Is Britain Overheating?

The 'narrative' of public discourse in Britain is so utterly unmoored in checkable economic data as to be positively delusional. For example, it is astonishing that today's news that Britain had a deficit of £20.8bn in 2Q – that's largest deficit Britain has ever had – barely generates a headline, let alone the alarm it should do. It is missing from Bloomberg's TOP UK, it is missing from Reuters UK headlines, and Google records the only online newspaper which seems to have noticed it is - god help us – the Guardian.

So it's possible you haven't seen that Britain's 2Q deficit in traded goods hit a new record of £28.1bn, and its deficit on international income expanded to £5.2bn – also a record. And you'll almost certainly not be reading that the estimate of the 1Q deficit is revised up to £15.4bn from the previous £11.2bn estimate.

However, this current account deterioration matters a lot, for two reasons:

It suggests that, for whatever reason, Britain's economy is consuming and investing more than it is earning, and at near cyclical extremes. As the chart below shows, Britain had a current account deficit of 3.1% of GDP in 2Q, and 3% of GDP in the 12m to June. The chart also shows that these are historically peak levels: it's where Britain was trading just before the near-recession of 2001, and it's where Britain was trading at the peak of the cycle in 2007.

Secondly, it tells us that Britain's private sector is no longer producing a savings surplus. In fact, during 1H2012 the private sector had savings deficit of £1.2bn, compared to a surplus of £32.65bn during the same period last year. This is an absolutely crucial development, since it means Britain's private sector no longer has a positive cashflow with the banking sector, and that recent levels of domestic demand (consumption, investment) have been running in excess of income (wages, profits). Unless the private sector can now sustain a savings deficit, we should expect British domestic demand to slow from here. What will it take for the private sector to sustain a savings deficit? Simple: a positive flow of cash from banks to the private sector – new lending in excess of new deposits being taken. How likely does that sound?

Of course, all this drives a coach and horses through most of the public 'narrative' about Britain's economy – of how the economy is dying for lack of demand, how more fiscal 'stimulus' is desperately needed, and how only more 'quantitative easing' can save the economy. In fact, it suggests an alternative narrative: that for want of productive capacity, Britain's economy is starting to overheat.

Delusional? Surely no more so than the other narratives we are invited to entertain.

Three Shocks & Surprises to Think About

Here are three of the shocks & surprises of the last week which look genuinely interesting - each of them worth following up in greater detail.  

1. The continuing collapse of Eurozone consumer confidence.  This is deteriorating far faster than the monthly data on retail spending, auto purchase etc suggests. 
2. The truly startling improvement in Spain's trade balance.  For the first time since the Euro was introduced, it looks like Spain is earning a current account surplus - and not just because imports are falling. 
3. China's August property prices. After the spectacular break-out in July, August's data tells us the authorities managed to retain control - absolutely necessary to broaden China's surprisingly narrow range of policy options.  

1. Eurozone Consumer Confidence September’s Consumer Confidence fell to the glummest reading since May 2009. This matters because the index has a good track record as a directional indicator, and because for the last nine months European demand has held up better than the erosion of confidence suggested. Bottom line, 4Q domestic demand looks extremely vulnerable.

In the chart, the domestic demand momentum indicator tracks retail & vehicle sales, labour markets and, where possible, real estate and construction data in Germany, France and the UK. It displays the results as an aggregate number of standard deviations from historic seasonalised trends. The surprising strength over the last three months originates solely in the Britain, whilst the most obvious signs of new weakness are showing in Germany. France, meanwhile, has been slowing gently but uninterruptedly since July 2011.

2. Spanish Trade Balance: Even if some combination of ECB largesse and sustained fiscal austerity manages to put the Humpty-Dumpty of the pan-Eurozone banking system back together, the Southern European nations still won’t be able to compete within the Eurozone or in the rest of the world, whilst hobbled by a currency far stronger than their economies would justify. That’s the underlying problem. Or is it?

Quietly, Spain’s trade data is beginning to improve so strongly that it begins to look as if Spain can compete, and is competing, successfully. So far this is overlooked – there is so little interest that the market cannot even muster a consensus forecast! The improvement isn’t just reflecting collapsing import demand. July’s data showed exports up 5.2% yoy, imports up 5% yoy, and the trade deficit falling to just Eu1.69bn. Almost certainly this means that for the first time since the introduction of the Euro, Spain will have earned a current account surplus in July! More, as the chart shows, over the last three months, Spain’s trade deficit is equivalent to just 10% of exports – fundamentally a modest imbalance. But if Spain can compete well enough to earn a positive cashflow in its transactions with the rest of the world, the Euro’s underlying problems look less impossible than common sense would suggest.

3. China Property Prices: The important message from August’s 70 cities price indexes is one of control.  The chart shows the net total of cities where the price of new homes rose during the August, minus those where prices fall – a net reading of +16. This is a retreat from July when prices rose in 49 cities and fell in only nine – a net +40. This surprise was a striking reminder that property is still seen as one of the few   potentially explosive saving/investment vehicles available to urban Chinese. And the authorities view that, correctly, as a potentially major political headache. Explosive property prices create political dissatisfaction, imploding property prices compromise the banking system and local government finances. So the ‘disappointment’ of the pullback in August is probably reassuring to China’s policymakers. After all, they spent most of August actively trying to dampen the market. If August’s data tells them have succeeded in taming the market without eroding the financial system, it helps the core agenda of financial reform, as well as making modest policy accommodation easier.

Three That Matter from Last Week's Shocks & Surprises

I think the three most important Shocks & Surprises from last week's data were these:

1. The 1.2% mom fall in US Industrial Production

2. No fewer than three  surveys indicating a major rebound of US economic confidence in September, plus another finding the same thing for August. 

3. Japan's Y625.4bn July current account surplus - far bigger than expected, but only a flea-bite on what's needed to fund the fiscal deficit. 

US Aug Industrial Production: The 1.2% mom fall in output during August was the worst result since March 09 – but the size of the fall itself is not the main feature. The sharpest falls were in utilities (down 3.6%) and mining (down 1.8%), but manufacturing contracted 0.7% mom.  Output of consumer goods fell 1.2%, materials fell 1.5%, industrial supplies fell 1.3% and business equipment fell 0.2%.Worst hit were vehicles (down 4%), but apparel/leather, plastic and rubber products, metals products and machinery also suffered. 

The fall didn’t come out of the blue, but rather reflects an attempt to adjust output to the lower levels of demand seen in recent months. In the six months to July, output momentum has been 0.26SDs above trend, but sales have been 0.15SDs below trend, exports have been 0.07SDs below trend, and inventories have been only 0.08SDs above trend. August’s weakness reflected an attempt to move back towards short-term equilibrium. Absent a sharp pick-up in domestic or foreign demand, or a vigorous re-inventorying program, the short-term adjustment in output is unlikely to have been completed.

Here's the chart which summarizes the situation: note that the last two times the momentum of output has significantly outstripped sales and inventories, without a compensating surge in exports, the industrial cycle slowed sharply. That's the threat in August's data, and it is repeated again in today's Empire Manufacturing Survey shocker - the first glimpse we've got of conditions in September.

2. US Sept Economic Confidence: If industrial data for August was shockingly poor, no fewer than four surveys found evidence of a major unexpected bounced in economic confidence: three for September, one for August. The chart amalgamates the three for September: in aggregate these were the most bullish readings since mid-2007. The three are: i)the University of Michigan’s prelim consumer confidence index, which was the strongest since Oct 2007; ii) the RBC Consumer Outlook index, which recorded its highest reading since the end of 2007; iii)  IBC/TIPP Economic Optimism index, which was the best since January 2011. 

The three indexes didn’t agree on why the US had cheered up so suddenly – Michigan and IBC/TIPP found expectations about the economy had improved whilst current conditions were stable or even deteriorating; RBC found the reverse. In addition, the NIFB Small Business Optimism Index’s August survey also recorded a recovery from recent lows.  

If US economic optimism is indeed recovering from the 2Q ‘soft patch’ it is important economic news, because the slowdown so far this year has been driven by a largely inexplicable rise in the private sector savings surplus, which has eroded domestic demand. In short, improved confidence could allow for a reversal of that trend and a rapid snap-back in domestic 

demand.

  

3. Japan July Current Account: What will it take to preserve Japan’s private sector savings surplus? July’s Y625.4bn current account surplus was sharply higher than expected, mainly reflecting a jump in the international income surplus to Y1,442bn, from Y580bn in June. But as the chart shows, even this surprise made no dent in the current rapid erosion of Japan’s savings surplus. During Jan-July, Japan’s entire private sector savings surplus has come to just Y1.77tr, whilst the amount of JRBs in issuance has risen by Y19.93tr. Evidently private cashflows alone are no longer supporting the market, but during the same period BOJ’s net holdings rose by Y8.32tr.

China - What Loosening?

• China's monetary data for August confirmed once again that no significant loosening of monetary conditions is yet underway, even if June-July represented the nadir of the current policy. Without such a loosening there is no reason to expect any recovery of domestic demand momentum during the rest of this year (or early next year, for that matter). 

• So far, the determination to push ahead with a fundamental economic restructuring accompanied by financial liberalization is trumping market demands for organized credit relief. But that means there's no short or medium term prospect of significant domestic recovery. China has chosen a truly hard road.

August's monetary data reported M1 growth slowed to 4.5% yoy, which was below the range of expectations, M2 growth slowed to 13.5% (from 13.9%), but new yuan loans rose by 704bn mom yuan, which beat the 600bn yuan expected. There were no great revelations here: the 0.9% mom rise in M1 was 0.32SDs below seasonal patterns, and the 0.6% mom rise in M2 was 0.26SDs below seasonalized trends. As a result, there was no change in liquidity preference (M1/M2) which continues to fall through historic lows (on a seasonalized basis). We can conclude that transactional and speculative demand for money is not yet recovering.

Similarly, although new yuan loan rose Y700bn mom, and 16.1% yoy, which was slightly more than consensus expected, it only conforms (nearly) to historic seasonal patterns – though this is the first time this year this has been achieved.

However, the price of that is continuing negative cashflow for China's banks, since those Y700bn in new loans were is Y200bn more than the Y500bn in the month's new deposits. As a result, bank loan/deposit ratio rose 50bps mom to 69% - the highest since January's seasonal high.

With reserve ratios not having been cut since May, the loan/available deposits ratio also rose, by 52bps mom to 86.2%. And so the dwindling of Chinese banks net deposit inflows continues, falling to 1.19tr yuan in the year to August 2012 from 3.266tr yuan in the same period last year. When one takes into account adjustments in reserve ratios, the net inflow slows to just 442bn yuan – a modest release of the brakes compared to the net outflow of available deposits of 2.322bn yuan in the same period last year.

One result of this that both real and nominal interest rates are rising. During the last month, 3 month bill rates have risen 26bps to 2.52% and three-year yields have risen 35bps to 2.91%, and they have coincided with the retreat in CPI inflation. Real 10yr yields are once again positive at around 1.5%, which is the highest they have been since late 2009. This is, of course, consistent with the aim of reasserting monetary order in China as a necessary precondition for gradual financial liberalization. But it is not monetary easing.

I measure changes in monetary conditions by tracking four aspects of money:

• how much of it there is (monetary aggregates)
• how much it costs (real interest rates)
• the volatility and underlying strength/weakness of the currency's international value
• the changing shape of the yield curve

Taking these factors together, one can see that conditions have been gradually but consistently deteriorating since the end of 2010, eventually reaching a position of severity similar to that reached in late 2008. The nadir seems to have been reached in May-June, and in the subsequent two months, although conditions remain historically tough, there has been a very modest improvement  

In China, monetary conditions remain the single most important factor determining momentum of domestic demand. The domestic demand indicator in the chart below averages sequential deviations from underlying seasonal historic trends in retail sales, urban investment, auto sales, real estate climate and total traffic volume.

If previous patterns are maintained, we can expect the slump in domestic demand to bottom out over the next couple of months. But, with no significant recovery in monetary conditions, there is no reason to expect any recovery of positive demand momentum any time this year.

  

Corporate Japan's Cashflow Vs the Calls Upon It

This week's release of Japan quarterly balance sheet and p&l survey by the Ministry of Finance reminds us again of how difficult it is becoming to sustain Japan's public finances, even at a time when the corporate sector is managing itself conservatively and well.

The Good News

The quarterly survey gives us the most detailed insight available into how corporate Japan is managing itself: uniquely, one can conduct a Dupont analysis on what amounts to virtually the whole corporate sector. And it is striking how much good news corporate Japan can eke out even in a tough global economic environment. Sales were down 1% yoy in 2Q, and down 0.9% on a 12ma, but operating profits were up 14.2% yoy.

In terms of operating margins, the last year has been a story of a marginally difficult trading environment (COGS/Sales up 0.3pps yoy) offset by much-improved discipline (SG&A/Sales Down 0.7pps), achieved mainly at management level rather than simply by sacking personnel (Personnel Expenses/Sales ratio fell 0.2pps).  

Meanwhile, the multiple of sales per employee to total expenses per employee has risen steadily from the recent nadir of 4Q11 and continues to recover. This obviously will tend to sustain labour markets.

The trading environment makes it difficult, but with total assets down 2.2% yoy whilst sales were down 1% yoy, a slow and modest recovery in asset turns is being made. There is evidence of balance sheet discipline: bills and A/R were down 1.1% yoy, whilst inventories were down 5% yoy: together these accounted for a quarter of the fall in total assets.

Finally, the financial leverage ratio (total assets/equity) fell to 2.81 in 2Q12 from 2.86 in 2Q11, and the net debt/equity ratio fell to 62.6% in 2Q12 from 67.5% in 2Q11, with corporate Japan cutting its net debts by Y24.3 trillion during the year.

The net result is that both ROE and ROA have just about been restored to where they were before the earthquake/tsunami/nuclear crises disrupted the economy. A job well-done then? In the uniquely difficult circumstances corporate Japan has been facing, yes.

The Consequences and Cashflow

But in a way, that's the problem, as we can see when we look at the cashflows. With ROE and ROA in recovery thanks to generally improving Dupont ratios, the Japanese economy should be enjoying the cashflow results. And so it is: using change in net debt plus investment in plant and equipment as a cashflow proxy, corporate Japan's cashflow rose 57.1% yoy in 2Q12, and 32% yoy over the 12 months to June, to Y63.0tr.

But the cash is being spent, with investment in plant and equipment up 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.

It is not just rising ROA which is responsible for that cash being spent:

1. Japan's capital stock is depreciating away: depreciation rose by 4.7% in the 12m to June. Simply to maintain current levels of capital stock demands re-investment of at least that much. To put numbers on it, depreciation allowances totalled Y8.53tr during 2Q, whilst investment in plant and equipment totalled Y8.3 tr. In the full 12 months, deprecation of Y36.66tr was answered by Y38.73tr in investment in plant and equipment. That investment accounted for 62% of cashflow.
2. Nonetheless, the amount of cash on corporate Japan's balance sheet, at 10.7%, is the highest it has ever been since the unwinding of the Bubble year's zaiteku financial games. Return on assets may be low at around 3.15%, but keeping cash on the balance sheet is even less attractive.

The result is that investment in plant and equipment is rising: 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.

But there are plenty of calls on corporate Japan's free cashflows, so that Y24.27tr needs to be put into two contexts.

First, how that net paydown of debt corresponds to movements in the Japanese banks' balance sheets. This will allow us to infer what must be happening to cashflows from the non-corporate sector. Bank of Japan data tells us that in the year to June, bank deposits rose by Y13tr, whilst the loan-book expanded by Y4.5tr – a net deposit inflow of Y8.5tr. But since we also already know from the MOF's quarterly survey of balance sheets that the corporate sector cut their net debt by Y24.27tr (ie, were responsible for a net deposit inflow of Y24.27tr), it must be that everyone else (mainly government and households) cut their deposits by a net Y15.8tr.

This is important: excluding the corporate sector, Japan is running at a savings deficit. The data simply doesn't allow much room for a net flow of savings from the household sector any more.

Second, how does the corporate sector's Y24.27tr in free cashflow compare to the amount of debt the government needs to raise? Here are the sums: in the year to June, the amount of JGBs in issuance rose by Y21.5tr and the amount of short-term financial bills rose by Y4.86 trillion. In all, the government needed to sell Y26.36 tr of its debt. Essentially all of the corporate sector's free cashflow. . . . and then a little bit more.

I have previously noted that Japan's private sector savings surplus looks to be in terminal decline. Indeed, from what we know now, it is rather surprising that it managed even the Y15.72tr surplus recorded in the year to June. What our ramble through the corporate sector's balance sheet reminds us, though, is how precarious the balance now is, even at a time when the corporate sector is managing its operations and balance sheets well during a difficult environment.

It raises the question quite urgently: unless corporate Japan is willing to stop re-investing, and thus see its operational asset base shrink, can we expect it to continue to finance Japan's fiscal deficits? And if not the corporate sector, who?