today.

Risk premia for the Eurozones vulnerables had been rising since April, mainly because it wasn't at all clear that Greece would warrant the Eu12b tranche of bailout funds needed to keep them going through September. In a pattern with which we are now familiar, the ECB and Germany are squabbling, and across the full range of European institutions, no-one can agree on just what degree of necessity and/or coercion of financial institutions would constitute a Greek default. During June Eurozone finance ministers met and failed to act, waited a fortnight, then met again and failed to act.

By the second week of July, bond market panic has spread to Italy, pushing the premium on Italian bonds to a then-unheard-of 2.73% (it's just under 3.5% now). This is the point at which the European Banking Authority releases the results of this year's new and improved bank stress tests. By their calculations, eight out of 90 banks surveyed need more capital: when private analysts rework the numbers marking to market bond holdings, they think probably 27 banks fail.

Finally, on July 21, a emergency summit of Eurozone leaders agreed a second bailout for Greece, carrying the headline total of Eu109 billion. As the Europols headed for the beach, it seems in hindsight very unlikely any of them really understood what they'd agreed. Still, no matter, the deal's the thing and within a week the premium on 10yr Eurovulnerables had fallen from 8.2% to 6.5%.

Very roughly, that's the background to the ECB's cock-up. Publicly, there was the July 7^th decision to raise rates by 25bps to 1.5%. (Possibly they were distracted by the succession struggle in which the French government was blocking confirmation of Mario Draghi as the successor to Trichet unless it was guaranteed a seat on the ECB's six-man exec committee.)

However, a more destructive mistake was to come. It is sometimes said, and in print, that the ECB doesn't disclose details about its bond-buying. That's true inasmuch as we can't see exactly what it's buying. But you can track the overall amount weekly through changes in its financial statements (which you can find here).

Anyway, here's what happened: as the chart showed, the ECB took advantage of the decline in premia during the next couple of weeks to start dumping bonds. In the week to August 5^th, the ECB sold a net Eu14.6 billion of their bond position. As the chart below shows, this level of selling was absolutely unprecedented in the ECB's recent history. It represented a sale of 11.2% of the entire amount of bonds bought since the start of the bond-buying exercise in May 2010. The ECB was getting its retaliation in first.  

 think that decision to take advantage of the post-agreement relaxation to quietly reverse out of its bond position is a mistake of historic proportions. One can say either that the effect was catastrophic, or one can say that the timing was stupendously unlucky. During the week in which the ECB was extricating itself from its bond position, European equity markets imploded. While the ECB was selling, the Euro Stoxx 50 lost 11.1%, and in the next three days lost a further 9.3% - the biggest crash since Lehman Brothers, and about one and half times the crash suffered by the S&P during the same period. The subsequent loss of economic and financial confidence of course makes all policy options much worse, since the Eurozone's debt problems are also, more fundamentally, a growth problem. Who knows what price will ultimately be paid?

And, of course, it was an expensive mistake also for the ECB purely in terms of protecting their bond position. In the next week (to Aug 22) they bought Eu22.1b, the week after than Eu12.7b, the week after that Eu5.7b, the week after that Eu12.7billion. At which point Juergen Stark resigned 'for personal reasons'.  

Something I Said?

No sooner had I pointed out that the European Central Bank's balance sheet was, by international standards, comparatively unleveraged, and that this represented a relatively cheap and politically discreet way of European politicians keeping their Doomsday Machine ticking, than Jurgen Stark, de facto ECB chief economist, and German keeper of monetary virtue, packs his bags and offs.

First they came for the short-sellers, then the hedge funds, then. . . .

Shocks and Surprises. Week Ending Sept 10

This was a week in which by and large consensus won out, much good though that did world equity markets: Euro Stoxx lost 6.6%, the Nikkei lost 2.4%, both the S&P and the Hang Seng lost 1.7%, and the Shanghai Composite lost 1.2%. What was being priced in this week was something below and beyond what the evidence is currently describing.

Case in point: Europe's markets got the worst kicking, but it was in Europe that the consensus won most often this week: Eurozone GDP revisions, Eurozone retail sales, Eurozone Services PMI, Eurozone Sentix Investor Confidence index, and even the Eurozone Composite PMI all came in roughly as expected. So too did French business sentiment, German imports and trade balance and UK industrial production: modest deterioration was expected, and modest deterioration was what was duly recorded.

Europe even sprang a couple of upside surprises : both French industrial production (up 3.7% YoY) and Germany industrial production (up 10.1% YoY) showed up the consensus as too cautious. But evidently these exercised less impact than the repeated confirmation of an increasingly gloomy consensus, laced with a couple of nasty shocks. The worst of these was the 2.8% MoM sa fall in German factory orders. This one got worse the closer you looked at it: capital goods orders fell 7% MoM, and export orders for capital goods were down full 12.8% MoM.

The US market hasn't yet recovered its poise from the Sept 2 non-farm payrolls shock (seasonally adjusted, there were no new jobs). I was sceptical about that number, and this week brought an answering upward surprise in the Job Openings and Labor Turnover data, which bust through the upper range of estimates, mainly on a sharp rise in manufacturing hirings, and also revised up the previous month's data. There were other pleasant surprises, including a the trade deficit which came in about US$5 billion lower than anyone expected, mainly owing to a 3.6% MoM rise in exports. Still, it's that Sept 2 labour market number which continues to set both the political and financial agenda.

The other story emerging from the week has yet, I think, to be fully appreciated: Japan's heroic recovery phase is over, to be replaced by an everyday series of mild disappointments. There were loads of these this week: monetary aggregates were noticeably weaker than anyone expected, machine tool orders growth slowed sharply (to 15.3% from 34.8% in the previous month), and machinery orders overall fell 8.2% YoY. When you look at the details, you find export orders for Japan's machinery collapsed 13.5% YoY. This is the same story in suspended or collapsing investment spending that saw Germany's export orders for capital goods falling 12.8% MoM.

And so to China, where investment spending accounts for 48.6% of GDP. By this stage, I hope it won't come as a surprise that the negative shock in China's August monthly data was the way in which investment spending came in far weaker than expectations (up 25% YTD, vs 25.4% in the previous month). There is a specific problem here: after the multiple scandals which have engulfed China's railway ministry – of which the Wenzhou high-speed rail disaster is only the most high-profile – this is a ministry which can no longer invest. Spending on railway infrastructure actually fell 15.5% YoY in August, whilst as recently as June it was rising 18.3% YoY. Much of the rest of China's August data so far has been roughly in line with expectations: retail sales (up 16.9%), industrial production (up 13.5%) and the HSBC/Markit Non-manufacturing PMI (50.6) – non of them surprised.

And yet, the week withheld one of its biggest surprises until today: China's trade data for August was much better than expected. In the case of exports (up 24.5% YoY), this mainly reflected how cautious the consensus has become – since the monthly gain was only slightly better than historic seasonals. But the growth of imports – up 30.2% YoY – was not only way out of line with consensus (which expected 19.1% to 23.1%), but was also a full standard deviation above historic seasonals. Such an appetite for imports strongly suggests that, at the very least, China's inventory cycle is on the turn.

Is it enough to challenge a gloomy consensus which got a lot of confirmation this week? We'll see on Monday morning.  

The Super-Sub in Frankfurt

I was challenged this afternoon to think of something that could yet buy time for the Eurozone – by definition something that didn't require Europe's politicians either to understand their catastrophic error, or to act with coordinated and effective purpose, but change market sentiment in the short and possibly even medium term.

And there is something.  Sometimes I hear fears that the European Central Bank is bust – that, put simply, it has bought far too many bonds from places that either aren't going to repay (Greece), or more banally would look ugly if they were ever marked to market (Portugal etc).

On the face of it, that's a reasonable worry: the ECB has capital and reserves of approximately Eu81.5 billion, upon the shoulders of which it carries Eu2.037 trillion of assets, of which Eu514 billion is lending to Eurozone banks, and Eu 523 billion are eurozone securities. It doesn't take an awful lot to go wrong with the underlying credits on those assets to wipe out the ECB's entire capital base – a 12% haircut would do it.

Looked at more closely, however, and it looks less worrisome. First, it is extremely hard to bankrupt a central bank. They go bust only if they carry huge net foreign liabilities which are suddenly withdraw. This isn't going to happen to the ECB, since it holds a net Eu 203 billion in foreign currency assets. About the only other way they could bankrupt would be if their licence to issue money or banking reserves was revoked by the governments of the jurisdiction in which they operate. And that's about it, really.

This has the following consequence: that, uniquely, the concept of marking-to-market the value of its domestic securities doesn't mean too much to a central bank, since in duration terms it can outlast any possible competitor. Just as you don't start a libel war with someone who buys ink by the barrel, so you don't play Bankruptcy Poker with a central bank. Even now, the ECB could stave off (the effects of) Greek sovereign bankruptcy by buying unqualified amounts of Greek sovereign debt in perpetuity.

Which leads directly to the question: we've established that the ECB has a financial leverage ratio of 25.4x (total assets/equity and capital). For a private company, that's way too much (even Goldman scrapes by with financial leverage of only 11.6x). But how does it compare with other central banks?

The answer is: extremely well. It turns out that among the world's central banks, the ECB is indeed the reincarnation of the Bundesbank. It's 25.4x leverage has to be compared with the US Fed's 45.8x (end 2010), or Bank of Japan's 52.6x (August 31, 2011).

What's more, as the chart shows, the ECB has tended to manage this ratio down when it can, taking it from a June 2010 crisis-peak of 27.6x to an April 2011 low of 23x (glad confident morning, that was).

Which leads to two conclusions and a suggestion. First, by international standards, the ECB is still on the sidelines in this crisis: it could buy about another Eu1,700 billion worth of dodgy Eurozone sovereign paper, and still be less leveraged than the Fed. And, excitingly, it wouldn't demand a raid on any particular European taxpayer's wallet to do it, and it could probably do so without exciting the outrage of Northern European electorates.

Second, it reminds us that a modest amount of new capital subscription for the ECB is a really great bargain for politicians  – every Eu 1billion subscribed buys possibly Eu 45 billion of new sovereign debt!

If I were a European politician unwilling/unable to face the electorate with a bill for bailing out Southern European governments, but keenly aware that current policies can lead only to disaster,  I'd be looking at the ECB's balance sheet with great interest. 

And the suggestion? Central banks don't just buy government debt – they can help recapitalize banking systems too.  In the aftermath of, say, a sovereign default? 

Funding Eurozone Banks? Nein Danke

I had intended to go into some detail about the technical and political difficulties in sustaining a complacency about China's growth in the next 12-18 months, but it will have to wait – until tomorrow most likely.

For today, this is what we need to think about: the average CDS price for 5yr European banks has risen to 473 basis points. In other words, the average price of insuring against default risk is 4.73% a year. Meanwhile, 5yr sovereign euro yields have fallen to around 1.43%, so with the best will in the world and a following wind, the average European bank can expect to have to pay around 6.2% for five year money. That's more than double the 2.9% a year that the Eurozone's nominal GDP rose during 2Q11. Anyone think it's about to grow faster?

But remember, that's an average only of those to whom the market is open at any price. You won't for example, find any prices for Irish banks, and precious few for Greek banks.

For those for whom the market is still open, here's what CDS markets are demanding:

Bank	5yr CDS Rate	Nationality
Banco Comercial Portgues (sub)	1825	Portugal
National Bank of Greece	1558	Greece
Banco Comercial Portues	1542	Portugal
EFG Eurobank Ergasias	1429	Greece
Alpha Bank	1414	Greece
Banco Espirito Santo (sub)	1308	Portugal
Banco Popolare (sub)	1225	Italy
Banco BPI	1117	Portugal
Caixa Geral de Depositos	1002	Portugal
Banco Espiritu Santo	995	Portugal
Kazkommerts	925	Kazakhstan
WestLB (sub)	863	Germany
Banco Monte dei Paschi di Siena (sub)	820	Italy
UniCredit SpA (sub)	722	Italy
RBS Plc (sub)	702	UK
Dexia	700	France
Banco Popolare	653	Italy
Societe Generale (sub)	652	France
Commerzbank (sub)	651	Germany
Lloyds Bank (sub)	643	UK
Banca Intesa (sub)	615	Italy
RBS NV (sub)	590	UK
Caja de Ahorros y Monte de Piedad de Madrid	585	Spain
SNS Bank NV (sub)	584	Netherlands
BBVSM (sub)	580	Spain
Halyk Savings Bank	570	Kazakhstan
Santander (sub)	545	Spain
HBOS (sub)	538	UK
Credit Agricole (sub)	517	France
Arab Banking Corp	510	Bahrain
Unione di Banche Italiane	507	Italy

At what point does the insurance become so expensive as to represent a market which is effectively closed? I'd say pricing would be painfully prohibitive for pretty much all of those in the table. This tells us that there's a profound reluctant to taking a credit risk on the subordinated debt of even French, UK and even German and Dutch banks. And the market is closing for the head-office of even some French and Italian banks, as well as the more predictable Spanish and Portuguese banks.

How much does it matter right now? Over the last week, there's been fairly widespread attention drawn first to the fact that no European corporates, let alone banks, have managed to issue bonds since August, and also to research showing European banks it doesn't matter too much, since European banks have completed 90% of their financing this year already. I think I know what the first of those means, but who knows what that second observation may actually mean? Are the financing plans those of dire necessity, or of an ambitious business plan? If the latter, are those business plans the same as they were four months ago?

I am thrown back onto two observations. The first of them is this: as of end-July, ECB data shows Eurozone banks have a loan/deposit ratio of around 113.1%, or 105% if you look just at the position with the private sector. This is barely lower than the 113.9% recorded in July 2010, although the private-sector LDR has come down during the same period from 106.6%. To maintain the current level of loans, European banks either need to attract more deposits, or take on other liabilities – essentially bonds or foreign liabilities. Neither look likely. The bond markets, as we have seen, are unwelcoming. And good luck with attracting foreign liabilities: as of July, they were down 7.6% YoY, or by around Eu 304 billion.

One alternative is to cash in foreign assets, of which the Eurozone's banks have a gross Eu 5.025 trillion, but falling (down 0.5% YoY in July).

The second is to hope, or ensure, that the LDR comes down faster, since a falling LDR amounts to a positive cashflow. It seems impossible to expect that this cashflow can come from the public sector, so it's private sector cashflows which will have to bear the burden. And the problem is, that cashflow is drying up very fast too. Take a look at this: 

What I'm measuring here is the difference between the rise in private sector deposits (cash in) vs the rise in loans made to the private sector (cash out). In the 12m to July, this calculation shows a net cash inflow to the banks of Eu 88 billion. This is chicken-feed compared to the previous crisis-peak of Eu 522 billion in the 12m to September 09. And things are getting worse: in the 6m to July, the net cash inflow was . . . just Eu 1 billion. In the three months to July, there was a net cash outflow of Eu 48 billion (though part of this outflow is seasonal).

From this, we can draw the following conclusions. First, we must expect another severe credit squeeze for Europe's private sector, starting right now. Second, we must expect Eurozone banks to sell-down foreign assets, starting right now. So far as I can tell, these are the only way to square the circle.

Adjustments for the New Normality

What's normal these days? You need to make your mind up about this today because as I write, equity markets across the globe are down two to three percent, and last Friday's US labour market figures are getting the blame. You know, the one that showed that 'the US economy had generated no new jobs in August'.

The question of normality arises because actually last Friday's job data showed nothing of the kind. What the US Department of Labor data showed was that the economy added 118,000 net new jobs in August. You can find the data, and the details here. To spare you the suspense, I can report there were healthy employment gains in construction (up 39k MoM), manufacturing (up 50k) ; and professional & business services (up 101k).

The problem is that this pattern of job growth was recorded before the seasonally adjustment process got to work. After it had completed its work, all net new the jobs disappeared from the data.

Now I don't want to impugn the US seasonal adjustment process unnecessarily, because it is trusted. That's not always the case: in some countries, seasonal adjustment regularly conjures up strange results, and sometimes fail the most basic tests of coherence. And in some emerging markets, the underlying structure of the economy is changing so quickly and radically that one shouldn't seasonally adjust at all. But in the US, neither is true.

But its readings now do and must intrinsically reflect a conviction that the historic data is the 'normal' against which today's data is judged and adjusted. Sometimes that doesn't seem right, and Friday's labour market data was one of those times. For August 2011 added 118K jobs;

• in August 2010 only 55K were added;
• in August 2009 125k were lost;
• in August 2008 116k were lost;
• in August 2007, 109k were added.

In other words, August 2011 was the strongest August for job creation since 2006.

The message, then, is this. If you think the US growth pattern is adjusting to a 'new normal' in which the urgent and successful desire by the private sector to adopt a lower financial-risk profile by deleveraging constrains the pattern of consumption and employment (see this piece), then August 2011 was a mildly encouraging month in the labour markets. If you expect a re-run of the post-1991 leverage-powered model of US economic growth, it was disappointing.

Either way, both adjusted and non-adjusted numbers agree, in August, non-farm payrolls were growing by 1.0% YoY – the fastest YoY rate since July 2007.

Shocks and Surprises, Week Ending September 2

Mostly the world took its cue from the US, where the shocks and surprises can be summarized as follows: during the first few days of the week,  a succession of measures tracking the industrial economy gave a series of modest and not-so-modest positive surprises (ISM PMI at 50.6). These were bolstered by surprisingly strong readings on personal spending (up 0.8% MoM) and factory orders (up 2.4% MoM), but were challenged by a series of shockingly bad readings on consumer confidence (from 59.5 to 44.5 in a single month!). Which did the market believe? Reluctantly, for the first three days it began to price-out some of the worst scenarios, perhaps on the basis that who, after all, could be expected to have retained their confidence during the final rounds of Debt-Limit Poker played during the first week of August?

All that was swept away on Friday by a set of US labour market data which were dark even by the standards of most economists’ worst projections (no rise in non-farm payrolls at all during August).  Personally, I suspect we will be revisiting that data and questioning the role of the seasonal adjustment process. However, for the time being, the lesson is very clear: it’s easier to believe that Shocks are not priced in, whilst pleasant Surprises probably might be. The wall of doubt is vertiginous.

Europe is following Wall Street’s cue, although with far less justification for optimism, given the combination of Europe’s debt problems (see this piece) and the audible ticking of the Euro Doomsday Machine. This week was entirely one-way traffic as far as Shocks and Surprises were concerned –  Eurozone PMIs and labour markets were far worse than expected, so were UK business readings.  Most worrying is the fact that Germany’s industry, built around its international trade in capital goods, is precisely exposed to just the sort of whiplash on capital spending which is an accelerating factor in all business cycle inflection points.

Asia is exposed to the West’s Shocks and Surprises at second hand, and at first glance the main news this week was the lack of negative shocks from China’s industrial sector. We had three separate readings on China’s industrial August, and all showed a modest uptick (within expectations), even though some of the lead indicators, such as new export orders, are deteriorating.

More worrying, perhaps, are signs from across the globe that input prices are once again rising: we saw this message coming from the US, from Europe, and from Asia, including China. This isn’t in the script for the second half of this year, and if it asserts itself, it will prove a complicating factor for Asian policy settings.  So far, the only confirmation of it in Asia has come from Korea, where a 5.3% YoY jump in CPI in August is the highest reading for three years, and was generated  rather worryingly not just by a jump in food prices, but also a 2.7% MoM jump in ‘misc’ goods and services. Well, there has to be a price for keeping your currency ridiculously low for ever to protect your exporters, I suppose. 

Japan's Noble Management

Every quarter Japan's MOF conducts a massive survey of private sector balance sheets and p&ls, collecting data from just over a million firms, large and small. This is closest anyone can get to seeing how Japan's economy really works in near real-time. It's doubly interesting right now because this is the quarter in Japan came face to face with the multiple disasters which followed the March 11 earthquake.

What's grabbed the headlines was a 7.8% YoY decline in capital spending during the quarter, which for some reason took Japan's economists by surprise. But forget that for a moment, because the survey tells us some other things about Japan, some of which are surprising in the best possible ways.

The first thing I do with these figures is look at what happened to corporate Japan's Dupont ratios. You know straight off these are going to be pretty nasty, given that the knock-out blow to the supply-side of Japan's economy pushed sales down 11.6% YoY during the quarter. Still, here's what happened:

1. Margins (operating profit/sales) fell from 3.31% in 1Q to 2.85% in 2Q. That compares with an average of 3.1% since 2000, and a reading of 3.27% in 1Q10. It's not even half a standard deviation below the long-term average.
   The details are surprising – uplifting even. There was no deterioration at all in the Cost of Goods/Sales ratio, which remained static at 77.3% - seemingly no profiteering at a time of colossal disruption and supply-pressure. The entire 46bp margin deterioration was owing to a rise in SG&A expenses (19.9%). And of that, there was a 117bp rise in total total personnel expenses/sales, offset by a 72bp fall in SG&A ex-labour costs.
   If we cut the jargon for a moment, this tells us that in the face of cruel disaster, Japanese management kept hold of its workers, and cut its own expenses in order to offset the cost of that benign policy. I think the word for that is 'noble'. More, management did it whilst maintaining margins with half a standard deviation of the long term average. The word for that is 'efficient'.

2. Annualized asset turns (sales/total assets) fell to 0.92 in 2Q, compared with 1.01 in 1Q and an average since 2000 of 1.05. This was, in fact, nearly three standard deviations below the long-term average. This is where the full impact of the disruption was taken – unavoidably.
   
   
3. Leverage (total assets/equity). Given that capital destruction fell on this economy in the most dramatic possible way, this is perhaps a little surprising. Total assets fell by Y50.8 trillion, and net worth fell by Y23.8 trillion – more total assets were destroyed than equity. So given a starting financial leverage ratio of 2.71X the net result was that Japan's financial leverage continued to fall, very marginally. If you want a more direct measurement, net debt fell by Y2.5 trillion QoQ, and net debt/equity picked up very slightly, to 63.8% from 1Q's 62.2%. The scale of this up-tick is barely distinguishable from the normal seasonal patterns.

In short, the interruption in supply-chains killed asset turns, but the impact on margins and leverage habits was far less pronounced than one would have expected.

All of which would tend to imply that the impact on corporate cashflows from this disaster were relatively modest. And that seems to be right. Japan's corporate cashflow is always significantly lumpy, but using a proxy of investment outlays + change in net debt suggests corporate cashflows came in around Y10.2 trillion in 2Q. This which was down from Y15.4 trillion in 1Q, but up from the Y3.3 trillion of 2Q10.

When we look at the secondary indicators of cashflow, the news is the same: there was no self-destructive rush to cut credit to the rest of the economy in order to bolster corporate cash coffers. Yes, accounts receivable fell by Y18.2 trillion during the quarter, but then sales fell by Y28.6 trillion – so accounts receivable as a percentage of sales was static (at 0.671). Meanwhile, inventories actually rose by Y2 trillion. If one looks at the combination of inventories and accounts receivable as a percentage of sales, as being an indicator of corporate Japan's extension of credit to the economy, it actually rose modestly during the quarter.

I don't want to over-react, and many words have already been written about the marvel of Japan's social cohesion in the face of disaster. What this quarterly survey illustrates is the role Japan's corporate managers in demonstrating and reinforcing that social cohesion under difficult circumstances. I believe that social cohesion is a form of capital (if you doubt it, consider how much capital was destroyed during London's riots). If so, although corporate Japan's investment in plant and equipment may have fallen 7.8% YoY during 2Q, in the long run, there was plenty of investment made during the quarter.