'Reaping the Benefits'

"In Ireland and Portugal export performance has also been strong, because programme countries are now reaping the benefits from their significant improvement in cost competitiveness." 

Thus Jörg Asmussen,  ECB board member, speaking at Bank of America/Merill Lynch Investor conference in Washington, 20 April 2013.

And here's what he was talking about : 

Ireland

In the 12 months to Feb 2013, Ireland's exports were 4% higher than during the same period of 2009/08 - ie, the nadir.  Currently, momentum is being lost quicker than at any time during that period. 

Portugal

Yes, during 2010 and 2011, Portugal did indeed manage to sustain positive export growth. But there's been no yoy growth during the last six months, and for the last eight months, the 6m momentum trend has been negative. 

I wonder what his speaker's fee was? 

Who's Got Economic Momentum?

• For industrial momentum, the ordering is US,  China, Eurozone, Japan
• For domestic demand, the ordering is US, China & Japan (tied), Eurozone
• Outliers & Likely Corrections: Industrial and domestic  demand momentum tend eventually to balance. On that basis, expect: i) vulnerability in Eurozone industrial momentum, and ii) recovery of Japanese industrial  momentum.

So which of the world’s major economies has the most positive momentum, and in what way?  I compile momentum indicators for the US, the Eurozone, China and Japan on a monthly basis, making separate indicators for the industrial economy and domestic demand. Where possible, the industrial economy indicator tracks production, exports (both local currency value and volume),  inventory/shipment ratios and capacity utilization.  Where possible, the domestic demand indicator takes in retail sales, auto sale, employment and wages. In both cases, the composition will alter slightly according to the availability of monthly data. For each item of data, I measure the deflection of the month’s data from seasonal trends, and express the result as a number of standard deviations from the average error. Expressing the result as a number of standard deviations allows me to take a simple average of the data I’m measuring.  Finally, I take the 6ma as defining the underlying trend momentum.

Industrial Momentum

Taking the industrial economy first, we can compare the 6m momentum trends. However, at this point, it’s worth emphasising that what’s being measured is changes in momentum relative to each country’s individual experience of the past decade, not absolute performance. Thus US industrial output may be growing by 3.5% yoy whilst China’s is growing by 8.9%, but the underlying momentum change may be (is) more positive in the US.

On that basis, the indicators are pretty unambiguous: the US has the most positive underlying industrial momentum, followed by China, then the Eurozone and lastly Japan.  In absolute terms, both the US and China are gaining momentum, whilst Eurozone and Japan are losing momentum. The leadership of the US is likely to be extended in March’s data, with today’s data showing industrial production up 0.4% mom sa (0.5SDs above trend) and capacity utilization also rising further to 78.5% (1SD above trend). 

Domestic Demand Momentum

For domestic demand, the picture is slightly different, and mostly tells a far more encouraging story. What’s not different is that the US plainly enjoys the most positive domestic demand momentum of these economies, and has does almost continuously since  1Q2011. But since August last year, the improvement in the US momentum trend has found close echoes in both China and (surprisingly) Japan.  

The improvement (relative to their recent experience)  is almost identical for both China and Japan – it is only fractional, but has been sustained now for the past four to five months. 

Finally, the charts confirm the Eurozone as a serious outlier, with domestic demand losing momentum for the past two years with no sign at all of any recovery, hampered by an unemployment rate which has risen almost uninterruptedly from 7.4% at the start of 2008 to 12% now.   Whilst the other major economies  can be seen to have their own cyclical patterns, and can also be seen to respond to other economies’ cyclical fluctuations, there  is no similar pattern in Eurozone domestic demand – rather, we have a continuous erosion of demand momentum. Unlike the rest of  the world, the Eurozone chart suggests Depression not cyclical recession.  

Imbalance and Likely Corrections

Finally, it is worth considering the difference between industrial momentum and domestic demand in each economy, on the basis that over time one would not expect industrial momentum to differ much from domestic demand momentum (and vice versa), in much the same way as one would not expect supply to differ that much, over time, from demand.  Where large deviations between the two occur, we might expect a tendency for them to reconnect – for example, if industrial momentum was sharply more positive than domestic demand, we might expect either industrial momentum to slow, or domestic demand momentum to accelerate.

The following chart, then, simply looks at 6m industrial momentum minus 6m domestic demand momentum. Where the line is positive,  industrial momentum is greater than domestic demand; where negative industrial momentum is not keeping up with domestic demand momentum.  The first thing to notice is that both the US and China are roughly balanced.  Second, for the last three years Eurozone industrial demand has run persistently stronger than domestic demand momentum (even though since 2008, the difference has averaged zero).  One would continue to expect either industrial momentum or domestic demand  momentum to change trend  in order to resolve this disequilibrium.  Personally, I think this suggests latent vulnerability in Eurozone industrial momentum.  Third, in Japan domestic demand momentum has survived better than industrial momentum over the last year. Japanese consumer confidence indicators tells that no abrupt collapse in domestic demand is anticipated: if so, these are grounds for expecting an upturn in Japanes industrial momentum in the short to medium term.  

Chinese Economic Momentum

Given the commentary on China's GDP and industrial data released today (Bloomberg: 'China Growth Loses Momentum in Blow to Global Expansion') I thought it might be useful to show what's happening to my momentum indicators for China's economy.
I compile three indicators: one for monetary conditions (tracks changes in money supply, fx, real interest rates, yield curve structure); one for industrial momentum (exports, both in Rmb value and in volume, industrial production, electricity production); one for domestic demand (retail sales, urban investment, auto sales, real estate climate index).
For each dataline I track, I express the previous month's movement as a number of standard deviations away from seasonalized trends.  Overall movements in underlying momentum are best captured using a 6m average.  The calendrical instability of Chinese New Year offers difficulties which I strive to deal with using as much information as I can muster, but the ramifications of Chinese New Year only really work their way out of the data by April.
I now have most of the data I need to construct these indicators, and where I do not yet have the data (auto sales, electricity generation, real estate climate) I have chosen to simply apply seasonal trends (ie, they are effectively neutralised).
The summary graph first:

Comment: Contrary to popular belief, monetary conditions are tightening, primarily as a result of the strength of the Rmb and positive real interest rates, though it is also true that monetary aggregates M1 and M2 are accelerating far less quickly than the growth of aggregate financing would suggest. Historically, when monetary conditions tighten, domestic demand is vulnerable, but so far momentum has only flattened out.  Industrial momentum is extremely volatile over the holiday period, but has exited with modestly positive momentum. 

Britain: Less Dead Than Advertised

The moral: A lot can be going right in an economy, but you won't notice it whilst zombies stalk the financial system.

The week after the Budget is not a bad time to take another look at the British economy. Were on to judge from newspaper headlines or the ex-cathedra pronouncements that the BBC mistakes for journalism you'd conclude there's little hope.

In fact, that's wrong: there's a surprising amount to like about the British economy right now: from my analysis, I think:

• Asset turns are about the highest they've ever been.
• Labour productivity has grown consistently mid-2009 and is now 2.6 Standard deviations above the 1998-2008 trendline.
• As a result of that, employment is growing – the latest data shows employment up 2.1% - and there's nothing mysterious about that strength.
• When you measure domestic demand momentum by looking at retail sales, vehicle sales and employment, you'll find the underlying 12m momentum is rising the fastest this century.

But there's one thing seriously wrong: zombie banks stalk the land plunging monetary velocity ever-lower. The unwillingness or inability to deal with the zombies immediately after the crisis of 2008/09 is by a very considerable Britain's biggest economic problem. It is truly disabling that Britain's politicians do not see this. Unwillingness to encourage and foster the development of a new and clean set of financial institutions – universally-distributed money market mutuals are the obvious vehicles – are the single major stumbling block to recovery.

Does the bullet-point list of good news seem implausible? Here's how I reach the conclusions.  

Asset Turns & ROC Directional Indicator 

First, I generate the asset-turns /ROC directional indicator in the same way as I do for any other country, by looking at nominal GDP as a flow of income produced from a stock of fixed capital, and then estimating that stock (and its changes) by depreciating all gross fixed capital formation over a period of 10 years. On these calculations, Britain's stock of capital shrank by 0.7% in 2012, whilst nominal GDP rose 1.5%, so asset turns continue to rise. In the face of rising ROC, gross fixed capital formation rose 1.4% in 2012, after shrinking 2.9% in 2011. In the absence of a major investment cycle, ROC will continue to rise during 2013.

Of course, in the face of bank deleveraging, the vigour of the investment cycle will be constrained by the limits to which investment spending can be financed by cashflow. Nonetheless, one should certainly expect investment spending to continue to rise.  

Rising Labour Productivity

Labour productivity is one of those concepts who's simplicity disappears as soon as you try to grasp it: if you are willing to overlook that, you will find current British labour market conditions baffling, with GDP basically flatlining, how can employment be expanding so vigorously? The key is this: merely looking at GDP per worker takes no account of changes in capital inputs. If workers' productivity rises are merely the result of a rising capital/worker ratio, ideas about 'effort' and the contribution of 'skill/experience' are lost. That seems wrong. So I measure GDP per worker, but deflate the number by changes in capital stock per worker. This calculation tells us that output per worker, minus changes in capital stock per worker, rose by 0.8% in 2012, having risen 1.4% in 2011 and 2% in 2010.

Now, some labour productivity gains are always experienced coming out of a recession purely as a result of operational leverage. The key point to realise is that the gains in productivity have passed that point: in fact labour productivity had regained the long-term trendline by mid-2011. By end-2012 labour productivity was 2.6SDs above that line. Breaches of that size suggest a secular change in trend – for the better - is now being discovered.

Such a change would help explain the rise in employment which otherwise might seem baffling: the number of people in jobs began to rise first in early 2010 (the initial response to rising productivity), took a breather throughout most of 2011 before rising again sharply in 2012 (as productivity broke through the trendline and kept on growing). In the three months to January 2013, employment was up 2.1% yoy, and in the 12m it was up 1.3%.

And there is another aspect to this: if investment in capital equipment is constrained by the lack of bank lending and expansion has largely to be financed through cashflow, and if capital and labour are to some extent fungible, then it may make sense for companies to take on more workers rather than buy new machinery. Ironic perhaps, but if credit constraints go hand in hand with positive cashflow, a substitution of labour for capital would allow rising employment to coexist with falling capital stock and flat GDP.

Domestic Demand: 12 Momentum Strength

Even if you have followed me so far, the next step will probably prove a step too far: domestic demand is no longer 'flat on its back' but rather has developed considerable underlying positive momentum. I freely grant that this is not obvious from recent monthly data: but this is partly because it is difficult to see through its unusual volatility. Looking at the 6ma deviation from seasonal trends, positive momentum had been maintained since May 2012 – the longest positive uninterrupted run since 2006-2007. More, this run has taken the 12m momentum to the most positive point in recent British economic history.

Such a positive reading is difficult to accept, as it runs absolutely counter to the popular economic narratives heard in the UK. Still, on a 12m basis:

• retail sales values are rising by 2.7% yoy, which is approximately the annual average achieved since 2008;
• car registrations are rising 6.4% yoy, vs a post-2008 average of minus 1.4%
• employment is up 1.3%, which compares with a post-2008 average of 0.2%.

The underlying improvement in the economic data is unrecognized both in popular economic narratives, but also in consumer confidence indicators, which show no sign of uptick at all.

The Problem: Zombie Banks

One reason is that Britain's fundamental problem remains unaddressed: its banks are still effectively zombies. This really is all over the data: in January M4 was down 0.2% yoy, the 24^th successive monthly of yoy contraction; outstanding sterling bank loans have fallen 7.8% over the last three years, and shows no sign at all of recovery; the British Bankers Assn today reported Feb mortgage loan approvals down 7.1% yoy in value.

This is no longer a matter of the net credit-worthiness of the private sector: currently the private sector holds £51bn of net deposits in Britain's banks, a reversal from the immediate pre-crisis peak net indebtedness of £293bn of October 2007. Nor is a lack of loan-demand responsible: Bank of England credit condition surveys for 4Q12 found the highest demand for both secured and unsecured lending since the immediate onset of the crisis.

Rather, the problem is that the banks are either unwilling or simply unable to lend. Having spent time in Japan, the problem is very familiar: they are simply zombies. One result is obvious: with zombies stalking the financial system, monetary velocity is unable to rise, and nominal GDP is constrained.

(Footnote about Volatility: One can, of course, set against that weak industrial data (exports, industrial production), but there's a serious caveat hanging over these data series in 2012, with the seasonal adjustment process generating a volatility quite unprecedented in both series' previous history. Faced with such an outbreak of volatility, one would naturally assume 2012's data 'comes from a different population.' Having written to the ONS about this, I can assure you that they are as puzzled/worried about it as I am. For the time being, I think you can't base an argument on this data.)

Shocks & Surprises Weekly FX Observations

It was a relatively muted week in fx markets, with no new trends established, and no existing trends challenged.  Rather, the dollar simply took a breather.  Please check previous weeks' posts for the relevant caveat: remember, there are no consistently reliable ways to forecast short-term currency movements, and these observations have no pretensions they have solved that problem.

Strengthening Trends
US Dollar: The dollar was steady on the week, but the strengthening trend in place since early Jan is not under challenge. The currency remains at its strongest since July 2010.
Rmb: The very gentle strengthening trend established in early October 2012 remains in place and has not yet morphed into stability against the dollar. But it is moving that way.

Weakening Trends
Euro: The weakening trend established during the previous week was neither strengthened nor challenged by this week's stability. But the current ceiling of around 1.31 is unchanged on the week.
Sterling: The weakening trend is unrelenting, and was not relieved in any way during the week.  The ceiling has now come down to 1.58 to the dollar.
Yen: The weakening trend in place since mid-December stalled during the last week, but is not under threat. The current ceiling continues to come down, and now stands at 87.1
A$: The new weakening trend was established in early Feb, and is not under threat: the current ceiling is around 0.961.
Turkish Lira:  Weakening trend in place since late Feb is not challenged: the current ceiling remains unchanged on the week at 1.782.
Gold: A steady week for gold, but it does not imply a challenge to the weakening trend in place since the beginning of the year. The ceiling continues to drop quickly, and now stands at 1,671 an oz.
Commodities CRB Index:  The current weakening trend is now entering its fifth month, unchallenged. The ceiling of 296 is unchanged on the week.

Japan's Deflationary Coils: What The Duponts Say

The compilation of quarterly balance sheets and p&ls by Japan's Ministry of Finance is one of the great statistical wonders of the world. It allows a fairly complete Dupont and cashflow analysis of the private sector, and by doing so allows us a deeper understanding of the pressures on corporate Japan, and the policy options being contemplated in response.

For 2012, the picture is surprisingly stable, but in a bad way: managements can and do attempt to extricate their companies from a vicious spiral, and we can track and admire their efforts. But with no topline growth - sales fell 2.9% in 2012 - the odds stacked against them are formidable, and their struggles end up tightening Japan's deflationary coils.  In the end, the decision to cut spending on plant and equipment (down 8.7% yoy in 4Q) is inevitable,  inexorable and politically intolerable. Hence the desperate hopes resting on Abe-nomics.

Dupont Analysis
Let's look closely at how corporate Japan managed in 2012, and start with the assumption that managers in Japan have as one of their main goals the preservation or raising of RoE and RoA. First, we can tell that 2012 was a year in which they almost achieved a stabilization in both: operating profits/shareholders equity (RoE for these purposes) averaged 8.8% in 2012, up slightly from the 8.6% achieved in 2011. Return on assets (RoA) also rose to 3.1% from 3.01% in 2011. In both cases, this is essentially a stabilization at historically low levels.

How was it achieved?  We can use Dupont analysis to tease it out, since changes in RoE can be made only through changes in asset turns (sales/total assets), financial leverage (total assets/shareholders equity), operating margins (operating profits/sales) or through changes in the tax burden.

Asset turns: Can't Shrink the Balance Sheet Fast Enough
The problem presents itself immediately, with sales falling 2.9% yoy in 2012, any attempt to preserve or raise RoE must start with an attempt to shrink the balance sheet in order to raise asset turns. And the attempt was made: by 4Q total assets had indeed been cut by precisely 2.9%, but on average the fall was only 1.8% - balance sheet cutting couldn't keep pace with the contraction of the top line.

This was the sharpest shedding of assets since 2002, but was nonetheless not enough: asset turns fell to 0.961 in 2012 from 0.972 in 2011, and on a 12 basis, 4Q was the fourth lowest asset turns in Japan's recent financial history, rivalled only by the depths reached in 2009.

But what can you do about the balance sheet?
On the liabilities side, it is bloated with cash on hand, which rose to 10.8% of total assets (from 10.7% in 2011), and was steady at 1.3 months of sales sales.
On the asset side, the intent to shrink the balance sheet led to a 3.7% yoy fall in inventories, and a 7% yoy fall in accounts receivable. In other words, it is stripping corporate credit out of an economy which for decades now has been without a functioning banking system.

Let's put that  into context, the fall in A/R and inventories amounted to Y16.74trillion in 2012, whilst the total increase in bank lending to the corporate sector rose only Y13.45 trillion in the same period, and total bank lending rose only Y5.47 trillion. In other words, the corporate imperative of shrinking balance sheets in order to raise asset turns is sufficiently large to deflate the entire economy.  And so, topline sales continue to shrink . . . 

Leverage: Shrinking Balance Sheet = More Cash = Deleveraging
Cutting leverage is the natural and automatic partner of trimming the balance sheet in the short term (unless shareholders' equity can be reduced by buying back and cancelling issued equity). And so financial leverage fell further, at a very slightly accelerated pace: total assets averaged down 1.8%, but equity fell only 0.5%, so leverage fell to 2.82 in 2012 from 2.86 in 2011.

You get the same conclusions looking at net debt/equity: net debt fell 5.1% yoy, and net DER fell to 62.3% by year-end, from 65.8% at end-2011. 

Margins: The Only Factor Doing the Lifting 
With asset turns and leverage both falling, any attempt to rescue RoE comes to rest solely on an ability to raise margins. And, actually rather remarkably, that's what Japanese management achieved: OPM were stable and average 3.22% for  year, up from 3.09% in 2011 and actually slightly higher than the 3.1% averaged since 2000. 

What's more, this is an achievement won the hard way: the cost of goods sold actually rose 0.1pp to 77.6% during the year, but SG&A ratio came down 20bps yoy to 19.1%, even though personnel expenses actually rose as a % of SG&A. In other words, it was the hardcore central admin costs that did the heavy lifting, falling by 30bps as % of sales. Plainly this is not the sort of thing that happens by accident, or which is achieved by lazy or complacent managements.

Conclusions: More Twists in the Coils

• As sales fell 2.9% yoy in 2012, Japanese management wrestled hard to maintain ROE and ROA. In some aspects, they met with admirable and surprising success. But it is a battle they must inevitably lose: it was not possible to shrink balance sheets sufficiently quickly to protect asset turns, even though attempts accelerated sharply in 4Q.
• Morever, whilst the attempt is being made, the net cash generation cut financial leverage ratios, which in turn eroded RoE.
• It is extremely difficult to boost operating margins sufficiently to offset the negative impact on ROE of falling asset turns and leverage. And despite exemplary control on SG&A, Japan's managements have not pulled this off.
• But in the meantime, balance-sheet control has stripped out more than three times net credit from their customers, in the form of inventories and accounts receivable, than the banking system managed to extend to the economy.  It these circumstances, it is well-nigh inevitable that domestic sales fell. 
• This is the very definition of chasing one's own tail, and it is therefore not surprising that although corporate cashflow jumped by 18% yoy in 2012, investment in plant and equipment rose only 0.8%, and fell 8.7% yoy in 4Q.
• This vicious circle of balance-sheet shrinkage, deleveraging and yet still-falling ROE also explains the urgent appeal of Abe-nomics: topline growth is needed at virtually any cost.   

Shocks & Surprises Weekly FX Observations

Please note the caveats of previous weeks: no way of forecasting currencies with consistent success has yet been discovered, and this is no exception. All I am trying to do is provide a consistent basis for recognizing the establishment and disruption of current trends. Please do not mistake this for trading advice. . . .

Watch List/New Trends
Euro: Last week's weakness finally looks to signal a change in trend, with the strengthening trend observed since mid-Sept 2012 probably being replaced by weakness. If so, we now have a ceiling of around 1.31.
Turkish Lira:  The currency joined the Watch List last week, and was sufficiently weak to establish a new weakening trend, succeeding the strength seen since mid-Sept 2012. The current ceiling is 1.782 to the dollar.

Strengthening Trend
US Dollar:  One by one, the other major currencies have fallen away, leaving the dollar strengthening against the rest of the world. The strengthening trend which has been in place since early January is still gathering momentum. Against the SDR basket of currencies, it is now at its strongest point since July 2010.
Rmb: No change here - a very gentle strengthening trend is still in place (since early Oct 2012), but is perhaps morphing into stability vs the dollar.

Weakening Trend
Sterling: I thought the weakening, established in mid-January, was possibly over-done last week (it was 3.5 SDs below trend!) with a short-term rebound likely. In the end, there was merely momentary stability, so little reason to believe the underlying weakening trend won't be resumed. The likely ceiling has now fallen to 1.59 to the dollar.
Yen: Still no threat to a strong weakening trend, in place since mid-Dec. The current ceiling of 86.4 continues to descend rapidly.
A$:  The weakening trend established in the first week of February is now obvious: the ceiling is currently still around 0.96.
Gold: On a trend basis, the metal has been weakening since early-Jan, and its ceiling has now come down to 1,678 and falling rapidly.
Commodities: After gapping down in the previous week, there has been no rebound, suggesting that the weakening trend is intensifying. The CRB Index trend ceiling has come down to just below 297.

Italy: Political Fracture Changes Everything

Credit where it's due - Wolfgang Munchau wasn't wrong, even though he was writing in the FT a month ago: 'Judging from the latest opinion polls, the most likely election result is gridlock, perhaps in the form of a Bersani-Monti coalition of the centre-left, possibly with a centre-right majority in the Italian senate, where different voting rules apply. This would leave everyone, more or less, in charge. Nobody would have the power to implement a policy. Everybody would have the right to veto one.'

With a busted political establishment and the EU's 'technocratic' post-democratic settlement rejected, it is difficult to see where Italy's next usable political architecture will be found. It is little short of tragic, since protracted political uncertainty can be expected to undermine and nullify the real gains made in Italy's economic structure during the past few years. More likely, the pay-off of austerity will simply be. . . deepening economic atrophy.

Let's first acknowledge the real gains made.  On a constant-dollar basis, I estimate that by the end of 2012 asset-turns in Italy had been restored to very near pre-crisis levels, albeit at the cost of a capital stock that was shrinking by around 3% a year. In nominal terms, of course, the situation is less attractive: although capital stock is now shrinking by around 1% a year, asset turns on that capital stock have recovered less than half of what they lost during 2008-2009.

More, Italy retains positive cashflow: it had a private sector savings surplus equivalent to around 2.2% of GDP in 2012, up from 0.7% in 2011 and a reversal of the minor savings deficit prior to the financial crash. This savings surplus (calculated as the current account minus the government budget balance), is also a tally of the net cashflows running between the private sector  and the financial system. Capital flight reflecting worries about whether Italy may ultimately exit the Euro may have stripped deposits from  Italy's banking system as a whole, but nevertheless the underlying domestic economy is quietly  generating  a net flow of cash from the private sector and into the financial system.

If this were a normal cycle, this could be an exciting inflection point:  the immediately-negative impact of recession upon returns on capital have been answered by a fall in the capital stock which has allowed asset turns to recover, and (on the constant-dollar reading) to reach pre-recession levels.  Moreover, there is a positive cashflow into the banking system from the private sector savings surplus allowing banks the financial leeway, and commercial incentive, to start extending credit once more. It is precisely at this point that there is both the motive and means to re-start the investment cycle - ie, for recession to be replaced by upswing. This is what normally happens in a business cycle.

But it is at precisely this point that Italy's genuine political instability matters, since it introduces radical policy uncertainty into investment planning. That uncertainty is likely to delay the re-start of investment spending, so the factors of production are most likely to continue to shrink, and with it the economy.  The creative destruction of recession morphs into a simple but protracted shrinkage  of the factors of production.  

And without growth, it is difficult to fashion a path towards debt-stability, given the starting point.
Taking government debt first: at end-2012 the Italian government reckoned its debt as Eu1.988 tr, which was a rise of only 4.3% on the year.  However, since nominal GDP contracted by an estimated 1.1%, the debt/GDP ratio continued to rise, hitting 127%, up from 121% in 2011 and 119% in 2010.

As a result, despite all attempts at fiscal control, the mathematics of continuing to service this debt have become more daunting, not less.  One can illustrate this by calculating the nominal GDP growth rate needed to merely to stabilize current debt levels (ie, by not allowing the interest paid to be capitalized), at recent interest rates. What interest rate? During 2012, 10yr Italian government bonds yields average 5.43%, with a standard deviation of 58bps.  If, generously, we accept a bond yield at the low end of the range (ie, one standard deviation below average), we reach an interest rate of 4.85%.  Quite by chance, that is also the yield which the market is asking today in the wake of the election result: up from lows of around 4.1%.  

Let us, then, consider a range of between 4.1% and 4.85% as representative.  In those circumstances it would require nominal GDP growth of between 5.2% and 6.2% a year in order to stabilize government debt at current levels, assuming no further fiscal deficit and payment of interest rates.

How likely a prospect is that? Even taking the lower hurdle growth rate of 5.2%, nothing approaching that level of growth has been achieved since 2000: the average nominal growth rate between 2001 and 2012 has been  around 2.3%.   Even if that 2.3% nominal growth rate can be attained once again, that will not merely not stabilized the nominal debt, it will not stop debt/GDP ratios continuing to rise.

Without nominal GDP growth, it seems impossible that debt/GDP ratios will stabilize, let alone improve.

The conclusions are grim:

• Italy's recession could have produced conditions in which an investment upturn was likely: indeed, in real terms, contracting capital stock has allowed asset turns to return to pre-crisis levels, whilst the economy generates a private sector savings surplus of about 2.2% of GDP - liquidity which would normally be expected to fund the subsequent capital investment upswing.
• Political fracture and instability are likely to choke off investment spending just at the point when the investment cycle should be responding to rising asset turns and the liquidity generated by a rising private sector savings surplus. 
• The recession is therefore unlikely to heal itself, but rather is likely to turn into a sustained contraction in the factors of production.  
• This is no longer a question of regained international competitiveness, but rather of political roadblocks to cyclical upturn.
• Italy's government debt levels cannot be stabilized without growth.  Government debt to GDP has risen to around 127% of GDP by end-2012, up from 119% at end-2010.
• Even if 10yr yields sink to 1 standard deviation below average 2012 yields (ie, around 4.1%), it would (theoretically) require nominal GDP growth of 5.2% with no fiscal deficit, in order to stabilize current debt levels. 
• Since 2001, Italy's nominal GDP growth has averaged just 2.3% a year. There is no reason to expect it to achieve that under current circumstances. 
• The price of the EU installing a post-democratic 'technocratic' government in Italy is thus extraordinarily high, since its subsequent popular rejection cancels out even those economic and financial gains which might have been made in time.  Italy is back to where it was when the crisis broke, only deeper in debt, and with a weaker structural base to its economy and no plausible political response to its plight. 

Shocks & Surprises Weekly FX Observations

Weekly Caveat Reminder: what follows are merely statistical observations about currency trends and  movements. My belief is that fx markets are, absent exceptional circumstances, usually efficient, which is why no way of forecasting their short-term movements with any consistent success has ever been discovered.  So whilst I believe that these observations are interesting, and that knowing the trend is likely to be useful, if  you trade fx and lose money, you have no right to blame me for any losses (And, sadly,  no justification for the charitable instinct that  I should be rewarded from your profits.)

Watch List / Trend Breaks
Turkish Lira: Joins the Watch List. The strengthening trend in place since mid-Sept came under challenge at the end of last week for the first time since October. It has broken through its floor of 1.7821, but it is too early to say for sure that it has broken trend.
Sterling:  Joins the Watch List for a different reason.  The weakening trend established in mid-January and accelerating strongly since, is beginning to look over-blown: during the last week, the fall came to 3.5SDs above trend - most unusual. The ceiling has fallen to 1.594 to the dollar, but it would be surprising if current levels of 1.516 were not lifted in the coming days.

Strengthening Trends
US Dollar: The strengthening trend against the SDR which has been in place since early-January continues to gather momentum. It is now at its strongest point since July 2010.
Rmb: The very gentle strengthening trend, which has been in place since early Oct 2012, is still in place, without having yet quite morphed into stability.
Euro: The weakness of the last two weeks is not yet sufficient to put the Euro on the Watch List: the strengthening trend which has been in place since mid-Sept is still in place, with the current floor still around 1.31 to the dollar.

Weakening Trends
A$: The weakening trend which emerged in early Feb is still in place. I would not expect it to be stronger than 0.96 any time soon.
Yen: There is no threat to the strong weakening trend, in place since mid-December.  The current ceiling of 85.7 is coming down rapidly.
Gold: The weakening trend established in early January continues to gather pace. The ceiling is dropping quickly, and is now at 1685 to the oz.
CRB Commodities Index: Visuals to the contrary, statistically the index showed a weakening trend since early December, and this is now emerging quite clearly. The index broke 298 as expected last week, and now has a ceiling of 297.

Reading the Zew: Freude und Angst

Yesterday's Zew Survey gave a surprisingly dour reading about the current state of the German economy, but added a  surprisingly positive result about the likely trajectory of the economy over the coming six months in its central  Zew Indicator. How should one read it? Indeed, apart from providing an insight into the mind of the German finance industry, can we learn anything much about the likely trajectory of the German economy.  

In the end, I think we can, but only if we read the survey results with care. The monthly Zew survey presents the views of a relatively small sample of the German financial industry, this month  it had 272 participants. For the 'current views' survey, they are  asked to indicate if they think currently the economic situation is 'good' 'acceptable (normal), or 'bad'. In the event, 18.2% thought it was 'good', 68.8% thought it was 'normal' and 13% thought it was 'bad'. The final reading index is simply the % 'good' (18.2%) minus the % 'bad' (13%), leaving a reading of 5.2 (%).

Similarly, for the headline economic sentiment index (the Zew Indicator), respondents are asked whether they think the overall economic situation will improve, worsen, or remain the same over the coming six months. In the event, 56.8% expect things to improve, 34.6% expect little change, and 8.6% think things will get worse – so the indicator reads a net 48.2.

There are several things to notice about this. First, both questions are subjective: it may be that German financial professionals are constitutionally fairly glum about current circumstances, but basically optimistic that things will get better. And in fact, that's exactly what the survey's history suggests: since 2000, the average reading of the 'current situation' index has been minus 13.5%, whilst the average reading of the 6m economic sentiment index has been +17.9.

But actually, that's misleading: Germany's financial industry isn't routinely glum about Germany's current circumstances, so much as bi-polar, swinging regularly from profound angst to roaringly positive consensus, and back again. To put this in context, the modestly positive readings found in the last four months are quite literally unprecedented this century. The structure of the survey doesn't compel such a result, and this sort of bipolar assessment isn't repeated as dramatically in assessments of the Eurozone as a whole, or the US, or the UK.

There is a conclusion to be drawn: history suggests it is most unlikely that the Zew current conditions survey will survive for long in its relatively phlegmatic state. Rather, we must expect the mood to resolve itself into either deep pessimism or triumphant optimism in the coming months.

The Economic Sentiment (the Zew Index) is a different matter altogether. February's survey was the strongest since Dec 2009. 

Before we welcome this as a precursor of the much-anticipated recovery of Germany leading the Eurozone out of recession, there are three things to understand about the Zew Indicator as it stands:

1. Although it is far more volatile than the 'current conditions' index, it is not significantly bi-polar – a wide spread of views is regularly attained.
2. On balance, the industry is generally optimistic (and why not? Equities do tend to rise over time).
3. These sentiments have no predictive power about how the economy will be experienced in six months time. If it were, one would be able to find some relatively stable relationship between the Current Situation Index which would echo Zew Indicator. In fact, the two are radically different.    
4. In practice, the Zew Indicator by itself is not a good indicator of GDP growth or even direction.

But this raises an important issue of the relationship between the two indexes: clearly the importance attached to the Economic Sentiment index will be a function of how Current Conditions are experienced. A Zew Indicator of 100 (ie, unanimous belief that things will get better) means something quite different if the current conditions index is extremely miserable (say, minus 50) than if it is already quite cheerful (say +50).

One can capture this relativity by adjusting  'how things are going to look' by 'how things are now: ie, one adds the current view to the expectation, to get a clearer idea of where things are going. 

When we do that, we find: 

First, the volatility of the index is contained, and the seemingly rather excessive belief that things generally get better is muted, with the average value since 2000 retreating to +4.4 (rather than +17.9, unadjusted).

Second, Although the adjusted index shows sentiment improved, this improvement does not represent a fundamental breakout from the travails of the last three years that the unadjusted index describes. Rather, this looks like a repeat of the bounce achieved at this time last year.  

Third,  we also find that the adjusted index gains  in explanatory and even predictive power . In particular, it has proved a reasonable indicator of the direction and strength of GDP growth (though admittedly, it's not something I'd want to model from).    

Conclusions: Read properly, then, it seems that the German financial industry, as surveyed by the Zew Institute, does have a pretty keen idea of what's going on in the economy.  So what are they really telling us this month?

1. The bounce in economic expectations is less dramatic than it is initially stated, closely resembling what happened this time last year.
2. The bounce in economic expectations is not yet sufficiently pronounced to compel a significant acceleration in GDP growth.
3. The view that the current situation is modestly OK is historically unprecedented – one would expect it to resolve into either gloom or joyous optimism very shortly.
4. If the Zew is going to be an early indicator of a modest recovery in the German economy, the most crucial thing to watch over the coming months is the 'Current Situation' index, rather than the headline Zew Index.

Shocks & Surprises Weekly FX Observations

Usual caveats apply: the purpose of these pieces is merely to identify trends, measure them and understand when they are under threat. In my view, going the one step further, and forecasting currency values is impossible - the best brains constantly try, and constantly fail.  Still, here are the observable trends:
Trend Breaks / New Trends / On Watch
Rmb: The strengthening trend which has been in place since early Oct 2012 is now very gentle indeed, and perhaps morphing into stability vs the dollar.

Strengthening Trends
US Dollar:  The strengthening trend which has been in place since early January is still gathering momentum. Against the SDR index, the dollar is not at its strongest point since July 2012.
Euro: The strengthening trend has been in place since mid-Sept and is possibly now accelerating. The current floor is around 1.31 to the dollar.
Turkish Lira:  The strengthening trend has been in place since mid-Sept 2013, and is not under challenge. The likely floor has come down to 1.78.

Weakening Trends

Sterling:  The weakening which emerged in mid-Jan is still strongly in place, and still possibly accelerating.  We're unlikely to see 1.60 to the dollar again any time soon.

Yen: No threat to the weakening trend that has been in place since mid-Dec. The ceiling of 84.5 continues to come down rapidly.

Australian Dollar: We identified a new weakening trend last week, and this has been confirmed this week. It seems unlikely it will climb back to 0.96 any time soon.

Gold: The weakening trend which made its first appearance in early November 2012 is gathering pace. Ceiling of 1694 is coming down rapidly.

Commodities: Our belief that the CRB Index had a downward inflection in late November 2012 has been painful. However, it now seems justified, with the Index retreating to around 298, which I would regard as its current ceiling. 

The Shizzle - Japan Bond Maths

The Shizzle Feb 13th, 2013

Why I’m writing:  'The BOJ said that they are increasing buying bonds, but they're also putting power into lowering interest rates. If the economy gets better, then l/t interest rates like a 10yr yield at less than 1% are unlikely. . . . . If we think about the future and if interest rates go up, then 67% in bonds does look harsh. We will review this soon.’   Takahiro Mitani, president of Japan’s Govt Pension Investment Fund (Y108tr in assets).

The evidence:  How much does Japan’s government depend on Bank of Japan, rather than private sector savings surpluses, buying the bonds it needs to float?

Yn tr	2012	2011	2010	2009
JGBs Issued	26.29	27.79	43.03	-10.63
FBs Issued	11.26	14.08	6.03	35.22
Total Supply	37.55	41.87	49.06	24.59
PSSS	15.77	27.53	49.74	13.94
Net BOJ Holdings	23.31	13.28	5.41	9.79
Total Demand	39.08	40.81	55.15	23.73
Demand – Supply	+1.53	-1.06	+6.09	-0.86

JGBs = Japanese Govt Bonds; FBs = Financial Bills; PSSS = Private Sector Savings Surplus; Net BOJ Holdings = Change in BOJ’s holding of JGBs, less changes in govt deposits

Conclusions:

·         In 2012, private sector savings surplus could have bought only 42% of the JGBs and FBs the government needed to sell. BOJ buying was the equivalent of 62.1%.
·         Between 2010 and 2012, annual debt issuance fell by 30.7%, net BOJ buying grew by 76.8%, and the private sector savings surplus shrank by 68.3%
·         Increasingly, Mitani-san’s portfolio, and the ability of PM Abe to finance expansion, depends pretty much solely on what BOJ decides to do next.
·         BOJ gov Shirakawa steps down on March 19^th.  Who his successor is really matters.

Follow up?  If you’d like further analysis, or to argue the toss about the conclusions, please email me on michael.taylor@coldwatereconomic.com

Shocks & Surprises Weekly FX Observations

Although nobody knows how to forecast fx movements with consistent success, a statistical approach to deviations from measured trends does at least allow us to say what is happening now, and when existing trends are under threat. Here are this week's observations, issued with the usual caveats - these are just empirical observations, if you use them to trade, and lose money, don't blame me:

Trend Breaks / New Trends
Australian Dollar: After spending two weeks on watch, A$ movements this week broke the strengthening trend, most probably establishing a new weakening trend.  Do not expect to see 0.96 again any time soon.

Strengthening Trends
US Dollar: Strengthening trend vs SDR in place since early January is still gathering momentum.
Euro: Strengthening trend in place since mid-Sept is not under threat, and is possibly accelerating. The current floor has risen to around 1.31.
Renminbi: The strengthening trend which has been in place since early Oct is still in place, but is perhaps morphing into stability vs the rising dollar. But for the Chinese New Year holidays, this would be a candidate for the Watch List.
Turkish Lira:  Strengthening trend in place since mid-Sept is still in place and not under challenge. The floor is now probably around 1.785.

Weakening Trends
Yen: There's no threat to the Yen's weakening, in place since mid-Dec.  The current ceiling of 84.03 is coming down rapidly. 
Sterling:  The weakening trend which has been in place since mid-Jan is strongly in place and possibly still accelerating. Sterling is not coming back to 1.60 to the dollar any time soon.
Gold: The new weakening against the dollar, in place since mid-December, is not under threat. The ceiling  has now probably come down to 1,701.
Commodities: Despite the run-up of the CRB Index during the last two months, this has not been sufficiently strong to reverse the weakening trend which has been in place since early Dec 2012.  Expect a short-term challenge to around 298.

A Week in Quotes

Global Growth
'It is not that discoveries no longer occur but that the rate has slowed. Without new knowledge, only derivative technologies are possible - and, however, important, they are incapable of sustaining the sorts of economic growth rates the world has enjoyed since the coming of the industrial revolution.' Andre Geim, Nobel Prize winner for his work on graphene, writing in the FT.

Japan Bond Yields

'If the economy gets better, then long term interest rates like a 10 year yield at less than 1% are unlikely. So 'If we think about the future and if interest rates go up, then 67% in bonds does look harsh. We will review this soon. We will being discussions for this in April-to-May. Any changes to our portfolio could begin at the end of the next fiscal year.'  Takahiro Mitani, President of the Government Pension Investment Fund, with Y108tr in assets to manage.

Apple and Unions in China 

'The position of chairman and 20 committee members of the Foxconn Federation of Labour Unions Committee will be determined through elections once every five years through an anonymous ballot voting process.'  Foxconn explains how its Chinese workers will choose replacements for the  c18,000 union committees whose terms expire this year and next. 

Apple and its Cash

'It has a sort of mentality of a depression. In other words, people who have gone through traumas  - and Apple has gone through a couple traumas in its history - they sometimes fell like they can never have enough cash.'  David Einhorn, of Greenlight Capital, urging Apple to disgorge more of its $137bn cash to investors. 

Fiscal Problems: Europe and US

'It's ridiculous sometimes when you look at the kinds of difference we're negotiating: a few billion over seven years. . . '  Luxembourg PM Jean-Claude Juncker on EU budget negotiations.

'Deficits are projected to increase later in the coming decade because of the pressures of an aging population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt.'  Expecting publicly-held federal debt to reach 77% for 2023, 'Such a large debt would increase the risk of a financial crisis, during which investors would lose so much confidence in the government's ability to manage its budget that the government would be unable to borrow at affordable rate.' US Congressional Budget Office.

Shocks & Surprises Weekly Espresso

This week's issue of the Shocks & Surprises Espresso takes a look at the implications of three sets of data:

• US personal income, which rose 2.6% mom in December
• German terms of trade for December, and their implications for the Eurozone
• Japan's 4.8% yoy rise in construction orders in December, including the 52.7% yoy jump in national government orders. 

In each case, I think there are things to be learned by looking at them in a little more detail. The Espresso is delivered in email form, and if you'd like to take a look, email me at michael.taylor@coldwatereconomics.com.

Shocks & Surprises Weekly FX Observations

Last week I explained the methodology behind Shocks & Surprises approach to currencies (here), but the caveats are worth repeating.  No-one knows how to forecast currencies with consistent success, and the ex-post factor economic rationalizations for specific currency movements are all as good, or bad, as each other. All I am trying to do in these pieces is identify current trends and likely changes in them in a way which is consistent, which I've been using for years, and has at least some modest statistical backing. If you trade off them, and lose, it's your own lookout.

Strengthening Trends
US Dollar: continues to strengthen against the SDR as it has since early June, and that trend is not under threat.
The Euro: continues the strengthening trend against the dollar that has been in place since mid-Sept, and is possibly now accelerating.  Currently it's likely floor is around 1.305.
Rmb: The current strengthening trend has been in place since early Oct, and whilst mild, is not under threat.

Weakening Trends
Sterling:  The emergence of the weakening trend in mid-January is strongly in place, and is possibly accelerating. Sterling isn't going to see 1.60 to the dollar again any time soon.
Yen:  There's no threat to the weakening trend that has been in place since mid-December. The current ceiling is 83.2 (ie, it would be a major surprise if it reached this leve), and is rising quickly.
Gold: The new trend of weakening against the dollar is not under threat. The current ceiling is 1,706 an ounce, and falling.

On Watch
Australian Dollar: I put this on watch last week, and it remains there. Whilst it seems clear that the currency no longer has a strengthening trend, it is too early to say whether its replacement will be stability or weakness.

A Week in Quotes

Eurozone - Two Views
'Last year there was a very tense mood here in Davos. This year I think we are seeing sentinment moving from stabilization to recovery, and that means I should get a chance to do some cross-country skiing.'  Olli Rehn, EU Economic and Monetary Affairs Commissioner.

'The ECB has already provided extra refinancing credit to the tune of Eu900bn to commercial banks in countries worst hit during the crisis, as measure by its payment system known as Target. These banks have in turn provided the ECB with low-quality collateral with arguably insufficient risk deductions. The ECB is now in the same position as private investors. It is guaranteeing the survival of banks loaded with toxic real estate loans and government credit. So the tranquillity is artificial'.

And . . . 'The proposal for bank resolution is not a firewall but a 'fire channel' that will enable the flames of the debt crisis to burn through to the rest of European government budgets'.

Finally  . . . 'Asset ownership in bank equity and bank debt trends to be extremely concentrated among the richest households in every country. Not bailing-in these households amounts to a gigantic negative wealth tax to the benefit of wealthy individuals worldwide, at the expense of Europe's taxpayers, social transfer recipients and pensioners'. Hans-Werner Sinn, of the Ifo Institute, writes in the FT.

China's Regulators on Wealth Management Products
'The banking industry's wealth management business has channelled funds that might otherwise flow into high-interest underground loans, illegal fundraising, and commodity speculation and has upheld financial stability'.  China Banking Regulatory Commission's Yan Qingmin. 

'Ninety nine percent of wealth-management products arae normal products, approved by the China Banking Regulatory Commission. Maybe there are a small number that are problematic but that's not a risk to the banking sector.'  Fang Xinghai, DG of Shanghai financial watchdog.

Japan,  FX Policies and Politics
'Europe is in no position to criticize Japan. Europe has brought about a prolonged weakness of the euro as a result of their own policies, whilst Japan has supported Europe through purchases of bonds.'  Yasutoshi Nishimura, Dep Economy Minister.
'To survive and prosper Japan needs to participate in international trade without being encumbered with isolationist ultra-nationalists. Like horses in blinders, they are unable to see beyond their noses.' Sir Hugh Cortazzi, former British ambassador to Japan, and long-standing friend of Japan, worrying about  having nationalist Harkubun Shimomura as Education Minister.

Australia Elections 
'Australia now faces an eight-month election campaign which will mean that some significant investment decisions by business will be put on hold.'  Innes Willcox, CEO of the Australian Industry Group comments on the vote to fix elections for the lower house and half the Senate for Sept 14th.

Taiwan - The Pension Problem Put in Context
'The pension system time bomb won't explode during my term . . . However, the train will definitely fall off the cliff if we don't start building a bridge right now.' President Ma Ying-jeou explains.