Japan: Welcome Back the LDP?

The LDP is back, this time armed with a mandate for aggressive fiscal and monetary expansion. It has long been my view that the LDP's decades-long efforts to bankrupt Japan would eventually be crowned with success. But as it moves re-occupies Nagatacho this time the world has changed. Most fundamentally, almost without exception its trading and investment partners are operating far below what used to be thought of as levels of potential output eagerly seeking any source of extra demand. Secondly, the major developed nations of the world have all despaired of traditional monetary policy instruments and/or effective supply-side reforms, and - not coincidentally - have central banks which are committed to financing more or less directly fiscal policies which are plainly unsustainable in the long-run.  

After decades of finger-wagging at the LDP's fiscal incontinence, Western governments find themselves facing problems which Nagatacho's politicians have known all their active political lives. As I put it, we're all in Howl's Moving Castle now.  So whilst Japan's actual financial is be worse than ever, it is no longer the sad and isolated exception it had become. Rather, it is merely further down the road much of the developed world is travelling: its government more indebted, its deflation more entrenched, its financial confidence more fully evaporated, and its demographic decline more advanced. 

So  if the Shinzo Abe is really prepared to double-down on 'irresponsible' fiscal and monetary policies once again, the success or failure of the gamble matters for politicians all over the world. 

This piece extends the analysis contained in this week's Espresso, to look briefly at some of the cyclical and structural features of Japan's economy Abe inherits.  It reaches conclusions which are slightly less negative than I expected. 


1. The Starting Point: Momentum  What condition will Shinzo Abe’s LDP find the economy in, and what are the constraints on, and opportunities presented by, the promised newly aggressive monetary and fiscal policies? I hope these four charts help. The first summarizes a mass of industrial, monetary and domestic demand data, showing 6m deviations from monthly seasonalised trends. 

The industrial indicator finds the current downturn in momentum is actually worse than after the March 11 earthquake/tsunami disasters (this measure includes output, exports, inventory/shipments and capacity utilization).  Japan's manufacturers are enduring a grim 2H12, with output falling 5.8% yoy in the 3m to October, and its exports falling 7.6% on the basis,  whilst inventory/shipment ratios rose a full standard deviation above the post-2007 average, and capacity utilization rates sank to half an SD below the same trend.

Despite the industrial weakness, domestic demand is just about holding steady to the underlying very weak trend. This measure include employment, wages, retail sales, auto sales, construction orders and service industries’ activity. What's propping up the indicator are surprisingly-strong labour markets: by October, employment was up 0.9% yoy (and more than a full standard deviation above post-2007 trends) and the monthly rise in cash earnings was also about half a standard deviation higher than trend. But there's little sign this relative strength is carrying through to final demand: auto sales were down 10.8% yoy in October, retail sales were down 1.2% yoy, construction orders were down 2% yoy.  Worse, the 4Q Tankan found companies are becoming increasingly worried about overstaffing. 

Finally, monetary conditions are only mildly positive, accurately representing that current quantitative easing policies are no major departure from Japan’s historic norms. They offer no salvation for the fragility of demand or industrial sector momentum. By November, M3 growth had sunk to 1.9% yoy, which is the lowest since 2009.  

What can Mr Abe conclude as he enters office: that the industrial sector is under considerable stress, and that its continued weakness may undermine the fragile stability of domestic demand. Finally, that current monetary policies are unlikely to help much.

2. Debt & GDP  On all traditional assumptions and measures, Mr Abe has extremely limited rooms for policy-manoeuvre. Here’s the chart which is the default worry for Japan: nominal GDP peaked in 1997 and 15 years later is 8.1% smaller, with no positive growth trend. Meanwhile, after stabilizing during 2005-2009, public sector debt is once again soaring, rising to about 225% of GDP (nb, this is my best attempt at counting public sector debt – it’s not easy: this includes taking into account FLP loans, whilst discounting net BOJ holdings of government debt).

We are already in unchartered territory, and there seems no likely exit from it rapid nominal GDP growth. And we know that Japan’s traditional combination of monetary accommodation, fiscal expansion and supply-side immobility does not deliver that. Historically, however, Japan has sustained structural private sector savings surpluses, encouraged by decades of financial repression, which have provided the cashflows needed to buy the debt issued by the government to finance its deficits. As a result, at end-Sept 2012, only 10% (exactly) of the stock of JGBs was owned by overseas investors, Bank of Japan flow of fund tables show. Whilst foreign investors might doubt Japan’s fiscal credibility, the audience that matters is overwhelmingly domestic.   

3. Private Sector Savings Surplus  But might that be changing? The days of big and reliable savings surpluses are over, exhausted mainly by the aging of the population (pensioners may scrimp, but they rarely save), and partly owing to the declining competitiveness and terms of trade of the corporate sector. To put some numbers on it: in the 12m to September Japan’s private sector savings surplus came to just Y7.746tr, whilst total outstanding JGBs rose by Y28.70 tr. In other words, the private sector savings surplus could finance only 27% of the debt, leaving the rest to come from a combination buying from Bank of Japan and overseas investors, and a financial system willing to sell other assets in order to finance JGB buying.

This sounds dreadful, but there are reasons why disaster has been slow to overtake Japan. First, obviously, holding only 10% of the JGB stock, foreign investors are not in a position to lead the market. Second,  Japan’s post-bubble financial history has bred a deep financial scepticism and risk aversion amongst Japanese savers, and Japanese financial institutions. This risk aversion naturally sustains a ready market for government bonds (rather than, say, equities or real estate). Third, the average debt-maturity bequeathed by decades of savings surpluses is high, at an average seven  years and one month.  Fourth, the government and bureaucracy retain a large degree of influence over the financial system, both directly and indirectly.  In other words, the cashflows have deteriorated, but the balance sheet defences are strong.     

To all this we can now add a fifth factor: right now, government debt markets the world over are sustained by ‘quantitative easing’. The days when bond yields were set by markets in order to discover the balance between supply of savings and the demand for them are, at the end of 2012, a receding memory.  Worrying about the erosion or evaporation of private savings flows is so. . . . . pre-Crisis. The world’s governments and central banks have set out to greet Japan. We’re all in Howl’s Magic Castle now.

4. Source of Profits  All this is known, and seems ultimately likely to prove disastrous. But in the meantime, the automatic assumption that these desperate monetary policies will immediately destroy currencies is no longer so easy to make. The key is in what we can expect to happen to Japanese corporate profitability (and thus cashflows, and the private sector savings surplus) under greatly expanded monetary accommodation and fiscal expansion.  

This is where it gets interesting, because it is not difficult to construct scenarios in which such expansion produces a benign spiral. Consider, for example, the source of Japanese corporate profits. By juggling economic definitions of GDP, one can isolate the major components of profits. These are: i) consumption minus wages; ii) exports minus imports; iii) government spending minus taxes; and iv) investment. 

As the chart shows, at the margin, what is driving profits is the excess of consumption over wages (ie, wage restraint), and the fiscal deficit, whilst the deteriorating trade position is sapping profits. If Abe does indeed put in place far more fiscal and monetary policies, one will see profits attributable to the fiscal deficit rise sharply (by definition), and one would expect also to see investment rising as well. If economic confidence is engendered, the contribution of consumer (vs wages) might be expected to be maintained, whilst the trade balance would deteriorate. With three profit factors rising vs one falling, it is reasonable to expect the market to anticipate and price a rise in profits.

And in those circumstances, rather than financial Armageddon, we may see the opposite – a bull market sustained by inward foreign investment.  

Bullish? Not really – merely a reminder that where Japan is concerned foreign investors are well informed about fear, but may yet discover the imagination needed for greed. 

German Industrial Demand, US Consumer Confidence, HK's PMI and China Demand

Here are three loose ends from last week's economic data worth a moment's reflection:

• German Industry Demand: The wildly contradictory lessons from very weak industrial production but very strong factory orders in October on balance suggests a short-term upward industrial inflection point.
• US Consumer Confidence: The collapse in December's consumer confidence measures - part post-election buyer's remorse, partly the shadow of the fiscal cliff - will probably be effaced by the slowly improving underlying fundamental dynamics of domestic demand.
• Hong Kong PMI:  November's PMI broke out and up from trend - Hong Kong is catching the leading edge of China's modest domestic demand recovery.  At the least, it justifies the Hang Seng's rally.

1.Germany Industrial Demand  It is no exaggeration to say that the industrial news from Germany this week was the most contradictory in its 21^st century to date. On the one hand, industrial output fell by 2.6% mom in October, which was the steepest monthly fall since April 2009. But at the same time, factory orders jumped by 3.9% mom – the steepest rise since January 2011. 

The contradiction between the two is intense: output of capital goods fell 4.3% mom, but orders for capital goods jumped 4.5%; output of intermediates fell 1.1%, but orders for intermediates rose 3.4%; output of consumer goods fell 0.9% mom (and 6.2% for consumer durables) but orders for consumer goods rose 2.1%.

What to make of the contradiction? Construct an orders/output index from this data, and you find the October combination has generated the single biggest monthly leap so far this century, returning the index to ‘normal’ levels. This index isn’t quite a book-to-bill ratio, but it is closely related, and in the past has anticipated near-term changes in direction of German output. The upshot is that the succession of grim output data from Germany (four contractions in the past five months) looks likely to be reversed in the coming 2-3 months. 

2. US Consumer Confidence  The looming fiscal cliff has meant that buyers’ remorse is more likely to feature in confidence surveys than any post-election surge in hope. And so it has proved, with both the Uni of Michigan’s preliminary reading and then the RBC Consumer Outlook index for December both slumping to the lowest levels since August, worse than expectation and trends respectively. The preliminary Michigan survey isn’t rich in detail, but December’s fall reflected a collapse in the economic outlook index to 64.6 from 77.6 in November – the biggest single-month reversal since March 2011, leaving the index 2.2 SDs below the 2001-2007 average.  The RBC survey was less clear-cut, the fall in the index was driven simply by a downward revision in spending plans, whilst employment expectations and investment plans deteriorated only mildly. 

How seriously should one take this reversal in December’s confidence surveys? Two things to bear in mind. First, they are interrupting a modest but by now fairly entrenched recovery in hard domestic demand data, visible since August.  The statistical nonsense of Nov’s unemployment rate aside, non-farm payrolls are growing around 1.4% a year (and about half a standard deviation above post-financial crisis norms), although this is not accompanied by real wage growth; auto sales by November were running at 21.6% yoy; and October’s retail sales grew at 4.6% yoy, with underlying 6m momentum trends turning positive for the first time since May. 

Second, even after the shocking falls in December, confidence is still higher now than it was throughout most of the last two years, reflecting a slow and steady recovery. It was the spikes in confidence  during October and November that look anomalous as much as  December's relapse.

Third,  since mid-2011, confidence surveys have done a very bad job in tracking the trends in domestic demand.  Provided the fiscal cliff is negotiated, one should place more faith in the hard data trends than in these confidence surveys.

3. Hong Kong PMI, China Demand and HSI Hong Kong regularly catches the winds from China, and the mild breakout from trend in November’s PMI echoes the improvement in domestic demand data from the mainland. In fact, at 52.2 HK’s PMI was above the l/t series average of 51.1 and was the strongest improvement in nine months.  New orders rose for the first time in four months, helped by new orders from China. Although input prices rose at the fastest pace in eight months, firms were able to raise their output prices for the second successive month, at the fastest pace since Oct 2011.  Meanwhile Chinese domestic demand data continued to recover in November, with retail sales rising 14.9% yoy and industrial production rising 10.1% yoy – both faster than consensus expected. 

If China is the underlying factor driving Hong Kong’s PMI, the result shows up in the Hang Seng Index: between January 2008 and November 2012 monthly changes (first difference) in the PMI and the Hang Seng have a correlation coefficient of 0.43, which sails through a 1% significance test. Sadly, though, these two seem to have a strictly coincident relationship, with no useful leads or lags. The best that can be said is that HK’s strong November PMI does not contradict or undermine the Hang Seng rally.

Outlook 2013 - Eurozone

GDP growth forecasts made to within a few 10s of basis points are, quite obviously, not meant to be taken entirely seriously. But getting the trend right is important, even if difficult. Today the ECB cut its forecasts for Eurozone GDP for 2012 and 2013, giving a range of minus 0.9% to +0.3% for 2013), whilst assuring us that a recovery should start 'later in 2013' with sufficient strength to produce growth of 0.2% to 2.2% in 2014. Are they likely to have the trend right?

You will have to scroll down for my conclusions. But it's fair to say they are not cheerful.

Here's how I set about narrowing the odds on getting the trends right. The unknown unknowns will always surprise us, and plenty of the known unknowns will do too, but the starting points I use in determining the outlook for 2013 are these:

1. What are the trends in the structural underpinnings of the investment cycle
2. Are they likely to change, or be changed?

Returns on Capital & Labour

And the starting point for the investment cycle (and thus also for employment) is shifts in returns on capital and labour. To estimate whether returns on capital are likely to be rising or falling I use a crude asset-turns model, first estimating the stock of capital by assuming all gross fixed capital formation is depreciated over 10 years, and then expressing nominal GDP as an income from that stock of capital.

For the Eurozone, it seems return on capital has been broadly stable for the last 2 years, managing a very modest rise during 3Q12. But there are three things to notice. First, that stability has been won only by allowing growth of capital stock to slow: on my calculations capital stock growth slowed to 0.5% yoy by 3Q, but it took a fall of gross fixed capital formation of 3.2% yoy in 3Q to achieve this slowdown. Second, by pre-crisis standard, ROC remains at historically low levels. Even if one knew nothing else about the Eurozone economy, one would expect that the current pattern of falling capital investment necessary to maintain currently sluggish rises in ROC would be maintained.

Germany's Cycle is Not the Eurozone's Cycle

The third point is that Germany's situation is not the same as in the rest of the Eurozone. In Germany, the ROC may be flat, but it is also at historically quite high levels – higher, indeed, than before the financial crisis. As a result, capital stock is still growing, by around 2.3% yoy. Meanwhile, outside Germany, ROCs are hardly rising from historically very low levels, and there is no longer any growth at all in capital stock. Given these differences, one would expect German investment and growth to continue even as recession continues and deepens in Eurozone-ex-Germany. To be clear: on this basis we can and should expect Germany's investment cycle to be maintained even as the rest of the Eurozone's fails to recover. Germany's economic preponderance over the rest Eurozone will intensify during this stage of the cycle.

And where investment leads, employment follows. During the early stages of a recession, companies lay off staff faster than they can reduce their stock of capital, so in the early stages of a recession labour productivity tends to rise. Subsequently, changes in labour productivity tend to normalize, with changes in output per worker usually simply reflecting changes in capital per worker. When one adjusts to take account of changes in capital per worker, you also find that changes in employment tend to follow changes in labour productivity – as one would expect.

In the Eurozone's case, the news isn't entirely bad. Yes, labour productivity (adjusted for capital per worker) is declining, but on a 12m basis the fall is rather modest compared with pre-crisis normality. And that surprisingly good productivity performance does seem to be providing a backstop for employment so far: the fall in employment during 2012 has been far less pronounced than during the initial phase of the crisis. If these trends can be maintained, the relatively modest rise in unemployment seen so far this year may not accelerate too much next year. (Considering the background, the rise in unemployment rate is modest – from 10.6% at the end of 2011 to 11.7% by October).

(NB. Believe it or not, Europe's unemployment trends are one of the less-dark parts of this picture.) The flip side is that this is also where there is room for disappointment / shocks).

Structural Issues – Money and Financial Institutions

In the absence of other structural issues, these relationships would tend to set the cycle direction. But of course, the Eurozone is a nest of intractable structural issues which concern the relationship between the economy and the Eurozone's financial institutions, and the relationship between the Eurozone's citizens and money. These issues are absolutely fundamental to decisions to save and invest, and so cannot be ducked.

The first issue can be stated quite simply: the Eurozone's financial institutions apparently have insufficient capital (or believe themselves to have insufficient capital) to buy or create risk assets. In addition, their deposit customers are currently reluctant to take the credit/duration risk of making longer-term deposits. Taken together there are two consequences: first, when the private sector secures a positive cashflow, any money they put into the bank is not re-lent to the private sector, so private sector credit contracts. Secondly, partly because these savings are not re-allocated to the private sector (but rather are merely lent to government), the total efficiency of money allocation falls, which we can see expressed in a fall in monetary velocity (GDP/M2). The lack of bank capital not only means a smaller proportion of savings are allocated to investment, it also means that the proportion which is on-lent is also allocated with decreasing efficiency (ie, with less marginal positive impact on GDP).

Structural Issue: Money, Fear & Savings

The second, and related, issue is the change in the relationship between the private sector and money, and in particular the impact of financial risk aversion. When people (or companies) are in the grip of financial fear, they will try to save more, and, having saved, will be cautious about how those savings are stored. We can track the rise of the savings impulse via movements in the private sector savings surplus; the second can be inferred from changes in the types of money people keep. In particular, we can track changes in the proportion of their money people/companies choose to keep in cash (ie, liquidity preference).

The trends of 2012 are very clear: both the rise in the private sector savings surplus (from 4.1% of GDP in 2011 to 4.8% in the 12m to Sept 2012) and the record rise in liquidity preference (with 56.5% of all money currently being held in cash or checking accounts) are both the product of financial fear. The relationships people have with money, and their attitude towards financial risk rarely change quickly – although when they do, the economic effects are profound. There seems little reason to expect any significant retreat in financial fear in the short term. Rather, it seems more likely that 2013 will see private sector savings surpluses climb back towards 2010 levels, whilst liquidity preference at best remains within the levels seen since 2010.

In normal circumstances, monetary policy has usually seemed to manage to influence levels of savings surpluses: depressing bond yields far below 'fair value' (a concept chipped out of blocks of short-term rates, GDP and inflation forecast) is usually followed by a fall in rates of surplus savings; pushing up bond yields far above 'fair value' has in the past been regularly followed by a rise in net savings behaviour. But as the ubiquity of 'quantitative easing' among the world's major central banks betrays, it is precisely those powers which have failed and are still failing.

Conclusions

• Germany's investment cycle is not the Eurozone's cycle – they are operating from fundamentally different starting points and are more likely to diverge than converge over the next couple of years.
• The current trends in return on capital and in investment spending by themselves point to continued contraction – the numbers give no reason to expect the cycle to turn 'later in 2013'.
• With no upturn in the investment cycle, there is no reason to expect labour markets to improve either. For the last two years, the performance of labour productivity has underpinned the relatively mild rise in unemployment. If this can be maintained, we may have no further dramatic acceleration in unemployment levels.
• The structural trends give no reason to expect an upturn in the investment cycle in the short or medium term. But the structural problems of the financial sector, and in particular its inability to buy/create risk assets will tend to exaggerate the negative bias.
• Quite reasonably in the circumstances, the financial behaviour of Europe's private sector suggests fear. Unless this can be changed, we should expect private sector savings surpluses to continue to rise, at the expense of consumption and investment demand. One result of this should be a continuing flow of savings into government bonds and foreign assets.

As I said at the beginning, the unknown unknowns will always surprise us. So let's hope the ECB knows something we don't.

2012: After All, A Dull Year

When you are working to prepare a set of pieces amounting to an 'outlook for 2013' document, one of the first things to do is to ask oneself whether this year's developments have been sufficiently benign or malign to compel you to put away the tools that worked/didn't work last year.

Now there are good reasons why economic commentary still tends towards the alarmist:

• Western governments still show no recognition that post-war fiscal policies have edged them towards bankruptcy (or over it, in some cases) - and there is no discernible voter recognition of it either;  
• there is also no acknowledgement that the flaws  in the structure of the world's financial institutions are fundamental, anachronistic, and fixable; 
• the jury is still out on whether China can make the historically-treacherous traverse between a financial repression/exogenous growth model and a fi  nancially liberalized/endogenous growth model;
• and the populations that drive world growth are still getting older. . . . 

So there's plenty to worry about. But since the Crisis of Western Financial Institutions, public discourse has rarely been less than apocalyptic. (Those in need of a regular fix of fire and brimstone could do worse than scan InvestmentWatch).  Whilst I strongly believe that the next 30 years will look very different to the last 30, it's not clear to me that the worst-case scenarios are the most likely.  (But then I grew up fretting about nuclear war, the imminent onset of the next ice age and Britain's actual bankruptcy.)  In fact, it is not  difficult to find reasons for  long-term optimism - it's just difficult to have them heard.

What's more, despite the background blizzard of intensely gloomy commentary, the fact remains that 2012 has been a noticeably dull year financially.

Take currencies: against the US dollar, the Euro has edged up 0.2%, Sterling is up 3.3% and the Yen down 4.8%.  Measured against the SDR basket,  the dollar looks likely to end the year within a percentage point of where it started.

And it's a similar story for world stock markets. Take the MSCI World Free Index - it's up 11.1% so far this year, which is a boring  0.23 standard deviations above the 1992-2012 mean average gain of 6.8%.  In standard deviation terms, the S&P has managed a gain 0.21SD above average, the gain for EuroStoxx is 0.16 SDs above average, for the Hang Seng 0.19SDs, Topix 0.32 SDs, for the FTSE 100 just 0.03 SDs above, and the Kospi's 6.6% gain on the year is 0.14SDs below the average. As the chart below shows, for equity markets, the years since 2009 have been, above all else, just lacking in volatility. 

To make matters even less interesting, globally markets have clustered to almost historically high levels of performance correlation.  One way of displaying this is to calculate the standard deviation of annual movements among international markets (in this case, S&P 500, EuroStoxx, TOPIX, FTSE 100, Hang Seng and Kospi).   So far this year, the standard deviation between index movements since the beginning of the year is just 5.7% - only in 2004 has it been lower.  

In short, this was a year to shut down your hedge fund. 

Even so, there are two ways to look at this dullness.  One can either say that financial markets are dismissing  2012's apocalyptic warnings and assuming that 2013 will simply extend the mix of mutedly positive trends currently visible against the gloom, or that 2012 was simply 'the lull before the storm'.