Shocks and Surprises, Week Ending April 27th

• Eurozone data is unambiguous that recession is lengthened, broadened and intensified in April. The ECB already has leveraged its balance sheet, but banks are still tightening lending conditions, so very little time has been bought very expensively.
• US data confirming a rapid U-turn in capital spending plans as industrial sector enters a soft patch. This looks like a tweaking of schedules to accommodate slightly weaker-than-expected demand, not a fundamental cyclical turning-point.
• China and Japan delivered negligible shocks or surprises, with both economies showing modestly strengthening trends.
• Taiwan leading and coincident indicators break up out of a year's miserable trend. Hong Kong's trade data disappoints – but is it covert capital flows disappearing?

Sometimes, the numbers tell their own story. Of the 84 pieces of data which I've logged this week, exactly half arrived within a standard deviation of the consensus forecast, or within a standard deviation of current trends. For the rest, it was a week of unusually gathering economic misery: there were 30 negative shocks, of which 18 came from Europe, compared with only 12 positive surprises, of which five came from the US.

Eurozone - Recession Intensifies and Broadens. What Now?

So we should start with Europe. This was the week in which it not only because clear that the Eurozone is not escaping recession, but worse – that the recession is most likely intensifying in 2Q, contrary to consensus expectation. The news to this effect came so thick and fast throughout the week that one can hardly mention it all. On Monday we had the April PMI readings which showed the manufacturing, services and composite PMIs all falling shockingly below expectations, with manufacturing in particular at a 34 month low. Worse, there were shocks in the core of the core: the German manufacturing PMI was the worst for 33 months, and whilst the French services PMIs was the weakest since October 2011. Later in the week a series of confidence surveys measuring general economic sentiment, as well as specific industrial and service sector confidence confirmed the deterioration in the environment. But by this time, the 'shock' factor was purely statistical, the insouciant belief displayed by the consensus that things weren't getting any worse looking extremely vulnerable even before the data was released. Nor was that the end of the shocks: French consumer spending fell 2% YoY, whilst the number of French jobseekers jumped 6.7% YoY; German consumer confidence fell back to December 2011 levels; Italian business confidence levels slumped to the worst reading in the series' history; and the UK service sector activity fell 0.4% MoM. None of these results were anticipated in the range of economists' expectations.

The complacent expectation that intensifying fiscal austerity softened only by the ECB's cheap three-year bank funding program could lead to anything else but deepening recession in the short term is difficult to explain. It was a belief, however, which was expressed in some detail in the economic consensus. It is difficult to explain this professional complacency.

That the consensus is failing means a new set of questions will now be raised. The most urgent of these is what more the ECB should and can do to ease monetary policy. The long term refinancing operations of the last few months have lifted the central banks' total assets/capital leverage ratio from around 25x in mid-2011, to around 35x now. But that extra money appears simply to have encouraged the banks to hold yet greater quantities of government paper (of deteriorating credit quality) whilst at the same time cutting lending to the private sector. This was confirmed by an ECB survey this week which showed that banks continued to tighten lending standards to the private sector yet more during 1Q12. So far the ECB has not even really managed to buy time in exchange for leveraging its balance sheet. So where does it go from here?

Outside the Eurozone, the UK's 1Q GDP preliminary results also suggested a recession, with the economy contracting 0.2% QoQ. Markets discounted, or rather dismissed the news within hours, noting that the key 3% YoY contraction in construction contradicted a series of surveys which had pointed to unusual strength in the sector.

US - Evasive Action

In the US, the shocks and surprises were evenly matched for a good reason: this was the week which saw the clearest evidence of US industry pulling a U-turn to avoid getting side-swiped by the Eurozone's car-crash. The message could hardly have been made clearer than in the monthly report on durable goods. First there was a positive surprise, that shipments of capital goods (non-defence, ex-air) had jumped 2.6% MoM – well above expectations – driven by a 6.5% MoM jump in shipments of machinery, and a 2.1% rise in shipments of electrical equipment. Yet the same report brought shock that total orders for durable goods fell an alarming 4.2% MoM. Although this fall was exaggerated by a near-halving of orders for civil aircraft, the remaining fall of 0.8% MoM in orders for capital goods (non-defence, ex-air) was also outside the range of expectations. The combination of unexpectedly heavy shipments of capital goods, accompanied by an unexpected fall in orders tells its own story of an abrupt scaling back in near-term capex plans. My view is that this reaction has arrived early and the US's 'soft patch' should this year be seen as precautionary and preventative rather than anything seriously cyclical.

The other feature of the US week was surprising strength regained by the property market, with positive surprises on pending home sales (up 4.1%), new home sales (surprising strength in March, plus upward revisions for previous months), and a rise of 0.3% MoM in the house price index for February.

Japan. China and NE Asia  - Loads of Data, Few Surprises

Although this was the big week of the month for Japanese data, with no fewer than 10 major data releases on Friday alone, there were no surprises at all, and only two negative shocks: industrial production rose only 1% MoM (vs central expectation of 2.3%), and housing starts also disappointed. Every other data-stream fell within consensus, or in line with current trends. There was nothing here that need force a rethink of the expectation that Japan's economy has started an unlikely upward curve.

By contrast with Japan, there was very little data from China this week, and none which delivered shocks or surprises. The HSBC Manufacturing PMI flash reading showed a modest but broadly-based improvement on the month, whilst remaining below the expansion/contraction line of 50. The Conference Board Leading index rose 0.8%, without breaking the current upward trend, with the easing of loan conditions providing a significant part of the impetus.

Elsewhere in Asia, there was one shock and one surprise which may be important. The surprise came from Taiwan, where for the first time for a year, the Composite Index of Coincident Indicators gave a positive reading, despite still-negative reports from exports and wholesale/retail sales. This improvement clearly broke trend. So too did the set of Leading Indicators, partly on the back of an improvement in the SEMI book-to-bill ratio to 1.13 in March from 1.01 in February. The ratio of Leading Indicators to Coincident Indicators is still rising, so this is a constellation both unexpected and extremely positive.

The shock came from Hong Kong's March trade, where exports shockingly fell 6.8% YoY, mainly thanks to an 8.1% YoY fall in exports to China, whilst imports fell 4.7% YoY, mainly reflecting a 4.5% YoY fall in imports from the US. It is not easy to interpret these numbers as faithful indicators of the state of China's economy. Historically, HK-China import and exports numbers have been inflated or deflated by widescale under-invoicing or over-invoicing, reflecting traders desire to move capital into and out of a China which was subject to more or less effective capital controls. As those capital controls loosen, we must assume that this practice will dwindle. It may take some time for the data to settle down.

Eurozone Recession Spreads to the Core of the Core

Yesterday's collection of Eurozone PMIs were truly dreadful. The real shocker was the reading of 47.4 from the Composite PMI, which was below 1SD from consensus, and was the result of  manufacturing PMI collapsing to a 34 month low, and services to worst for five months.  It suggests Eurozone’s recession is intensifying during 2Q12.  GDP fell annualized 1.3% in 4Q11, and central forecast for the Eurozone’s 1Q12 based on the Composite PMI  (which does a better job than either the manufacturing or services PMI) is a contraction of 0.9% annualized (with a 1SD range of minus 2.4% to +0.6%). And unless April’s trend reverses dramatically, 2Q12 looks like contracting 2.6% (range, minus 4.1% to minus 1.1%).  The consensus can live with annualized  1QGDP falling 0.9%, but the 2Q forecast is three times worse than consensus.

The Composite PMI isn’t unerringly accurate as a GDP forecaster: it has signalled quarterly contractions three times in the last couple of years, twice wrongly. In 3Q09 PMI signalled contraction of 0.9%, but GDP grew 1.9%; 3Q11 PMI signalled a contraction of 0.4%, vs an outcome of +0.5%; and in 4Q11 it signalled a contraction of 2.1%, considerably worse than the 1.3% contraction recorded.

Recession in the Eurozone periphery is no surprise. The worst of today’s news came from the core of the core. Germany’s manufacturing PMI slumped to 46.3 – its worst reading for 33 months. New export orders were particularly badly hit, as orders from S Europe dried.   France’s services PMI also collapsed to 46.4, its worst reading since October 2011 and only the second monthly contraction since then.  If German manufacturing and French services can’t grow, the Eurozone won’t grow.

Continued and intensifying recession makes every detail of the Eurozone’s fiscal pact more tenuous economically, politically and financially. 25 EU members agreed to cut fiscal deficits to 4.6% of GDP this year and 3% next year: bond markets and currency markets will find those targets much harder to believe today than yesterday.  

Shocks and Surprises, Week Ending April 21st

·         US data shocks tell us we're back in a 'soft patch': industrial data, labour markets and real estate all reported results worse by 1SD or more from consensus.

·         Europe has a busy data-week, producing few shocks or surprises. Probably the most shocking event was ECB’s revisions to current account balances for 2010 and 2011, which cut the annual deficits by an average of 86%.

·         Japan's puzzling strength continues: March trade data was surprisingly strong, and so, just about, does domestic demand.

·         China and NE Asia released little data, and no challenge to consensus views.

US – The Soft Patch Arrives

Evidence for a 'soft patch' in the US came in thick and fast as no fewer than seven data-releases slid more than a full standard deviation below the range of estimates. From the industrial sector, the Empire State manufacturing index slid to just 6.6 from March's 20.2, and the Philadelphia Fed survey fell to 8.5 from 12.5 in March. These two surveys are among the earliest indicators for April's industrial activity, and both were shockingly weak. Industrial output data for March was flat MoM for a second successive month. This was a shock, but even worse, the output data hid a 0.2% MoM contraction in manufacturing, which was offset mainly by a 1.5% MoM rise in utilities output. This flatlining in the industrial sector found echoes in labour and property markets. Thursday brought a second successive week in which initial unemployment claims rose above the range of expectations. And finally, outcomes for housing starts, existing home sales, and the NAHB Housing Market Index all fell more than 1SD below the range of expectations.

Eurozone – Busy but Few Shocks/Surprises

Truly, Europe’s major surprise of the week came from the way the ECB revised the last two years' current account data, cutting 2010 and 2011 deficits by an average 86%.  Yes, data gets revised, but when such major revisions are made to such central data, it cannot help but make you question the basis upon which policies are made. Besides that, although the wires were busy, there were few shocks or surprises (tally: 17 datapoints on consensus; four surprising on the upside, and three shocking on the downside). Moreover, one of the surprises (UK's retail sales rising 1.8% MoM in March), and one of the shocks (Eurozone's construction output falling 7.1% MoM in Feb) told us more about the weather than the economy: Germany froze in February (construction fell 17.1% MoM), whilst March sun brought out clothes shoppers in the UK.

Japan – Baffling Run of Strength Extends One More Week

Japan's run of stronger-than-expected data extended to March's trade data, in which exports rose 5.9% YoY (vs an expectation of just 0.2%), and imports rose 10.5% YoY (vs expectation of 7%). The strength of export was largely attributable to a 44.7% YoY jump in auto-exports, whilst Japan's import bill was swollen by petroleum (up 22.8% YoY) and petroleum products (up 32.1%). (Soaring oil imports are what happens when Japan closes its nuclear power plants). Domestic demand indicators were less clear: March department store sales surprised with a 14.1% YoY jump, but convenience store same-store sales disappointed by rising only 0.4% YoY. The jump in condo sales in February was reversed to a 6.1% YoY fall in March, but average prices rose and inventory is getting cleared.

China and NE Asia – Little Data, No Surprises

Japan apart, Asia produced almost nothing to trouble consensus. In China:

·         FDI used during the first quarter was reported down 6.1% YoY;

·         a rise in news orders propelled the MNI Business Sentiment survey for April slightly higher;

·         the 70 cities real estate data showed prices of new residential property falling in a net 38 cities in March (vs a net 42 in February).

All three came in slightly higher than expectations or central trend, but in each case by less than a standard deviation: no need to revise the consensus.

Similarly, the little data released in NE Asia need not detain us: Taiwan export orders fell 1.6% in March, and S Korean export prices were flat YoY – both in line with expectations and trends. In fact the only surprise delivered by Asia ex-Japan this week was the 16.8% MoM collapse in Singapore's non-oil domestic exports – a puzzling collapse which was attributable neither to electronics, nor pharma, nor even Europe. 

How to Account for the US 'Soft Patch'

The shocks to consensus on US industry keep coming: this week we've already had disappointments from April's Empire State Manufacturing survey (just 6.6 vs a consensus of 18), and a second consecutive month where industrial production flatlined (and manufacturing fell 0.2%). The previous couple of weeks saw shocks from regional manufacturing surveys in Milwaukee, Kansas, Richmond and Dallas. It's time to start asking what ails US industry right now: why is another 'soft patch' materialising in the data?

We do not have the dramatic excuses of last year: we've had no environmental catastrophe punching holes in global supply chains; and though WTI oil prices have risen, the movement from around US$100 a barrel in 2H11 to a rapidly fading peak of US$110 is no repeat of the 2010-2011 jump from around US$85 to US$112+. What's more, banks are once again lending modestly (up 5.1% YoY in March and early April) and commercial paper markets are open to non-financial domestic companies (up 17.8% YoY). Finally, throughout 1Q we've got used to housing markets and labour markets, perennial bear-factors, are regularly delivering more positive surprises than negative shocks.

With none of the usual suspects fitting the frame, it's time to try to account for the soft patch from the bottom up – ie, by looking carefully at where US industrial output ends up. And it turns out that this step-by-step accounting approach does yield some answers.

Industrial output must either be bought by someone directly, be added to inventory, or written off. When we look at monthly data for manufacturing and trade sales, we find they remain relatively robust (latest data February), rising 7.6% YoY, and with a positive underlying sequential momentum which remains unchallenged (the 6m trendline for sequential movements is 0.21 standard deviations above the 10yr average). So sluggish domestic sales by themselves don't look to be the problem.

Output which isn't immediately sold to the end user can end up as inventory temporarily: there's a measurable lag of about four months. Total business inventories are matching sales, rising 7.6% YoY in February: there's no story here, since inventory/sales ratios have been essentially unchanged now for a full two years. No pressing inventory adjustment is likely to be generating a 'soft patch'.

But now let's consider the difference in momentum between what's being produced (industrial output) and where it ends up in the domestic economy (sales and inventory). In the chart below the blue line tracks momentum of sales, and the pink line tracks momentum of output minus inventories. In a closed economy which typically operates somewhere near equilibrium, the two lines would track each other closely – as indeed they do usually.

What if they don't match, however? Let's look at the difference in momentum between the two. In the chart below, the thing to remember is that if the line is in positive territory it tells us that the momentum of output is greater than the momentum of end sales plus inventories – in other words, one can and should expect a correcting retreat. Conversely, if the line is below zero, sales and inventories additions have greater momentum than domestic production, and one should expect a positive correction from industrial output.

More, the direction of travel helps us understand the mini-cycles which bubble up in the data. Thus by late 2010 the US had reached a point where for the first time since the financial crisis hit, momentum of sales and inventories was stronger than momentum of industrial output, heralding the unexpectedly strong growth in output during 1Q11. So it's really not surprising that the 'soft patch' of 2011 caught everyone by surprise, nor is it surprising that commodity markets reacted so strongly to the upturn. The shock of supply-side disruptions distorted the picture even more, and it was not until well into 2H11 that output momentum began to catch up once more with sales and inventories.

Notice what's happening now, however, is that that catch-up period has ended – all other things being equal we would expect a modest step-down in pace, unless the pace of sales and inventory momentum lifts.

So far, we have considered US industry operating in effectively a closed economy. But that's wrong. International trade can be seen as a balancing item: when output is rising faster than (sales + inventories), then one possibility is that the surplus output can be exported. Similarly, when output is lagging (sales +inventory) the shortfall in supply to the domestic economy will be made good by imports. As our final chart shows, it doesn't always work out like that – there's more flex in these arrangements than our accounting methods acknowledge.

However, what is clear is that the signals for trouble come when momentum of output minus (sales + inventories) is positive and rising, whilst momentum of exports is negative and fading. That's the point at which you must expect cuts in output – an industrial recession in other words. This was the situation in 2001-2002, and much more intensely in 2008-2009.

Obviously, US industry is not in a similar position now – but it could be getting there. If the trends seen in the last nine months were simply to be extended for a further nine months, the position would become similar: output momentum would be rising significantly faster than (sales + inventories), whilst the ability to export the surplus dwindles as export momentum turns negative. It is precisely to avoid this dynamic that the 'soft patch' is emerging.

What conclusions can we draw from this?

First, the industrial 'soft patch' is no simple mistake or data-blip: rather it is a slowdown necessary to secure something like industrial equilibrium. It can be expected to maintain downward pressure on bond yields, downward pressure on commodity prices (both of which are already manifest) but also, if it lasts, downward pressure on the dollar.

Second, the US industrial cycle is not self-contained, and is not insulated from trends in world trade. In fact, fluctuations in world trade play a crucial role in finding, keeping and maintaining the balance between domestic supply and demand. Right now, that means the US industrial cycle is exposed particularly to potential downturn in Europe, as well as to potential reflation in China.

Third, the imbalances are only just emerging, and industry is acting to ensure they don't curdle into a recession: the modest shocks now ought to prevent worse shocks later. But the exit from the soft patch is likely to need positive momentum surprises in sales, or inventories, or exports – and preferably a combination of the three.

ECB Loses 86% of the Eurozone's Current Account Deficit

What is one to think about the Eurozone's revision of absolutely fundamental data which evaporates 86% of the zone's current account deficit for the last two years? That is what has the European Central Bank has unveiled today, revising down the 2010 deficit from Eu42.16bn to Eu6.79bn, and the 2011 deficit from Eu29.49bn to Eu 3.21bn.

Although these are some of the biggest revisions of major macro-numbers I've seen for a while, they are curiously inconsequential, because what ails the Eurozone is nothing to do with cashflows, and everything to do with balance sheets. Probably the most serious medium term consequence is on the credibility of the institution itself - it is, after all, meant to making policy at least partly on its seemingly unstable  monitoring of the Eurozone economy.

What is the basis of the revisions, and what do they do to our understanding of the underlying cashflows of the region? At the moment, the ECB says simply that the huge 2010-11 revisions are 'mainly owing to revisions for income on direct investment'. The ECB's notes strongly imply that these revisions are related to revisions for the Eurozone's net direct investment position generally. Those revisions led to the ECB cutting its statement of the Eurozone net foreign direct investment liability position, by Eu 69bn to Eu 1,224bn as of 3Q11. But that's far too small a shift in the underlying capital position to produce such a dramatic improvement in the Eurozone's current account cashflows.

For now, the exact justification for the revisions remains mysterious. What it means, however, is that in 2010 official data now shows the Eurozone with a current account deficit of 0.3% of GDP, rather than 1.8% of GDP. In 2011, it had virtually no deficit at all (0.1% of GDP) rather than the 1.3% deficit previously recorded. Europe's savings and investment are now virtually balanced, apparently. Moreover, the private sector savings surpluses must correspondingly have been better than previously thought (around 5.8% in 2010 and falling to around 4.1% by 3Q11).

Fundamentally, it doesn't contradict what we already know: that the Eurozone private sector is generating substantial savings surpluses, which are fetching up as positive cashflows into its banking system. Those cashflows (deposits in minus loans out) amounted to Eu218bn in the 12m to February, and cut private sector net debt to Eurozone banks to Eu 376bn. All that cash inflow, and more, has been used by Eurozone banks to buy foreign assets: in the 12m to February, Eurozone banks' net foreign assets rose Eu262bn to Eu934bn.

In other words, every measure concurs: the crisis of the Eurozone is generating substantial net outflows of capital from the region. So here's a final note from the ECB's data-release: at the end of 2011, gross external debts of the region amounted to Eu11.3tr, or about 121% of GDP. Those debts had fallen Eu126bn in the last three months of the year.

Shocks and Surprises, Week Ending April 14th

• China takes the most direct-possible route to ease up the cashflow cramps of 1Q, as bankers' acceptances surge more rapidly even than direct bank lending. The reflation is on. . . .
• Japan provides its fourth week of consensus-bustingly strong data, this time led by orders for machine tools and for machinery. Street-level confidence survey also jumps unexpectedly to a full standard deviation above the series 10yr average
• Eurozone's financial disaster resurfaces in a week that also delivered surprising strength in industrial production, and unexpectedly strong German trade data.
• In the US, labour markets and trade data (imports down 2.7% MoM) suggest a soft patch, but consumers and businessmen's view of economic outlook surprise on the upside

China: A Reflation both Dramatic and Stealthy!

This week brought the end-of-the quarter data for China, with releases bringing news not only of many element's of March's trading environment, but also quarterly GDP data. And yet this news mostly merely confirmed expectations: GDP data, industrial production, investment and consumption data, monetary data and both export and import totals all arrived within a standard deviation of consensus expectations.

Despite that, it was in the details of China's monetary data that the week's most important surprise could be found, buried. And the surprise is that the aggressive reflation of China's economy has already begun. On the face of it, M2 growth accelerating modestly to 13.4% (from 13%) and M1 stuck at 4.4% (from 4.3%) was nothing surprising. New bank lending of Rmb 1,010 bn in March was a surprise, in that it was slightly higher than the Rmb 740bn to Rmb 848bn range of forecasts. But a big monthly lending total during one of the first three months is the rule rather than the exception in China's banking year, and new lending of Rmb 1tr+ is not unknown.

The real surprise came in the the details of China's new 'aggregate financing' total. This 'aggregate financing' includes bank lending, but also bonds, equities, foreign borrowing, trust loans and bankers acceptances. Whilst bank lending in March at Rmb 1,010bn was only Rmb 299.3bn higher than in February, the 'aggregate financing' was Rmb 820 bn higher, at Rmb 1,860bn. This is a huge total, equivalent to 17.2% of 1Q nominal GDP. Drill down to find what's driving it, and you find China's banks wrote a net Rmb 276.9bn of bankers acceptances in March, a reversal from the Rmb 31.2bn net redeemed in February.

Now, when economists second-guessed the timing, scope and nature of China's eventual reflation, the squabbling has mainly centred on the extent to which the relaxation would come via cuts in reserve ratios or cuts in interest rates. What's happened here is neither: rather, the rise sudden jump in bankers acceptances is an absolutely direct response to the cramping in corporate sector cashflows which we have previously identified. Old-timers will remember the 'triangular debt' problems which used to plague China in the 1980s and 1990s, in which unpaid bills are allowed to mount up among companies well past the point of easy netting off, resolution, or payment out of cashflows. Historically, when “triangular debt problems” began to torpedo the economy, the central bank started printing money. Today, since China's banks have been made to keep very low loan/deposit ratios, there's no need to print money: rather, the banks can simply be allowed to mobilize their resources, by, for example, writing bankers' acceptances. It is a very direct way indeed to respond to the seizing up of cashflows.

Compared with this policy surprise, even the other shocks and surprises delivered by China seem rather mundane: March trade data showed export growth at 8.9% (towards the top of expectations) whilst import growth slowed to 5.3% (right at the bottom of expectations), which taken together produced a US$5.4bn surplus which was better than expected. Also breaking upwards out of a declining trend was China's monthly Entrepreneur's Confidence Index – although no details were given, it may be that cashflows are improving.

But there was also a negative inflationary shock, with March CPI showing 3.6% YoY, up from February's 3.1%. Not only was this unexpected, but it was generated by a sequential rise that was a full standard deviation above historic seasonals. On the face of it the main reason was a 7.5% YoY rise in food prices (up from 6.2% in February). But in addition there was a surprising sequential jump in non-food prices, masked by an exceptionally easy base of comparison, and stemming ultimately from a jump in transport and telecoms prices, in turn driven by hikes in petroleum prices.

Seemingly, China's policymakers agree with those analysts who have downplayed this result. However, on a statistical basis, this was a negative shock.

Japan and NE Asia: Despite Tankan, Japan is re-tooling

For the fourth week in a row, Japan's economic data contained significant upside surprises. This week's data specifically called into doubt the previous Tankan's forecast that there will be no expansion of capital spending this year. Machine tool orders roses 2.4% YoY, and whilst that was no break in trend, domestic orders jumped 29.1% MoM and 24.7% YoY, which was a sequential jump fully 2.3 Sds above historic seasonal patterns. Later in the week, core machinery orders rose 4.8% MoM, despite a 18.3% MoM fall in foreign orders. Manufacturers' orders rose 16% MoM (driven by chemicals, oil and foods) and non-manufacturers' rose 2.3%. (Bank lending data was also stronger than expected, despite rising a meagre 0.9% YoY: however, this looks more the product of lazy forecasting than true evidence of surprising strength.) Finally, the Economy Watchers survey of current conditions for March not only jumped far more strongly than expected, but arrived at a level that was a full standard deviation above the series' 10yr average.

After literally decades of disappointment, it will take far more than four weeks' of surprisingly robust data for the consensus on Japan to change.

Elsewhere in Northeast Asia, the week brought little challenge to consensus, with the most prominent perhaps being an unexpected fall in S Korea's unemployment ratio to 3.4% in March from 3.7% in February – a fall which looks genuine enough.

Eurozone: German Trade Still Robust

Even as the Eurozone crisis claws its way out of the ECB's wallet again, the industrial sector can still spring some positive surprises: industrial production rose unexpectedly by 0.5% MoM in February, although this was still down 1.8% YoY. On closer inspection, though, the surprise was really confined to the Netherlands, where output rose a baffling 13% MoM.

German industrial output fell 0.2% MoM, but any disappointment there was offset by a set of German trade data for February showing vigorous growth beyond anyone's expectations: exports rose 1.6% MoM (up 13.4% YoY to countries outside Europe), and imports jumped 3.9% MoM. But there's no evidence from Germany's data that its trading strength is doing much for the Eurozone, since trade with the rest of the Eurozone was geographically the weak spot.

And, of course, Europe also produced negative economic shocks, of which the worst was probably Britain's trade deficit, which expanded far beyond the worst expectations of economists as exports fell 3.4% MoM whilst imports were flat. Over recent weeks, Britain's data has managed to confound the Eurozone doldrums – and indeed it was at it again this week, with like-for-like retail sales rising 1.3% MoM in March. But the price for that relative domestic resilience is a newly-deteriorating trade deficit.

US: Labour softens but outlook improves

The shocks and surprises in the US this week look linked. First, the weekly tally of initial unemployment claims jumped unexpectedly to the highest reading since early December. If last week's non-farm payrolls data had not been so shocking (up just 120k, vs an expectation of 205k) this would have carried less import. As it is, the sudden weakening of labour market data has been sufficient to re-start speculation of a third round of quantitative easing, and driven 10yr Treasuries back to around 2% levels from the 2.3% levels seen only ten days ago.

But if the durability of the labour market recovery is being questioned, some weakness in demand is also narrowing the trade deficit unexpectedly. Trade data for February showed the deficit narrowing to US$46bn in February, primarily reflecting a fall of 2.7% MoM in imports. And there's little doubt but that it's slackening consumption demand that's driving the fall in imports: imports of consumer goods fell 6.3% MoM, food and beverage fell 6.3% and imports of autos contracted 4.2%.

This sits awkwardly with the news from the wholesalers, who reported surprising strength in both sales (up 1.2% MoM) and inventories (0.9% MoM) in February.

If the labour market data does presage another 'soft patch' for the US, the message has not yet got through to consumers and businessmen consulted about their expectations by surveyors. The IBC/TIPP Economic Optimism index jumped to the highest reading since February 2011, driven primarily by improved expectations about the economic outlook; and although the University of Michigan's preliminary consumer confidence index for April retreated slightly, measurements of confidence in the economic outlook continued to rise to new levels.

Shocks and Surprises, Week Ending April 8th

• Japan's run of upside surprises continues with huge jump in car sales, break-out in Leading Indicators, and strong cash earnings. But Tankan shows no corporate Japan doesn't believe it: no investment follow-through is contemplated yet.
• In China, official and HSBC/Markit PMIs for manufacturing sector contradict each other. HSBC's more gloomy assessment fits better with the available evidence, but this week will give us a clearer picture for March. In NE Asia, manufacturing PMIs for both Taiwan and Korea surprise on the upside, but March export data doesn't.
• In Europe, UK extends its run of positive surprises, whilst consumer sentiment remains glum. In the Eurozone, retail and industrial sector data continues to deteriorate shockingly. But French consumer confidence is strangely buoyant and trade balance deteriorates.
• US non-farm payrolls provided a shocking disappointment which throws the spotlight back on Ben Bernanke's recent policy thoughts.

Japan: Upswing with No Corporate Believers

Japan extended the run of positive surprises which we've noticed over the last couple of weeks (see last week's Shocks and Surprises). The positive signals from may be difficult to account for, but increasingly they're even more difficult to ignore. Or are they? This week, for example, we learned that vehicles sales jumped no less than 78.2% YoY in March. Since there's no survey taken to form consensus, it's easy both to miss the strength of this result, or – if it's noticed at all – dismiss it simply as reflecting the exceptionally easy base of comparison generated by the disasters of March 11, 2011 and their aftermath. But it was 12.3% higher than March 2010, 54.1% higher than March 09, 5.6% higher than March 08, 2.1% higher than March 07. And sequentially is was a full standard deviation above seasonalized historic trends. In other words, this was a fully-functioning surprise indication of domestic demand.

And it was supplemented by the most positive reading from the Leading Indicators Index since January 2008, a reading which, once again, was a full standard deviation higher than the average since 1990. Further, we had an unexpected rise of 0.7% YoY in cash earnings in February, despite a 17.7% YoY fall in bonus earnings.

Economists aren't the only ones not to fully recognize or react to the way signals from Japan are confounding expectations – corporate Japan isn't buying it either. We know this from unexpectedly dim readings from the quarterly Tankan survey of corporate attitudes: business confidence both for 2Q and for the outlook for the year disappointed mildly, without actually deteriorating QoQ. Far more disappointing is the reading that corporate Japan does not intend to raise capex at all this FY (started April 1). Right now, there's simply no follow-through to the signals of strengthening domestic demand.

China – Official and HSBC Manufacturing PMI both surprise – in different directions

The week for China and its neighbours in NE Asia (excluding Japan) was dominated by two sets of shocks and surprises. The first came from China, where we had a straight conflict between the HSBC/Markit reading of China's manufacturing PMI, and the official manufacturing PMI. HSBC's survey found a further contraction in March, led by the sharpest fall in new orders measured this year, to which manufacturers responded by cutting payrolls and purchasing activity. By contrast, the official manufacturing PMI discovered the best reading for a year, in which there were sharp rises in new orders and output,and more moderate rises in purchases and employment.

Both cannot be right, and the weight of corroborating evidence is clearly on the side of HSBC's more gloomy reading. This week will probably settle the dispute, since we will get data for trade, output and investment and retail sales for March.

Among China's Northeast Asian neighbours we've already seen how Japan's economic readings are surprising on the upside at the moment, and we also got positive surprises from both South Korea and Taiwan this week. South Korea's manufacturing PMI came in at the strongest reading for a year, with new orders being driven both by domestic and exports demand. Taiwan's manufacturing PMI was similar, producing the best result since April 2011, with the growth in new export orders continuing to accelerate. We got a related surprise from Singapore's monthly Electronics Sector Index, which improved more than expected driven by strong rises in both production and export orders, even as inventories fell and orders backlogs expanded.

That said, it remains difficult to square the improvements in these surveys with current trade data: South Korea's exports fell 1.4% YoY in March, and Taiwan's fell 3.2% YoY (reported today), and in both cases, the slowdown looks well spread geographically, with sharp fall-offs in exports to Europe, and no significant sign of recovering strength in China.

UK's Positive Surprises – Can It Escape Eurozone Recession

Within Europe, the UK delivered a series of three positive surprises, whilst the Eurozone, including the core of Germany and France gave us a series of negative shocks. The UK's positive surprises came from the Markit PMIs for both construction and services. The construction measure gave the strongest reaidng since June 2010, with the strongest growth in output coming from the commercial sector, and the sharpest jump in new orders since September 2007. The service sector surprise was less pronounced, but it took the 1Q12 average to the strongest since 2Q10. Both construction and service sectors are now reporting growth in employment and purchases. This renewed strength is surprising, not only because it diverges from the experience of the Eurozone, but also because it finds no echoes in recent consumer confidence studies, which over the last three weeks have been shocking in their misery. But perhaps actual economic behaviour is a more accurate guide than responses to opinion-surveyors. For example, this week also showed UK car registrations up 1.8% YoY in March. It may not seem much, but March is a crucial month for UK car sales, typically representing 18% of the year's sales, and this result was in fact more than a full standard deviation above seasonalized historic trends, and, in addition, was powered by a 7.4% YoY rise in private car purchases.

Meanwhile in the Eurozone, the week brought negative shocks from:

• Eurozone retail sales, which fell 0.1% MoM and 2.1% YoY;
• German factory orders for February (up 0.3% MoM but down 6.1% YoY), with orders from the Eurozone falling 3.2% MoM, in particular led by a 9.4% MoM collapse in Eurozone orders for consumer goods.
• German industrial production for February, which fell 1.3% MoM and rose 1% YoY. Although statistically a 'shock', the weakness was intensified by extremely cold weather in the first half of the month which contributed to a 17.1% MoM fall in construction output.
• France's trade data for February, in which a slowdown in export growth (to 1% MoM) and continued import growth (2.8% MoM) resulted in a trade deficit far bigger than expected. Most worrying is France's trading position with the rest of the Eurozone: exports to the region fell 0.9% MoM, whilst imports jumped 6.9% MoM. We have previously noted the strange surge in consumer confidence in France following the ECB's decision to extend cheap three-year money munificently in December and February. It's not difficult to see these trade numbers as an expression of that strange and lop-sided surge in confidence.

US: Labour Markets and Monetary Policy

This week was above all concerned with US labour markets, in which Good Friday's sharply disappointing non-farm payrolls data (up only 120k, vs an expected 205k, and Feb's 240k), brought into focus a recent speech by Fed chairman Ben Bernanke.

The abrupt slowdown recorded in non-farm payrolls was a real shocker – since the previous three months had averaged 246k. If it is confirmed (and it was contradicted by an ADP Employment change reading which was strong at 209k) it will train attention on the various pieces of data which have disappointed recently: the series of regional Fed manufacturing surveys, and, this week, vehicle sales, and construction spending (down 1.1% MoM).

And that in turn will focus attention back on the Fed's intentions. The argument made by Bernanke in his recent speech is a two-parter. The first part warns that intense recessions can lead to a lower structural participation ratio, and hence depress the growth potential of the economy. The second part says not only that this is unacceptable, but that monetary authorities can and should act to avert it. If the first part of this argument is an important statement of economic history, the second is, to say the least, contentious – since the one sure way to discover the (new) limits of the productive capacity of the economy is to print money until inflation is actually discovered. Whilst this seems extraordinarily complacent, even reckless, as a methodology for determining monetary policy, Bernanke does at least seem right that there's no obvious sign that the US is yet bumping up against its supply constraints.  

What's Going Right for Japan

Japan’s leading indicators index for February surprised not only because it was comfortably better than the range of expectations, but because it was the strongest reading since January 2008, and was almost exactly a full standard deviation higher than the series average since 1990.  We’ve become utterly used to Japan being a neutral or negative contributor to world growth, so it’s easy to let this slip by unnoticed and unexamined.

But it’s only the latest in a bunch of data from Japan over the last three weeks which has surprised positively. Earlier in the week, the 0.7% YoY rise in cash earnings sounds miserable, but was far stronger than the 0.1% expected, let alone the 0.3% YoY fall recorded in Tokyo core CPI. Last week, housing starts annualized to their highest reading since August, retail sales rose 3.5% YoY (beating consensus and range),  and overall household spending rose 2.3% YoY (beating consensus and range). On the industrial front, March’s manufacturing PMI gave its best reading since August 2011 and the Shoko Chukin SME gave its best reading for a year.

So the jump in the Leading indicators index isn’t simply a blip: something is stirring in Japan.  But here are two cautions:

• Usually an upturn in the Leading indicators index is anticipated and confirmed by an earlier rise in the Leading indicators relative to the Coincident indicator.  This hasn’t happened yet.
• And do the Leading indicators really tell us about the future, or merely confirm the present? The evidence of the last 20 years or so calls its forecasting value into question.

Returning to those fundamental ratios with which I track all economies (return on capital, labour productivity, leverage, savings flows, monetary velocity, liquidity preference etc), there's only one which is currently surprising. But since it's 'terms of trade', it matters. 

And it matters for Japan particularly, because its international terms of trade have fallen so sharply and regularly over the last 20 years that one has to use a semi-log scale simple to show it correctly. One of the most baffling things about Japan has always been why it has been unwilling or unable to price its goods internationally.  Well, since May 2011, Japan's terms of trade have done a very good impression of stabilizing, after hitting bottom during the commodities frenzy of 2008.  It is tempting to see this as evidence that the bankruptcy of Elpida Memory is not in vain.

At the same time as the unexpected stabilization of Japan's terms of trade, the yen has also given back all the strength against the SDR of the last six months. The result is that not only is Japan's relative ability to price its goods better now than it was in, say, July 2011, but also the yen is less uncompetitive internationally than in July 2011. 

We have virtually no experience in how positively a stabilized terms of trade might affect profitability, cashflow and investment-morale of corporate Japan.  However, we can suspect that the reaction will be rather like that when you stop banging your head against a brick wall. Nice.  And  for now, that seems to be the reaction that Japan's data is picking up.

Fed Policy, Bond Yield and the Investment Cycle

There's a soundbite doing the rounds which sees the build-up of undistributed corporate profits in the US as being a function of the Fed's policy of keeping rates close to zero, and of artificially depressing bond yields. The argument is that the Fed's policy, and its public advocacy by Mr Bernanke, sends businesses the unequivocal message that there's no growth to be expected, so why bother investing. As a result, the US is seeing only a shallow capex upturn characterised only by investment by marginal companies which will evaporate like morning mists as bond yields rise to reasonable levels.

Though I'm no fan of Mr Bernanke's public mugging of Taylor rule earlier this year to allow a phony theoretical justification for any decision the Fed may wish to take, it's worth taking the few minutes needed to nail this argument. First, companies clearly are stockpiling cash, but they are also investing: last year, the annualized growth in private nonresidential investment averaged 8.3%, roughly five times the annualized rate of GDP growth. Second, private nonresidential investment in 2012 accounted for 10.8% of GDP, which is precisely the average contribution since 2000. The numbers simply don't bear out the characterization of a shallow capex upturn.

Moreover, when business leaders are surveyed, they do not seem to echo Mr Bernanke's pessimism. Among large corporations, by February and March the CEO Confidence index had recovered to early 2011 levels, with nearly 73.5% of those surveyed expecting revenue growth this year, and 52% expecting to raise capex budgets. For small businesses, the story of recovered confidence is very similar, with the NFIB Small Business Optimism Index recovering to the highest levels since 2007. True, in historic terms, that's still not very optimistic, but the improving trajectory seems undeniable.

Surveys and opinions can change. What needs challenging is the notion that the Fed's work to keep bond yields artificially low can be expected to actually scare away investment. On the face of it, it seems a silly argument. And when we look at the history, it seems even sillier.

In an earlier post, I constructed a 'fair value model' for US treasury yields normalized for growth, inflation and policy rates, and looked at the deviation of actual yields from those 'fair value yields'. When yields were lower than 'fair value' they represented bad value as investments, when they were higher than 'fair value' they represented good value as investments. I then showed that artificially low bond yields have seemed to have a predictable impact on savings levels and savings surpluses: when bonds represented significantly bad value, savings did indeed dwindle, and when bond yields represented good value, they rose in response.  

Using the model, we can look at how bond yields being lower or higher than 'fair value' has been associated with changes in investment behaviour. The argument being made is that artificially low bond yields will depress investment because of the signal being given out about likely future growth. The alternative possibility is that artificially low bond yields will stimulate investment. So which is it to be?

The graph tracks both deviations from 'fair value' for US 10yr treasuries and deviations from long-term trends for private non-residential investment spending. There's really no doubt about the result:  historically when bond yields have fallen below fair value investment has tended to recover to above-trend, and conversely, when bonds are yielding more than their fair value, investment spending has tended to be choked off. Do not be worried that the relationship is being manufactured by a clever manipulation of axes – there's a negative correlation between movements of the two which is significant at the 1% level.

In short, Mr Bernanke's policy is innocent of this charge, at least. And, oh yes, we should expect the current capex recovery to continue to gather pace this year.   

Shocks and Surprises, Week Ending April 1st

• Domestic demand stirs in Japan, with partial answer from industrial sector.
• All but one report from China discovers sharp deterioration in industrial sector as cashflows and profits cramp. But the official manufacturing PMI reports best conditions of the year!
• Income and spending patterns in the US show savings ratio in retreat, with a correction/pullback in spending likely in the short term. But this is probably not the start of repeat of 2011's 'soft patch', even though regional manufacturing surveys bring bad news.
• In Europe consumers celebrate 'back from the brink' but business discovers recession. Monetary totals flatter as banks' stampede back into government bonds crowds out private lending

Japan: Domestic Demand Stirs

However unlikely it may seem, the flow of data suggests something is beginning to stir in Japan. This week brought positive surprises both from domestic demand, and also from the industrial sector. Retail sales rose 2% MOM and 3.5% YoY, and later in the week overall household spending was reported to have risen 2.3% YoY – the most rapid growth since March 2010. Then on Friday, housing starts jumped to their highest reading since last August. From the industrial sector, the Shoko Chukin SME confidence index improved beyond expectations to its least-negative since March last year (before the earthquake). At the end of the week, the manufacturing PMI came in at its strongest since August 2011, primarily on the back of a jump in new domestic orders (export orders grew only negligibly, owing to weak Chinese demand).

For Japan, this seems almost heady stuff. However, there are at least two reasons for celebrations to be muted. First, the improvement in the industrial sector has not yet shown up in industrial output, which fell 1.2% MoM and rose only 1.5% YoY – both in line with expectations. Second, and more disappointing, investment intentions revealed over the weekend in the Tankan show no sign of cyclical recovery – investment intentions for FY12 are no better than flat.

China: Industrial & Cashflow Deterioration is Contested

In China the balance of evidence suggests a quite sharp deterioration in industrial conditions – although it should be stressed that the evidence is actually contested. However, the clearest signal came at the beginning of the week, when China reported that although revenues rose 13.4% YoY during Jan-Feb, industrial profits dropped by 5.2%. A drop in profits is absolutely compatible with topline revenues growing more slowly than the c20% YoY rise in capital stock. It is also compatible with the sharp cramping in cashflows that we've tracked through the economy over the past couple of months.

Then came a spate of manufacturing surveys. The MNI Business Conditions survey was disappointing in its preliminary version: but the final version was even worse, with significant downward revisions on new orders and current production, and a real collapse in expectations of future orders and production. This was followed over the weekend by the HSBC/Markit manufacturing PMI which also recorded the fastest decline in new orders so far this year, led by domestic orders. In response to that, manufacturers reportedly are cutting both staff and purchasing of materials.

Despite all this, the official manufacturing PMI came out with the best reading of the year – an improvement far outside the range of expectations. It reported sharp rises in output and new orders (though only a slight improvement in export orders), with backlogs of work, purchases and employment all rising.

This official reading clashes with everything else being reported about China's economy.

US: Probably Not the Start of another Soft Patch

The most striking data this week was the divergence between monthly personal income and spending data. Personal income growth seems stuck at around slowed to just 0.2% MoM, leaving the 3ma stuck at 0.3% for the third month in a row. Meanwhile, personal spending jumped to 0.8% MoM, which in turn depressed the personal savings ratio to just 3.7%, the lowest rate since January 2008.

On the face of it, this is unsustainable, and we should expect an early reversal of these patterns, and in particular some short-term weakness in personal spending. However, notice also that since there appears no threat to the a rate of personal income growth which has been effectively steady for a full year, the expected oscillation of spending over the next couple of months is unlikely to herald a significant slowdown, or a re-run of the 'soft patch' we saw emerging this time last year.

In addition, it's now clear that there's a very steady downward trend in the US personal savings ratio, which has been largely uninterrupted since the middle of 2010. If this continues, it means the expected reversion to trend is unlikely to take the require the savings rate back to anything much above the 4.3% recorded in January.

But the second trend from the US this week is more worrying – a further clutch of regional manufacturing surveys which have shocked on the downside, and all of which have reported a sharp deterioration in new orders (this despite an unexpectedly positive 1.4% MOM rise in shipments of capital goods (excluding defence and air). These shocks arrived from Dallas, Richmond, Kansas and finally Milwaukee. Of the regional manufacturing surveys this week, only the Chicago PMI managed not to disappoint. Given that consumer sentiment surveys are still solid (the University of Michigan survey surprised on the upside this week), labour markets still improving, and consumer credit totals still rising, it seems harsh for the moment to interpret these manufacturing reports as heralding a soft patch. Nonetheless, they are slightly unnerving.

Europe: Relief and Recession

Signals from Europe continue to show a contrast between buoyant popular hope that the Eurozone crisis has been solved, or at any rate postponed for now, and the business realisation that the price of that stabilization is recession. Thus French and Italian consumer confidence surveys surprised on the upside (though German and British surveys disappointed), but surveys of Eurozone business confidence deteriorated worse than expected both for the general climate, and also specifically for the industrial sector.

These contradictory signals have been emerging for the past few week: in truth, a greater proportion of economic data from Europe conformed to expectations than for several weeks, suggesting that the worst of the shocks are indeed behind us for now.

Finally, no account of Europe's data this week can miss the data which showed Eurozone M3 growth accelerating to 2.8% YoY in February – an acceleration fuelled by the ECB injections of Eu1tr+ of cheap 3yr credit (Eu489bn before Christmas, Eu 530bn at end-Feb). This was the strongest M3 growth since September, and the third month of acceleration.

But the recovery is entirely  a public sector affair: liabilities to government rose 5.4% YoY, but liabilities to the private sector rose only 2.2% YoY (down from 2.8% in January).  On the asset side of the balance sheet, credits to government rose 6% YoY, driven by a 13.1% YoY jump in holdings of government bonds. By contrast private sector credits nudged up just 0.3%.

Drill down to the banking sector data, and the dynamic is obvious: in the last two months, loans to the private sector have risen Eu2bn only, whilst banks have added Eu120bn to their holdings of government bonds.  Holdings of government bonds are now equivalent to 19% of all private deposits, up from 16.9% in July 2011, and are growing at 5% a year. Loans to the private sector, meanwhile are growing at 0.5% YoY. Most of the ECB’s cheap credit has simply been re-deposited back in the ECB. But by offering huge incentives to prop up ailing Eurozone government bond markets, the ECB has also inadvertently underwritten a massive crowding out of private borrowers – one which is now intensifying Europe’s credit crunch.