China's Cramped Cashflows

It would be nice to have something calming to say about China's Jan-Feb industrial and profits data released today, but in truth, they are awful both in general and in detail. At face value, they confirm what the monetary and banking data has been indicating for several months now – that China's corporate cashflows are now cramping very badly, and that this is showing up both in profits and in flows to and from the financial sector.

And I see no reason not to take them at face value, although they are tricky to interpret primarily because 2011 was the first time that they were released on a monthly basis: before that we got them only four times a year. As a result, the analytical community has only a limited history upon which to judge them. However, fools rush in where respectable buy-sides fear to tread, so here goes. . .

During the first two months of the year, industrial sales were up 12.9% YoY, but industrial profits fell by 5.2%. The rise in sales seems about right: during the same period, Rmb exports were up 2.2% YoY, retail sales were up 14.7%, bank lending was up 14.9% and bank deposits were up 12.5%. The problem is that China's extraordinary sustained investment spending means it's capital stock is growing at around 19% a year (estimated by discounting all investment over a 10 year period). So if topline growth falls much below 19% YoY, the result is that asset turns must fall, and with it, most likely, will fall RoE and cashflows.

This is recorded in the 5.2% YoY fall in profits. The collapse in profits to around 5%, down from 6% in the same period last year. This margins squeeze is not yet quite of the scale we saw in late 2008, but the similarities are obvious to see, and are not explained simply by seasonal factors. 

(A word of warning: China began publishing this data monthly only last year. Before then, it was issued once every three months. Therefore, period to 2011, the monthly line has been produced by interpolating between the three-month data points. We don't know what impact this interpolation has had on the monthly line, but it will have had none on the 12m line.)

That's not all: the cashflow crunch shows up in other ways too, most worryingly in the rise in receivables. In the year to end-February, the receivables recorded by China's industrial sector rose by 1,077bn yuan, whilst total sales rose by 1,378 bn yuan. On that data, it seems that on a net basis, the rise in receivables is equivalent to 78% of the rise in sales: only 22% of the marginal increase in sales during the year to February has been paid for in cash. Receivables are likely to be a highly seasonal number, but if anything the situation seems to be getting worse. Between November 2011 and February 2012, receivables fell by 473.1bn yuan: during the same period in the previous year, receivables fell by 720.1bn yuan.

There is a similar story in inventories of finished goods, which were up 19.6% YoY by end-Feb. Moreover, between November 2011 and Feb 2012, they had fallen by only 91.4bn yuan, which compares to a fall of 172bn yuan in the same period in the previous year. In short, inventories of finished goods have risen relative to sales, and they continue to clear the market at roughly half the pace they did last year.

So the story is: slowing sales, falling margins, surging receivables and rising inventories. Apart from that, everything's fine.

Shocks and Surprises, Week Ending March 25th

• Europe: Intensifying gloom from output surveys; surging optimism from confidence indicators
• Asia: Japan benefits from trade resilience; three China output surveys suggest moderate and lingering weakness
• US: Housing data initially shocks on the downside, but closer inspection lightens the mood

Europe: Singing in the Rain

We continue to have a clear split between data recording what's happening to output, and data recording levels of optimism. This last week, the monthly collection of PMIs for the Eurozone delivered a flurry of body-blows, as PMIs for the Eurozone, but also separately for Germany and France all came in below the range of expectations. The numbers themselves tells not merely of a contraction which has pushed the Eurozone into technical recession during 1Q, but worse, a contraction which is still intensifying. The disappointments encompassed the Eurozone manufacturing PMI (47.7 in March vs 49 in Feb), Eurozone services PMI (48.7 vs 48.8), the Eurozone composite PMI (48.7 vs 49.3), German manufacturing PMI (48.1 vs 50.2), German services PMI (51.8 vs 52.8) and French manufacturing PMI (47.6 vs 50). Italy produced a shock of its own, with industrial orders falling 7.4% MoM in January, reflecting a 7.6% MoM collapse in domestic orders.

German manufacturers are the single brightest hope to shorten and moderate the Eurozone's current recession. But, it was the German manufacturing PMI which was the most shocking, because the details recorded a fall in employment for the first time in two years, whilst input inflation accelerated to its highest since June 11. German manufacturers thus found themselves facing rising costs they could not pass one to customers, and which also left them unable to stimulate sales by discounting.

So it seems perverse that the week also brought a surprise recovery in European consumer confidence, to the best reading since April 11. But it is evidently no flash in the pan.

In France, the Business Confidence Indicator recovered beyond expectations to the highest level since November, based on a jump in export orders sentiment. In addition, in the UK, the CBI's survey of trends found optimism about pricing is far above expectations, and the best since June 11. This was not the first week that European optimism has proved surprisingly strong: in the previous week we saw Germany's Zew survey of economic expectations for both Germany and the Eurozone recover far beyond the range of expectations. And these were joined in the UK by the best reading since September of the Lloyds Employment Confidence survey.

At this stage, one can only read these jumps in European optimism as a relief reflex as the Eurozone backs a few steps away from catastrophic financial crisis. Who wouldn't be more cheerful in these circumstances. The proof of the pudding, however, is in the eating: and in this case, what really matters is whether the immediate financial relief translates into improved credit conditions and monetary conditions. The data for that arrives on Wednesday this week.

Asia: Don't Blame World Trade

Meanwhile, Asia continues to benefit from the surprising resilience of the world's trade cycle, even though China continues to struggle inconclusively with its own cyclical and (more difficult) structural issues. The resilience of the trade cycle was exemplified this week by a surprisingly good set of trade numbers from Japan for February, in which exports fell only 2.7% YoY (vs 9.3% in Jan and an expectation of 6.5%), thanks to a 11.9% YoY rise in exports to the US (which offset falls of 10.7% YoY to the EU and 13.9% to China). This export strength allowed Japan to record a small trade surplus for the first time since September.

Finally China. This week delivered three private surveys attempting to track current business conditions: the HSBC Manufacturing PMI Flash; the MNI March Business Sentiment Survey Flash, and the Conference Board Leading Economic Index. Whilst none of these provided any reason for early optimism, only the HSBC Manufacturing PMI Flash fell outside the range of expectations, declining to 48.1 in March from 49.6 in February. Most worryingly, all of the six subindexes came in below 50 (ie, recorded a contraction), and this contraction is new for output, employment and stocks of finished goods indexes. Not just the size of the overall decline, but also the uniformity of the details means this was a genuine shock.

In that light, it was natural to extend the shock to the MNI Business Sentiment Survey (down to 56.7 from 58.9) and the slowdown in the Leading Economic Index (up 0.8% MoM, after rising 1.5% MoM the previous month). Natural but wrong: although there are no consensus surveys for these two indicators, both these two surveys came in exactly in line with recent trends, and should not significantly accelerate a consensus on China which should be mildly gloomy (but is probably intensely gloomy).

US: Housing Market Wobbles

Main detail of the week was an unexpected deterioration in housing market data. This disappointment arrived in three tranches: first the NAHB Housing Market index reading for March was no better than flat; then the monthly house price index for January also came in flat, and with an additional sharp revision downwards for December (to 0.1% from 0.7%). Finally, new home sales for February fell to the lowest point since October 2011.

Yet this was not the all the housing market information delivered for the week: building permits for February came in higher than expected, with single family homes up 4.9% MoM, and housing starts and existing home sales both came in as expected.

So it's perhaps useful to look at the shocks a little more closely – particularly because the that the housing market will eventually clear is a major part of the belief in a sustained cyclical upturn. And the signals were less grim than initially appears. First, although the NAHB Housing Market Index disappointed, it didn't fall, but rather held steady at the most optimistic reading since 2007. Moreover, the details disclosed an improvement in future conditions, and a sharp jump in the regional reading for the Northeast (cyclically the most depressed regional housing market). Second, the drop in new home sales isn't quite what it seems, either: sales dropped 1.3% MoM, but the median prices jumped 8.3% MoM to the highest level since July 2011. What the numbers reflect is a drop-off in sales of houses priced under US$150,000, not a generalized deterioration in the market.

World Trade: Still No Great Depression

Back in December, I pooh-poohed the IMF's warning that the world might be tipping back into a new 1930s-stye Great Depression by looking at what the global trade data was telling us (see Trade Data vs 'The New Great Depression'). I concluded that 'so far not only is the slowdown nothing like what happened at the end of 2008, but it's less dramatic even than the slowdown which accompanied the near-recession of 2000-2001.'

Three months later this is still the case. The hinge of world trade remains the extraordinarily close relationship between what the G3 imports (US, Eurozone, Japan), and what Northeast Asia exports (China, Japan, Korea, Taiwan). Usually, it's hard to slip a cigarette paper between their changes in momentum.  

We have data for G3 imports for January, which shows imports up 6.8% YoY in dollar terms (US up 10.1% YoY, Eurozone up 0.1%, Japan up 17.8%). We also have NE Asia's export data for January and almost all of it for February too (for Japan we are working from the first 20 days data). That shows exports up 12.1% YoY (China up 18.3% YoY, Japan down 1%, Korea up 20.6% and Taiwan up 10.3%). No doubt the February export data is flattered by the rebound from January's Chinese New Year, but the fact remains that the 6 months trendline for sequential momentum broke into positive territory in February for the first time since August. Moreover, February data from both Singapore and Taiwan suggests that the squeeze on electronics exports appears to have relaxed (see Shocks and Surprises, Week Ending March 18^th).

The chart below shows how the current situation differs both from 2008/09 (obviously) but also remains far better in both YoY terms and underlying sequential momentum than in 2000/01.  

One further note: whilst a better-than-expected trading environment will be welcomed by almost everyone, it does continue to shine a light on China's underlying problem – that increases in its market-share are now won increasingly expensively in terms of investment spending (see this piece). China continues to win market share, but only slowly now. Whilst my best forecast is that China can expect its export total to grow around 10% this year, this no longer matches the c19% growth in China's capital stock. In other words, even in these conditions export growth will no longer be sufficient to support asset turns, return on capital, and private sector cashflows.   

Shocks and Surprises, Week Ending March 18th

This was a week of incremental change only, in which the most consequential data-point was probably the European trade balance for January, in which the non-seasonally adjusted deficit of Eu7.6bn was more than double the Eu 3bn expected. The important point about this was the resilience of Europe's import demand: although imports rose only 3.6% YoY (vs 0.9% in December), this was generated by a sequential change which was 1.1SDs above seasonalized historic trends. In seasonally adjusted terms, imports rose 2.4% MoM. In other words, the expected collapse of European import demand isn't yet visible. Unless it surfaces over the coming couple of months, people will be revising up numbers for NE Asian exports and growth.

Two positive surprises out of Asia this week perhaps prefigured/echoed this:

• Singapore's non-oil domestic exports jumped 30.5% YoY in February, with electronics exports finally beginning to recover, up 23.3% YoY. One contributing factor to this was that exports to the EU were up 11.9% YoY (vs a fall of 14.5% YoY the previous month).
• Taiwan's noticeably strong Manpower survey for 2Q, which recovered to a net positive reading of 36%, which was 1.1 SDs above the series' long-term average, and a sequential reading 1.3SDs above the long term average sequential change. The data from Taiwan's electronics-intensive industrial economy has been in decline since the middle of last year, so this improvement in the labour market environment was genuinely unexpected.

A third indicator gets an honourable mention in this theme: the 20.1% MoM jump in export orders received by Japan's machinery industry in January (up from a rise of just 5.6% in December).

US

This was a week with no significant shocks or surprises in the US data: we are used to labour market data being marginally better than expected and industrial economy indicators stuttering but generally improving. Industrial production came in flat MoM, against an expected 0.4% MoM rise, but the shock-value of this disappointment was moderated by a revision upwards in the previous month's data by . . . 0.4%. In addition, the US$124.1bn current account deficit for 4Q11 was roughly US$9bn bigger than expected, but is largely explained by the way the strength of the dollar (up 1.7% QoQ vs the SDR) deflates net international income receipts.

Perhaps marginally more worrying was a modest but unexpected retreat in economic confidence captured both by the University of Michigan reading (74.3 in March vs an expected 76.0 and 75.3 in Feb) and also in the IBD/TIPP Economic Optimism Index (47.5 in March vs 49.4 in Feb and 50 expected). These two should perhaps be viewed as a warning shot across the bows of the upturn, with doubts emerging about the economic outlook. At the moment, this message is neither coherent, nor unchallenged (the Bloomberg Consumer Comfort index, for example, came in stronger than expected this week). But it is worth watching.

Europe

Apart from the surprising strength of imports, the main feature of the week was the cheery optimism of German investors, as recorded in the Zew survey's of economic expectations both of Germany and the Eurozone. Whilst current situation readings rose only fractionally, there were very sharp jumps in expectations of the future (from +5.4 to +22.3 for Germany, and from -8.1 to +11 for the Eurozone). This is no doubt a reaction to the successful delay/defusing of the Greek sovereign debt crisis – in which the Eurozone has successfully dawdled through the crisis whilst the banks have quietly passed about US$37bn of their May 2010 US$68bn holdings of Greek debt to the Eurozone taxpayer, and thus cut their possible losses by at least 45%.

Against that, we had news that Eurozone industrial output grew only 0.2% MoM in Jan, having contracted 1.1% MoM the previous month. And, of course, output growth is concentrated in Germany, up 1.5% MoM, whilst France rose only 0.4%, Italy fell 2.5% and Spain fell 0.2%.

Finally, although this was probably China's most dramatic week politically since 1989, with the fall of Bo Xilai coupled with more public agonising from Premier Wen Jiabao about the absolute necessity of political reform to accompany the next, crucial, wave of economic and financial reform, we can only record that the drama didn't extend to the economic data. Foreign direct investment was recorded as falling 0.9% YoY in February (vs an expected rise of 14.6% YoY), and the Manpower employment outlook survey showed no significant overall improvement. It is just possible, however, that the 70 cities survey of real estate prices released over the weekend began to sketch out a bottom in the market.   

One Day the EU Will Apply to Join Turkey

I've spent the last couple of months an investment bank in Bahrain which had (past tense) an ambition to ally the surplus capital of the Gulf region to the financing opportunities presented by the historic emergence of Turkey and its near neighbours. To my mind, that was (and is) a hugely inviting prospect. Istanbul is one of the few cities that can claim to be the centre of the world, and right now hosts an alliance of demographics and growth that I remember from the great Asian emerging markets of 20 years ago. The long and short of it is that Turkey is a country of 74+mn, with a median age of 28.5 years, a per capita income averaging around US$10,300. Over the last decade its real GDP growth rate has averaged 5.3%, but it's been a rough old journey, with a standard deviation of 4.4%.

Growth, opportunity and volatility – what's not to like for an emerging market investor?

Right now, it looks as if 2012 will be another rocky year, with investors needing to take a view on how far Turkey overheated last year, how quickly it is rebalancing its economy between domestic demand and exports, and how much appetite world markets have to keep financing Turkey's investment spending. My sort of questions, in other words. (Incidentally, I expect the usual suspects will markedly underestimate the capital appetite for Turkish risk at this point: the key datapoint being the 110% jump in FDI – the world's stickiest money – last year).

My starting point is, as usual, to run the Flow Essentials charts to get to the underlying ratios Turkey's economic growth and financing depends on. Start with estimated growth of capital stock and the direction of ROC. My assumption is that when you've got a rapidly expanding banking system (loan growth of 42.3% last year) you must have significant misallocation of resources, disguised temporarily by inflation (up 6.5% on average in 2011, and rising sharply, to 10.6% YoY in January). But even using deflated numbers, on my count capital stock is growing around 8.6% pa (or 16.5% nominal), but ROC was no worse than flat last year.

And this was borne out by the monetary velocity reading, which again was no worse than flat.

This was a genuine surprise: the expected misallocation should have shown up far more starkly on these charts.

Still, leverage must have been rising sharply, and banking data tells us that banks' loan/deposit ratio rose from around 80% at the beginning of the year to 89% by the end of the year, and that this had been financed at least in part by an increase in foreign liabilities from a net US$16.74bn at the beginning of the year to around US$20.4bn by the end of the year. But once again, one would have expected the rise in leverage of the banking system, and is escalating exposure to the jitters of its foreign liabilities to be more extreme. Run the numbers, and it turns out that only 9% of the rise in the loan book was funded by the net increase in foreign liabilities – slightly less than the 11.2% that was funded by banks' running down their holdings of domestic securities.

But in the end, we cannot escape the fact that even if Turkey's rapid 2011 growth has been driven by rather less inefficient resource allocation than we had expected, and even if the financing of the growth was rather less reckless than it might have been, Turkey's growth was still powered by a major private sector savings deficit. In fact, I estimate that that deficit came to 8.7% of GDP in 2011.

And here is the rub: judging how far and how fast that savings deficit is being corrected this year is surely the key to potentially one of the most exciting turnaround stories of the year.

Yesterday Turkey reported that it ran a current account deficit of US$5,998mn in January, slightly down from US$6,565 mn in December, and US$6,022mn in January 2011. Nonetheless, this was taken as a slight disappointment (consensus had expected a deficit of only US$5,500mn for the month), because the monthly improvement was only approximately half the improvement of the trade balance. The surplus on 'invisibles' amounted to only just over US$1bn, which was 24.1% less than in January 2011. Part of the reason for this, no doubt, was the stalling of the tourism trade: tourist arrivals rose only 0.6% YoY in January – no doubt reflecting Europe's straitened economic circumstances.

So far so gloomy. However, what matters for Turkish financial markets right now is the extent to which, and the pace at which, it winds back the private sector savings deficit which ballooned to around 9% of GDP last year. Movements in the current account are a crucial part of this calculation, and here the news is distinctly better.

In nominal terms, the 3m private sector savings deficit hit bottom in May 2011 at Tkl 33.99bn, and has since moderated. That progress was continued during January. In the three months to end-Jan, the PSSD improved to Tkl 26.57bn – only Tkl 2.38bn above where the balance was the same period last year.

Private sector savings surpluses and deficits usually have a distinctive seasonal pattern (as do current account balances, and government fiscal balances) so we can also assess how current changes in private sector savings flows compare to 'normal' conditions. And, as the second chart shows, when judged on this basis, Turkey's private sector savings cashflow position continues to improve, with the pace of improvement having picked up noticeably in the three months to both December and January.

Shocks and Surprises, Week Ending March 11th

There is a difficulty, because the biggest shock of the week was China's February trade data, but the  explanation for US$31.5 bn February trade deficit is quite different from that we're picking up from the way in which exports and imports deviated from consensus.

For the record, China's export growth of 18.4% YoY was far below the consensus forecast of 31.1%, whilst import growth of 39.6% YoY was within the range of consensus expectation (which ran from 20.4% to 42.2%). Judging from that consensus, the explanation for the trade deficit is simple: exports are weak, mainly thanks to a slowdown in European markets.

The problem with that conclusion is that it is wrong. I cannot explain why the consensus forecast for export growth in February was so high: simply adhering to seasonal patterns would have suggested growth of 13.6% YoY. In fact, exports did slightly better than normal seasonal patterns despite problems in the EU. True, exports to the EU rose only 2.2% YoY (vs a fall of 3.3% in January), but exports to the US were up 22.6% YoY (5.4% in January), to HK were up 22.5% (down 16.4%), and to Asean were up 34.1% (5.6%).

Is my reading of February's relative export strength merely a trick of the Chinese New Year calendar? No: February's sequential export growth was 0.33 SDs above seasonalized trends; combined Jan-Feb export were 0.11 SDs above trends, and Dec-Feb exports were 0.04SDs below trends.

The same sort of analysis for China's imports gives a very different result: China's 39.6% YoY jump in February represented a sequential jump of 19% MoM, which was 2.41 SDs above seasonalized trends. For Jan-Feb, the growth of imports was 0.77SDs above trends, and for Dec-Feb imports were 0.31SDs above trend.

In short, exports were resilient, but the import bill was a true blow-out. I have no idea how the majority of the 29 economists forecasting China's February export growth generated their forecasts.

Unfortunately, the obvious but incorrect storyline of the trade balance being undermined by weak exports is easier to square with the rest of the shocks and surprises of China's February's data than the true story of powerful import demand breaking the trade surplus. For February's data also produced negative shocks on:

• industrial production (up 11.4% YtoY during Jan-Feb, vs consensus expectation of 12.5%);
• retail sales (up 14.7% YoY during Jan-Feb, vs a consensus of 17.4%);
• M1 monetary aggregate (up 4.3% YoY in February, vs consensus of 6.1%).

Other data (M2 up 13% YoY and new yuan loans up 710bn yuan in February, urban fixed asset investment up 21.5% YoY during Jan-Feb, CPI up 3.2% YoY and PPI flat) arrive in line with consensus. 

How, then, to explain coherently this spread of surprises and disappointments? I think two contradictory forces are revealed. First, the really sharp slowdown in M1 growth, coupled with a disappointment in retail sales and a suddenly serious trade deficit all tells us that the economy itself right now is not generating positive cashflow. This lack of cashflow (largely a function of the misallocation of investment since late 2008) is finally having an impact on spending patterns and consumer sentiment. Although measured consumer confidence picked up slightly in January from the record lows of late 2011, it remains at historically low levels (in January about 1.3SDs below the long-term series average.)

But the surge in imports tells a completely opposite story – one in which China's trading environment is expected to improve sharply in the near future, and is therefore re-inventorying sharply. Thus February's data disclosed sharply higher import volumes of crude oil, refined products, iron ore and copper. This expectation is backed by the unrecognizedly resilient export growth, and is bankrolled by new yuan lending which, at 1.45tr yuan during Jan-Feb, was fully 50% higher than the same period last year! And that new lending is also, of course, directly showing up in the sustained investment spending, and even in other regional data, such as the 20.1% MoM in export orders recorded in January by Japan's machinery industry.

If this is the balance of forces – negative cashflow generation offset by sustained new lending funding investment spending and reinventorying – then we should expect the latter force to prevail over the short to medium term.

Elsewhere in the world, the shocks and surprises of last week revealed little we didn't already know: in the US, non-farm payrolls surprised positively not only by adding 227k during February, but also because of major upward revisions made to the (already positive) data for January and December. US consumer credit totals also surprised positively for the third month in a row, with non-revolving credit rising US$20.7bn on the month. Economists have not yet figured out what is happening – but essentially it's the Federal Government which is doing all the new lending. Is it too cynical to observe that this is an election year?

Europe continues to produce exclusively negative shocks, with the tally this week including Italian industrial output (down 5% YoY), UK industrial output (down 3.8% YoY), German factory orders (down 4.9% YoY). In addition, we also saw the unexpected deterioration in France's fiscal position during January, as spending was up 24.8% YoY, whilst revenues were up only 14% YoY. Is it too cynical to observe that this is an election year?  

China Money Too Tight to Mention

Since China's policymakers have a close knowledge of the pressures in the financial system (local govt loans, property loans etc), and since they also have the money squirrelled away to deal with them (the 16.76tr yuan in reserved deposits), a hard landing should be avoided. That judgement depends, of course, on policymakers doing the right thing at the right time.

The overall message from February's monetary data is that the time is getting shorter. The immediate worry is the renewed collapse in M1 growth, which fell to just 3.1% YoY in January, and managed only the limpest of recoveries to 4.3% in February. These are the lowest growth numbers in China's recent economic history (including the worst days of 2008/09), and reflect a genuine sequential fall rather than a high base of comparison. What we're looking at is a collapse in liquidity preference which in turn reflected a collapse in transactional and speculative demand for money. Further along the logic-line, this shows up in sharply slowing retail sales (they rose only 14.7% YoY during Jan-Feb, down from an average of 17.1% last year).

But the more pressing worry is that the slowdown in broader money totals signal a real deterioration in the underlying cashflows of the private sector. One can see this most easily by looking at the cashflows of the banking system, simply by measuring the difference between changes in deposits (cash in) and loans (cash out).

As the chart shows, since the middle of last year, the 12m measure of cashflow (before changes in reserve requirements) deteriorated sharply, from around +4.5tr yuan to under 2tr yuan currently. In fact, on a 3m basis,banks' cashflows have been persistently negative since September, and on a 6m basis have been negative since November.  

But that's not the end of the story, since for the last few years, PBOC has simply commandeered that cashflow by raising (or lowering) deposit reserve ratios. Once those actions have been taken into account, we discover bank cashflow was negative throughout 2011 and has remained sharply negative in 2012. Only with the lowering of reserve ratios has this been (very modestly) reversed over the last three months.

Squeeze banks' cashflow enough, and the message gets through not only to the banks but to their customers too. The result? I construct a monetary conditions indicator for China which takes into account monthly deviations from trend or long term averages for monetary aggregates, real interest rates, the yield curve and for movements in the Rmb (vs the SDR). Here's what it looks like now:  

Although the plunge has been less dramatic, the squeeze of the last year has led Chinese monetary conditions to a place as bad as we say in late 2008. Policy reversal is needed, and soon.  

Bond Yields and Saving Behaviour in the US

What relationship, if any, consistently holds between interest rates and private savings behaviour? Do savings really go up when interest rates go up? And can excessively high savings ratios be brought down by keeping interest rates low? If so, what rates, and how low? And if savings rates stay high regardless does that mean we're in some sort of liquidity trap?

I should probably have had this down decades ago when I first encountered an ISLM graph, but the truth is that I've never met anyone in the market who actually uses ISLM analysis. Or mentions it.

Instead I have focussed on private cashflows and savings behaviour, usually looking at private sector savings surpluses and tracking their impact on bond yields. For emerging markets, this is often crucial: the most powerful financial dynamic bar none in emerging markets is what happens to government bond yields when a private sector savings deficit flips over into a surplus, or vice versa. In these cases, the cashflows are easy to trace: if an economy develops a savings surplus, then on a net basis, the private sector is dumping cash into a financial sector which, by definition, can use it to buy only government bonds or foreign assets. Hence bond prices rise and yields fall. Easy money.

Even in the massively-open and highly disintermediated financial system of the US, traces of the relationship remain.

Interesting though this is, it's hardly a complete theory linking bond yields with savings behaviour. Nor would one expect it to be: if private sector savings surpluses and deficits were the only determinant of bond yields, the world wouldn't have so many fixed income economists (and professional Fed watchers). And the financial world would never had heard of 'fair value models' for bond yields.

So let's look at those models. In my experience these fair value models regress and regularly recalibrate from three factors:

• policy rates
• inflation rates
• growth rates

A movement, or an expected/forecast movement in any one of these will change what the model signals to be the 'fair value' of a bond.

Anything that regresses and recalibrates enough will end up looking like it has useful explanatory power. Here's how my simple fair-value model of US bond yields compares with what actually happened over the last 21 years. It's not a superb fit, and even if it was, that would be testament simply to the power of serial recalibration rather than the theory it allegedly sets out to test.

Nonetheless, the conclusions which we can draw from this model are remarkably similar to those wrested from doubtless far more sophisticated models produced by our august Wall Street friends. And so are the conclusions are drawn by comparing actual bond yields with 'fair value' yields. What screams out in retrospect is that during 2004-2008 bond yields were far lower than 'fair value'. And from there it is but a step to conclude that the chief reason for that was that policy rates were set too low for too long, and, moreover, were expected to be kept too low for longer still. The graph serves as the charge-sheet against Alan Greenspan. And as it looks as if the same thing is happening again now (bond yields far lower than 'justified' by likely economic growth and inflation), we might eventually find it thrown into evidence against Ben Bernanke at some later date.

What the chart is saying right now is simple: bond yields are simply too low, making bonds an unattractive investment. Let's put it even more bluntly: who in their right minds would save to invest in bonds right now? At which point, we get to ask (and answer) an important question – regardless of the absolute nominal bond yield, does sufficiently 'bad value' in bond yields usually dissuade saving, and do sufficiently 'generous' bond yields usually encourage saving?

And I think we can answer than question empirically with a simple 'Yes'.

Consider the relationship between the deviation of bond yields from fair-value, and movements in the private sector savings surplus. The chart below illustrates it well, and that's not just because I've fiddled the axes. More importantly, the correlation between sequential movements in these two during the last 87 observations passes the 1% significance level quite easily.

For those of us interested in recent US economic history, and in global savings/investment imbalances, this chart is pretty irresistible, as it links the descent into major private sector savings deficit during 1997-2000 and again in 2005-2007 with bond yields being somehow maintained at levels which actively discouraged saving. When yields rose (relative to 'fair value') savings deficits were trimmed and reversed.

And now? Bonds represent absolutely rotten value, and as long as this is the case, the US private sector savings surplus will continue to decline, boosting US consumer demand at a pace slightly exceeding those of private sector income growth (widely defined).

One more thing: there is absolutely no sign of a Keynesian 'liquidity trap' anywhere on this chart.

Shocks and Surprises, Week Ending March 4th

Over the last few months, the US, Europe and China have provided a steady series of view-adjusting shocks and surprises, whilst Japan's sustained moderate misery has surprised no-one. Until last week, when first Japan reported a 4,1% MoM jump in retail sales in January, then followed up the next day with a surprise 2.0% MoM rise in industrial output.

But these two were then eclipsed by a surprise 7.6% YoY rise in capital spending reported for 4Q in the Ministry of Finance's enormous quarterly survey of balance sheets and p&ls. This was far removed form the 6.5% YoY fall expected. The details showed manufacturing investment rose 5.7%, whilst non-manufacturing rose 8.6%. There were big jumps in capex in construction (88.7%), wholesale/retail (24.6%), real estate (35.7%), but also in machinery (83.1%), business machinery (25.3%), and chemicals (10.5%).

It's tempting to get rather excited by this: after all, by virtually every measure 2011 was a rotten year for Japan, with currency strength compounding the misery already perpetrated by earthquake, tsunami, nuclear accident and political uncertainty. The same quarterly data shows sales fell 3.7% YoY, operating profits fell 8.6%, operating margins fell from 3.26% in 2010 to 3.09% in 2011, ROA fell to 3.01% from 3.32%, and ROE fell to 8.2% from 9%.

So why is capital spending up 7.6% YoY? There are two possible levels of explanation, of varying cheeriness. Let's take the cheery explanation first. One can argue that increased capex is simply the dividend now being paid for decades of corporate balance sheet restructuring. This chart takes two interpretations of leverage: financial leverage (total assets/shareholders equity), and net debt/equity ratio. And yes, they have both finally stabilized, a mere 22 years after they the bubble imploded.

That in itself is potentially a game-changer. But there's more – after deleveraging comes a cash build-up. And here it is:

So, after completing deleveraging and building up a cash horde, the logical next step is to start spending/investing once again. And so, we have the third chart. . . 

But at this point, the observant will see that the headline 7.6% YoY growth in capital spending is rather more impressive than the actual amount, compared with past spending plans. And in fact, such spending hardly breaks out of the investment slump we've seen since 2008. There is an awful lot of sustained investment spending to be done before we can describe a new era of Japanese industrial investment is underway.

At which point, we look at a fourth chart, which expresses current spending on plant and equipment with depreciation allowances. And the key point here is that even the 7.6% YoY rise in spending during 4Q still leaves total investment only very marginally higher than the depreciation on existing capital stock. In short, this surprise isn't (yet) telling us Japan is expanding its capital stock – it is still merely treading water.

Eurozone: In Denial

Elsewhere, for the most part, the data-run from the Eurozone continues to suggest that economists are strangely reluctant to acknowledge the unfolding recession. German retail sales fell 1.6% MoM, with pretty much everything falling – furniture was down 3% MoM, infotech donw 2.2%, autos down 1.7% and even clothes/shoes were down 0.9%. Similarly, French household consumption fell 0.4%, buoyed only by a 2% rise in spending on energy and a 1.4% rise in food spending. Elsewhere, French spending on durable goods fell 4.3%, and autos fell 7.6%. Why should this be surprising? Despite economists' unanimous expectation that the unemployment ratio would remain unchanged at 10.4%, it jumped to 10.7%. There are some absolute horror stories in that data – most notably Spain's ratio rising to 23.3%. Dreadful though it is, that is expected. But Germany's ratio is also now rising, to 5.8% from previous 5.7% (that's the EU count – Germany's own count puts its unemployment ratio at 6.8%). This month, only Austria bucked the trend of rising unemployment.

But there was one surprise – Eurozone M3 growth rose 2.5% YoY in January, recouping most of the ground lost in December's 1.6% YoY shock. The key statistics in all the monetary and banking data for January, in my opinion, was the 0.3% MoM rise (not seasonally adjusted) in bank lending to the private sector – this followed consecutive falls of 0.8% MoM in December, 0.1% in November, and 0.3% in October. In other words, January saw a modest and very probably temporary brake on the pace of household deleveraging. On the other side of the banking system's balance sheets, total deposits rose 0.6% MoM (nsa), up from 0.2% in December, allowing the YoY to rise to 2.7% in January from 2.1% in December. That's the good news. The less good news is that the rise in deposits was almost entirely the work of governments: government deposits jumped 23.1% MoM, whilst everyone else's stagnated at 0.1% MoM. Yes, there are strong seasonal patterns at work in December and January differentiating government private sector deposits – but they are not normally this strong. January's partial recovery in Eurozone monetary data will not be long-sustained.

US – Softer January, Harder February

From the US came an unexpected raft of worse-than-expected data – made all the worse because the shocks came from hard data, rather than surveys of intentions or dispositions. First durable goods orders fell 4% MoM in January, with capital goods orders, ex-defence and air down 4.5% MoM. Orders for machinery collapsed by 10.4% MoM, primary metals fell 6.7%. Shipments of capital goods did better – they rose 0.4% MoM, and both unfilled orders rose (up 0.5% MoM) and so did inventories (up 0.7%).

This was followed later in the week by unexpected weakness in personal income growth (up 0.3% MoM – wages up 0.4% MoM, but transfer payments fell 0.2% whilst social insurance costs rose 1% and taxes rose 1.6%). Personal spending also disappointed, rising only 0.2% - and within this demand for goods rose 0.6% but services stagnated entirely.

Finally, the roll-call of bad news was completed by an unanticipated fall of 0.1% MoM in construction spending, mainly reflecting a 3.9% MoM fall in hotel-building.

All of which was more grim news than we've seen from the US for a number of months now. However, there was solace in that all those negative indicators reflected reports of activity in January. Meanwhile, hard data was arriving from February which painted a far stronger picture. ISCM Chain Store sales jumped 6.7% YoY, even though sales of luxury goods were flat. And total vehicle sales topped an annualized 15mn for the first time since early 2008. The Conference Board consumer confidence index also jumped to its best reading since February last year , as readings both on current circumstances, and future expectations jumped.

2012 - A Summary

In 2012, the major economies of the world will find their business cycles are less synchronized than any time over the last ten years. The fate of the world's major economic power-houses will rest on the underlying fundamentals of return on capital, financial leverage, terms of trade and policy-development.

The reason for this is that domestic imbalances of savings and investment (recorded in current account surpluses and deficits) are less pronounced globally than at any time since 2001.

As a result, these economies will also be less hostage to international capital flows and their volatilities. Investors will gradually discover that we're exiting the 'risk-on, risk-off' world, and backing blindly into a world where asset discrimination once again begins to matter, a lot.

US – Accelerating Recovery

Chief beneficiary of this is the US, where we expect the recovery to continue to accelerate throughout 2012, and we expect both the current consensus forecast of 2.2% in 2012 (up from 1.7% in 2011), and the US Federal Reserve's band of 2.2% to 2.7% will prove to be excessively conservative.

By my estimate returns on capital are around their highest since 2000 and are still rising, which will continue to foster investment spending; labour productivity continues to grow (adjusted for changes in capital stock), which will underpin the slowly- accelerating addition of jobs; and, most importantly, I believe that the net develeraging of the economy which started in 2008 is now complete. I do not expect significant re-leveraging to take place this year, but the mere fact that deleveraging is no longer the key dynamic will shift the economy out of its modest 2.4% annualized growth trend which it has sustained since the end of the recession in 2009 and towards a 3%+ rate.

As this faster growth path becomes acknowledged I expect to see bond yields rise from their current excessively-low level (roughly 180bps below 'fair value' in our models). For now, it is faster growth, not higher inflation, that will do the damage to the bond markets.

This scenario faces threats from both the upside and the downside. On the upside, if monetary velocity (GDP/M2) even stabilizes at its current precedent low levels, then somehow we have to expect double digit nominal GDP growth. On the downside, the cycle could be choked off by a sustained rise in commodity prices sufficiently strong to erode the US terms of trade sharply. What would it take? Oil at US$140 a barrel would be threatening but not conclusive; oil at US$165 a barrel would trigger a 'soft patch' to disrupt the recovery.

Eurozone – Not Eurogeddon, but Recession

The ECB's willingness to supply Eurozone banks with cheap long-term funding, coupled with the US Federal Reserve's willingness to supply ECB with enough dollars to plug the hole left by financial institutions' capital flight from Europe (Eu135bn in December alone!) makes it likely the Eurozone can avoid financial implosion this year.

But it is unlikely to avoid recession. All three main ratios underpinning the business cycle point towards recession: nominal GDP growth is now so slow that asset turns and return on capital are falling – which usually triggers a downturn in the investment cycle. Europe's terms of trade have deteriorated back to their 2008 lows. And the pace of bank deleveraging, which has been the most gentle of headwinds during the last five years, is picking up dramatically. Falling returns on capital, rock-bottom terms of trade, and accelerated deleveraging dictate a private sector recession. And that's before the impact of tighter public sector budget discipline is taken into account.

Nor is it easy to expect an early exit from this recession, since the underlying problems of competitiveness within the Eurozone are ignored entirely by the current attempts to 'save the Euro'. Yet these issues will eventually be addressed in one way or another. The bullish view is that eventually Germany will reconcile itself to very rapid nominal GDP growth, including a bout of inflation and a current account deficit rather than watch deflationary forces consume southern Europe. This may, in the end, be correct. But it won't be in 2012.

China – No Hard Landing, but Hard Choices

The expectation that a hard landing will be forced on China by combination of disappearing export growth plus mounting bad debts in the banking system, linked both to local government and property projects, is wrong. The Chinese government has spent two years taking stock of the problem and trying to work out precisely who should pick up the bills coming due. It's a fraught political problem, but at least the money is there to pay them.

But this is not the main worry. Rather, the wildly-successful growth strategy pursued by China pursued in earnest since the mid-1990s is reaching exhaustion point. Policymakers have been extremely clear in their repeated assertions they wish to move China from an investment-led conomy to a consumption-led economy. But to make that transition is extremely difficult since it involves a complicated and sensitive re-modelling of China's financial system. China has had the best economic and financial advice on the topic that exists, but no-one really knows what will happens when the re-modelling gets underway in earnest this year.

Because of this radical uncertainty, our expectation of Chinese growth slowing to around 8% is best interpreted as an assertion that a hard-landing will be avoided, but that the environment for all involved in China's economy is likely to be unusually difficult and unpredictable.  

2012 China - The Wild Card

The expectation that a hard landing will be forced on China by combination of disappearing export growth plus mounting bad debts in the banking system, linked both to local government and property projects, is wrong. The Chinese government has spent two years taking stock of the problem and trying to work out precisely who should pick up the bills coming due. It's a fraught political problem, but at least the money is there to pay them.

But this is not the main worry. Rather, the wildly-successful growth strategy pursued by China pursued in earnest since the mid-1990s is reaching exhaustion point. Policymakers have been extremely clear in their repeated assertions they wish to move China from an investment-led conomy to a consumption-led economy. But to make that transition is extremely difficult since it involves a complicated and sensitive re-modelling of China's financial system. China has had the best economic and financial advice on the topic that exists, but no-one really knows what will happens when the re-modelling gets underway in earnest this year.

Because of this radical uncertainty, our expectation of Chinese growth slowing to around 8% is best interpreted as an assertion that a hard-landing will be avoided, but that the environment for all involved in China's economy is likely to be unusually difficult and unpredictable.

The most likely trajectories of the US and the Eurozone are not too difficult to determine: getting China right, however, is a far harder task both for economists and, much more importantly, for policy-makers. The bad news is that the situation is complicated, since China's economy is beset with both cyclical and structural difficulties. The better news is that there is no-one more keenly aware of the fact than China's policymakers, and they have the financial resources available to act effectively.

If those resources are deployed cleverly, China should avoid a hard landing (which is generally defined as growth falling below 8%). If they don't – well, there are easily enough cyclical and structural problems to drag the economy down. One is given confidence by the the extreme attentiveness with which China's policymakers have tracked and measured the build-up of problems over the last two and a half years, and the clarity with which they explain what they are attempting to do. Nonetheless, the cyclical and structural problems are complicated and interlinked, and economic history offers many examples of promising economies which have flunked similar tests.

Cyclical Problems

The most obviously element of China's cyclical problem is easily stated: as one of the world's largest exporters, China is exposed to any major cyclical downturn in world trade.

This vulnerability is easy to overstate: in recent years the surge in domestic demand has cut the overall importance of exports to China's economy. Back in 2007, exports were equivalent to 35% of GDP – this proportion had fallen to 26% in 2011. In net terms, China's current account surplus peaked at 11% of GDP in mid-2007, but had fallen to 3.9% by the end of 2011. Moreover, if one models carefully, the scenarios under which China's exports grow much less than 10% this year require some quite extreme assumptions about the US and Eurozone demand. A rise of 10% in exports during 2012 would be half the 20.3% recorded in 2011.

The external sector will be a modest drag on growth, but China's domestic economy has more worrying cyclical problems – most particularly the overhang of (probably bad) debt from local government spending during 2009 and 2010. Last year, the National Audit Office put the amount of outstanding loans to local governments at Rmb 10.7tr, equivalent to 23% of 2011 GDP. Local governments almost certainly wasted a lot of borrowed money on projects which will struggle to generate the cashflow to make repayments. This puts the onus back directly onto local governments themselves. But their revenues are also linked to property sales: in 2010, income from property sales amounted to no less than 27% of total local government revenues. Since the central government is quite determined to deflate existing property bubbles and deflate any that it suspects might be forming, this compromises the health of those local government loans even more.

No doubt these problems are not overstated, but China's bureaucrats - world-class worriers by inclination - have been assiduously tracking them since at least early 2010. If the Chinese government had not resources with which to bolster both local government finances and/or the capital of the banking system, they would be as dangerous as they are regularly described. But they have. Between 2007 and 2011 China's central bank raised reserve ratios on deposits from 8% to a peak of 21.5%, mainly to sterilize net capital inflows. By the end of 2011, the 'reserved' deposits commandeered by the central bank amounted to just under Rmb 17tr, equivalent to 36% of GDP.

The central bank and will release those deposits back into the monetary system as required – and they are surely enough to offset liquidity pressures stemming from any foreseeable deterioration in the loan-book (which, after all, currently totals only Rmb 55.5 trillion). Indeed, the process has already started, with reserve ratios being cut by 50bps in both December and February, in response to a sharp slowdown in monetary aggregates.

The conclusion is straightforward: despite its deteriorating internal cashflow and emerging credit-quality problems in the banking system, China's economy need not be forced into a 'hard landing' in 2011 by financial or liquidity constraints.

Structural Problems

The cyclical problems on their own are manageable. But China faces extremely difficult structural problems too, which policymakers are unwilling to ignore any longer, and which complicate economic management hugely this year.

Of course, the structural problems also intensify the cyclical problems. For example, the deterioration in China's cashflows are ultimately linked to deteriorating return on capital, and in 2011 China's private sector savings surplus had shrunk to 5% of GDP from a peak of 11.5% in 2009. On current trajectories, this surplus will contract nearly to zero over the coming two years.

The structural problem stems from the approaching exhaustion of China's existing growth model, in which huge saving levels are encouraged in order to finance correspondingly huge investment programmes, which subsequently turn out more goods than the domestic economy needs, and which therefore has to find markets for its surplus production abroad. There are two reasons this model has reached its sell-by date. First, it is increasingly difficult to either ignore or control the swathe of inefficient investment which depressed return on capital (and compromises banks loan portfolios). Secondly, China has grown so big that the rest of the world can no longer be expected to find an appetite for all the surplus production China wants to sell them: every percentage point of export market share won is gained at an ever-increasing investment cost.

If China is to switch to a growth model in which consumption rises more quickly than investment, the whole structure of savings and capital allocation (banking, bond markets, stock markets) will have to change radically. This is the most difficult policy traverse in the world, and one which the IMF has been poring over with the Chinese government in order to discover what sort of sequencing of financial reform will cause the least disruption.

And here we come to the real difficulty: there is every sign that China's government intends to press ahead with these reforms even in the face of the cyclical difficulties. What no-one knows is:

• How quickly and radically they intend to act;
• Whether they will press ahead even if cyclical pressures are more intense than expected;
• What effective resistance can be expected from the major beneficiaries of the current system of capital allocation (principally State Owned Enterprises, and the personnel of the Chinese Communist Party);
• Whether the forthcoming generational mass change in leadership will disrupt the agenda. (The change in leadership takes place throughout 2012 and 2013 and encompasses all parts of China's structures of political and administrative governance);
• What the economic impact of financial reform will be in terms of savings rates, investment rates, consumption rates.

The truth is, China is a wild-card in the global economy in 2012. A 'hard landing' will almost certainly be avoided, because China has the financial resources to generate cashflows to avoid one. And it will choose to avoid one. But at the same time, if China's policymakers believe they can safely advance structural financial reform at the cost of a growth slowdown, they'll probably choose to do it. Currently the consensus forecasts for China in 2012 and 2013 are 8.5% and 8.4% respectively – my own view is that it will be somewhat slower at around 8% in both years.

2012 Eurozone - For Now, A Normal Recession

The ECB's willingness to supply Eurozone banks with cheap long-term funding, coupled with the US Federal Reserve's willingness to supply ECB with enough dollars to plug the hole left by financial institutions' capital flight from Europe (Eu135bn in December alone!) makes it likely the Eurozone can avoid financial implosion this year.

But it is unlikely to avoid recession. All three main ratios underpinning the business cycle point towards recession: nominal GDP growth is now so slow that asset turns and return on capital are falling – which usually triggers a downturn in the investment cycle. Europe's terms of trade have deteriorated back to their 2008 lows. And the pace of bank deleveraging, which has been the most gentle of headwinds during the last five years, is picking up dramatically. Falling returns on capital, rock-bottom terms of trade, and accelerated deleveraging dictate a private sector recession. And that's before the impact of tighter public sector budget discipline is taken into account.

Nor is it easy to expect an early exit from this recession, since the underlying problems of competitiveness within the Eurozone are ignored entirely by the current attempts to 'save the Euro'. Yet these issues will eventually be addressed in one way or another. The bullish view is that eventually Germany will reconcile itself to very rapid nominal GDP growth, including a bout of inflation and a current account deficit rather than watch deflationary forces consume southern Europe. This may, in the end, be correct. But it won't be in 2012.

For more than a year now the world has worried that the Eurozone's financial problems are so extreme that they must inevitably drag the region into recession, and possibly much of the rest of the world with it.

Mainly these concerns are correct: the introduction of Euro-financing to countries who's productivity growth cannot begin to keep pace with German productivity growth has opened up huge gaps in competitiveness within the Eurozone which had been masked only by enormous build-ups of Eurozone debt. In the process, the nominal GDP of the weaker countries soared extraordinarily compared with the GDP of the core Eurozone countries, primarily Germany, and also compared to other developed economies. The chart below shows how it happened.

Now this debt financing is no longer available, and the underlying competitiveness issues widely understood, the Eurozone as currently constituted is living on borrowed time. By my calculations, even if labour productivity in the peripheral countries of the Eurozone had kept pace with Germany's, the scale of 'internal devaluations' needed in these countries to restore their intra-Eurozone competitiveness are simply impossible to achieve. Greece needs a devaluation of around 55%, Spain 50% and Ireland 45%. On the other hand, the scale of 'internal devaluation' needed by Portugal (18%) and Italy (10%) seem plausible.

Sooner or later, these devaluations will be made, either by massive and economy-shredding deflation in the peripheral countries (which surely could not be achieved without intense political disruption), serious and sustained inflation in the core countries (distinctly unwelcome to Germany), or through these countries accepting and external devaluation through exiting the Eurozone.

These choices seem obviously to most observers outside the Eurozone, but they currently elude the imaginations of Eurozone politicians and policymakers. And in the short-term, they continue to believe they are faced primarily with a liquidity problem (which can be resolved in the medium term by various 'rescue' expedients) whilst in the medium term the most visible aspect of the problem – the build-up of government debt – can be addressed by cutting public spending, closing fiscal deficits.

I expect they will continue to believe this even if Greece defaults and devalues later this year. Greece can yet be declared a 'special case', and the policy of liquefy the Eurozone banks whilst tightening the fiscal austerity screws will be maintained.

In the short term, it remains a reasonable expectation that continuing major infusions of extra liquidity can indeed prevent the underlying economic incompatibilities of the Eurozone from degenerating into uncontrollable financial crisis. For the ECB, even after taking into account the huge new lending of long-term money to Europe's banks at cheap rates (Eu489bn in three-year money in late December, with more to come later this year), still remains only modestly leveraged by central bank standards, with a total assets/equity leverage ratio of around 33x. That ratio could rise to around 45x before it would stand comparison with either the US Federal Reserve or the Bank of Japan.

But postponing financial catastrophe is not the same thing as fending off recession, and my three main cyclical indicators – return on capital, terms of trade, and leveraging trends - all point to recession in the Eurozone this year. There are three main indicators: return on capital is already falling; terms of trade have fallen back to 2008 levels and area likely to fall further if commodity prices continue rising; and bank deleveraging still has a long way to go. Beyond that, the ECB's new largesse is perversely also having the effect of accelerating the deleveraging process by making buying Eurozone sovereign bonds a much more attractive business for banks than the risky business of lending to the private sector.

By my estimate, the Eurozone had recovered about half the return on capital it lost during the financial crisis in 2008, unlike the US where the recovery was far quicker, and where ROCs are now at their highest level since 2000. Worse, it seems that ROC peaked in 3Q11 and almost certainly fell marginally again in 4Q11. When asset turns (sales/total assets) begin to fall one can expect investment spending to fall in sympathy – although this may be delayed by other factors which disguise or delay the underlying deterioration.

But there are only two disguises available in the medium term: either operating margins (indicated by international terms of trade) can rise, or financial leverage (indicated by bank loan/deposit ratios) can rise. Right now, neither of those tactics are available: whilst the Eurozone's terms of trade were steady throughout most of 2011, they are just about as bad as they were in 2008 at the height of the commodities boom. And whilst bank loan/deposit ratios have fallen consistently throughout the last five years, the fall has been so gentle it has merely allowed the ratio to drift down from a peak of 117% in 2007 to 104.4% now. Compare that to ratios elsewhere: 82% in the US; 96% in the UK; 68% in China and 70.6% in Japan and it is clear that the European banks still have a lot of deleveraging to do, and probably at a rather more rapid pace than during the past five years.

Indeed, one can see this more rapid pace emerging since December. Ironically, it is also hastened by ECB's determination to prop up Eurozone sovereign bond markets by making huge amounts of liquidity available to Europe's banks. The banks face a practical question: why take the risk of lending to the private sector when you have the choice both of taking the ECB's money and buying sovereign bonds, or alternatively, of simply putting the money back on deposit with ECB?

And that's what's happening: when ECB auctioned Eu 489bn of cheap three-year money in mid -December, the banks used that funding partly to lengthen their debt maturities, so the absolute rise in ECB lending came to only Eu214 billion. As more short-term debt has matured and not been replaced, the gross new lending has fallen to only Eu 122.25bn. Meanwhile, what have the banks done with the money? Overwhelmingly, they have re-deposited it back to the ECB: since mid-December, financial institutions' deposits with ECB have jumped by Eu307bn. In other words, the impact of the ECB's supply of cheap money to the Eurozone banking system has been, very perversely, to leave the ECB's net supply of credit to financial systems down by Eu 184.8 bn. In fact, the ECB's net supply of credit to financial institutions is now at its lowest point since the crisis began.

It is quite possible that in the next few months the ECB will become a net holder of deposits from Europe's banks. And, not surprisingly, at the same time, European bank lending, and European monetary aggregates are slowing very sharply.

In conclusion: the upside potential in Europe this year is limited to avoiding full-scale financial crisis. Even so, we should expect a year of unrelieved recession for the Eurozone as a whole, and on current policies there is no real reason not to expect this financial/economic stalemate to drag on throughout 2013 as well. Bond yields, naturally enough, are unlikely to rise. However, as precautionary savings ratios rise, we should expect the private sector savings surplus also to rise, which – if the Japanese example is anything to go by – also suggests we should not expect any collapse in the Euro (whatever this currency turns out to be).