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.