Corporate Japan Unfazed, Unmoved in 3Q

Japan's quarterly survey of private sector p&ls and balance sheets is usually more revealing than the GDP estimates.  After all, these allow us to pick apart just how corporate Japan is making money, and what it's then doing with the money it's making. The short answer is that despite the pressure on topline revenues during the last six months, operating margins continued to rise, thanks to gains in employee sales easily employee costs. Those sustained margins mean cashflow remains strong, up 56% yoy in 3Q and up 64.1% on a 12m basis. But there's still no significant appetite to re-invest that cash: investment in plant and equipment rose only 5.5% yoy, equivalent to only 77% of cashflow during the last 12 months. Moreover, that investment once again only just covered the depreciation expenses claimed.

Good News First: Margins Survive Sales rose 2.9% yoy against a fairly easy base of comparison, with the quarterly result just as disappointing in 3Q as in 2Q: in other words, the topline continued to suffer from the after effects of the sales tax rise.  Still, operating profits rose 3.8% yoy, which pushed up the 12m OPM to 4.07%, the highest since the immediate aftermath of the Bubble in 1991.  

How has that rise in 12m margins been achieved, and is it sustainable? For the quarter, the cost of goods ratio rose 0.8pps to 78% in 3Q, and rose 0.3pps to 77.7% in the 12m to Sept. For the quarter, this was only partly offset by a 0.4pp fall in SG&A/Sales to 18.3%, but on a 12m basis, SG&A fell 0.8pps to 18.3%. The main driver behind that improvement was personnel expenses, which rose only 1.7% yoy in 3Q (compared to the sales rise of 2.9%). For the quarter, personnel expenses/sales fell 0.4ps to 12.6% of sales, and on a 12m basis, they fell 0.6pps to 12.5%. More directly, sales per employee rose 7.1% yoy and 9.6% on a 12ma, whilst expenses per employee rose only 2.2% yoy and 4.3% on a 12ma. The sales/expenses multiple per employee rose to 7.98x in 3Q14, which was the highest since 4Q10, and on a 12m basis it rose to 7.91x, the highest since 2Q11.

There is no reason to think that corporate Japan will be content to allow this multiple to slip – certainly not before it reaches the levels around 8.3x that was achieved immediately prior to the financial crisis.

And Now The Less-Good News  But despite the ability to maintain margins, corporate Japan has not entirely managed to escape the tax-generated headwinds which slowed the economy. After all, it is easier to patrol margins in these circumstances than to restructure the balance sheet in the face of a probably transient shock to the top line. Corporate Japan's asset turns (sales/total assets) were hit hard in 2Q, slipping to an annualized 0.91 from 1 in 1Q, and although they edged up to 0.93 in 3Q, this has not been enough to rescue the 12m multiple, which fell marginally to 0.939. This is as low as this multiple has been (and the same as in 4Q09), but it is not impossible it will fall further in 4Q.

In addition, corporate Japan's ultra-conservative attitude towards the balance sheet needed no adjustment to the disappointment in 3Q topline growth: net debt fell by Y2.92tr qoq, and cash on hand rose by Y4.375tr, cutting the net debt/equity ratio by 1.2pps to 53.5%, another record post-Bubble low.

The result is that for both ROA and ROE, the margin gains being squeezed out of the workforce were lost this quarter by the fall in asset turns and leverage.

Nevertheless, whilst the recovery in ROA and ROE has stalled, cashflows remain very strong: investment in plant and equipment came to Y9.45tr in 3Q, up 5.5% yoy, whilst net debt fell Y2.92tr during the quarter. In all, then, that amounts to Y12.36tr of cashflow achieved in 3Q, up 55.5% yoy and up 64.1% on a 12m basis.

The problem is that nothing in these balance sheets suggest any increased willingness to deploy that cash back into the economy. Although investment spending over the last 12m is up 5.2%, this amounts to only 77% of cashflow: meanwhile, amount of cash on the balance sheet amounted to 11% of total assets, the highest since the immediate aftermath of the Bubble. And it's still climbing. Meanwhile, the Y9.45tr in 3Q capex is actually slightly less than the Y10.715tr claimed in depreciation expenses: unless Japan's depreciation schedules are unrealistically aggressive (but they are!), this implies an actual shrinkage of the the capital stock of corporate Japan. And 3Q was not exceptional in this regard: over the last 12 months, capex spending was only 2% more than the depreciation expenses booked!

US - Searching for the Cycle

In 'My Firmest Conviction' I argued that to date, the current expansion has been unusual for not developing any of the normal cyclical accelerators which usually give dynamic drive to a business cycle.  Rather, it has been what one might call a steady-state supply-led expansion. This lack of cyclical development is extremely unusual in recent US economic history, and it surely won't last for ever.

So it is important to keep a keen eye out for the emergence of pro-cyclical accelerators. These would include:
• an break-out of capital investment coming in response to rising demands on existing capacity;
• an acceleration in wage inflation in response to tightening labour markets;
• a spurt in consumption demand as inflationary expectations and a fall in precautionary motives allow a fall in the personal savings rate; and, of course,
• a solid inventory cycle.

The last two weeks have brought data which bears on all of these. For the investment cycle and for labour market cycle there are enough indications to keep expectations alive, but also in both cases there is no sign yet that these signs are generating predictable economic consequences. For the consumption cycle, the reported recovery of consumer demand is flatly contradicted by consumer behaviour, as personal savings ratios rise and consequently dampen consumer spending. Finally, there is no sign of life in the inventory cycle.

Investment Cycle Accelerator  October's capacity utilization rate came in at 78.9%, retreating from September's 79.3%, the highest it has been since pre-crisis mid-2008. It has been a long grind to get there, but utilization rates have essentially recovered to pre-crisis levels, and are still grinding higher. The implication is obvious: one should expect an acceleration in investment spending to kick in soon. Capital spending is growing, but there’s little sign that it is accelerating sharply: rather, the rise in orders of capital goods (nondef, ex-air) has been volatile, whilst fundamentally sticking to a 2010-2014 trendline which implies growth of around 5% pa in nominal terms.

This week, the NFIB’s Small Business Optimism survey for October, rose modestly to 96.1pts, which was one of the most optimistic post-crisis readings,  but was still 0.7SDs lower than the 2004-2008 average. More importantly, the subindex tracking the proportion of respondents planning to increase capex in the next 12m rose to 26%. Now, although this is one of the highest readings of recent years, it is still far lower than the proportions maintained pre-crisis. In fact, even with this reading,  capex intentions have recouped only about half the ground lost in the financial crisis.  Conclusion: the rise in capacity utilization is not yet enough, and probably not nearly enough, to engender an investment accelerator to the cycle.

Labour Market Confidence and Wage Inflation  When labour markets tighten, they tend to generate higher wages, primarily because with the pool of possible employees narrows, a company needing to fill an opening has to offer higher wages in order to lure away an employee from his/her existing job, or perhaps attract him/her back into the labour force. But the willingness to demand higher wages is also a function of an employee’s confidence in the labour market, and that will be revealed directly by the quit ratio (ie, the proportion of employees quitting their job in any given month). When quit ratios are low, it implies that workers are extremely unwilling to leave a job, presumably on the grounds that another job is difficult to find. When quit ratios are high, it implies greater employee confidence in the underlying strength of the labour market.  

Now, the current US expansion seems to be supply-led, and one of the signs of that is that the openings rate (number of new openings as a proportion of the labour force) has not only recovered to pre-crisis levels in the past four months, but at 3.4% in August rose to the highest level since early 2001. But contrary to expectations, this has not generated any significant wage pressure: in fact wage growth has been stuck at around 2% pa since 2010.  One explanation has simply been that employees have had very little confidence in the underlying strength of the labour market, and have consequently been unable/unwilling to demand higher wages. And that interpretation is borne out by the quit ratio, which fell from around 3.5% in 2007 to a low of around 1% in 2009, and has only very gradually and partially recovered. However, September’s JOLTS survey showed the quit ratio jump to 2% in September, which is finally within reach of pre-crisis levels.  Needless to say, it is probably a long way from here to a significant acceleration in wage pressures, but this week’s news perhaps brings that prospect nearer.

Consumer Confidence, Spending and Saving  Consumer confidence surveys, whilst not absolutely unanimous, suggest consumer perspectives on the economy have improved substantially: this week, for example, the Uni of Michigan November confidence survey reported the most optimistic assessment of current conditions and the outlook since July 2007, and in this it mirrored the Consumer confidence index’s conclusion for October, which was the strongest since October 2007. The natural corollary of this is that one would expect a fall in precautionary savings ratios which would accelerate retail sales. Has it happened?

It has not, because whatever respondents may be telling confidence surveyors, their wallets are telling a different story.  Retail sales rose 0.3% mom in October,  only reversing the 0.3% mom fall recorded in September and, as the chart shows, sales are struggling to maintain the growth rates maintained since 2010. The wider measure of personal spending tells the same story: the 0.1% mom fall in personal spending in September pushed the dollar total to furthest below the 20102-14 trend since the worst days of the 2013-2014 winter.  But at the same time, the personal savings ratio rose to 5.6%, which is the highest since 2012, and 40bps above the Sept 2013 level. In fact, if the rise in savings ratios seen throughout 2014 is maintained, it will take personal savings ratios back to 2010-2012 early-recovery levels. Far from revived confidence generating a boost in consumer spending based on falling precautionary savings and/or rising inflationary expectations, the reverse seems to be happening.   A rise in savings ratios, perhaps partly based on falling inflationary expectations (also reported in the Uni of Michigan’s November confidence survey), is compromising consumption demand.  

Inventories  There are no such complications about the inventory cycle: what data we have does not suggest any significant volatility: inventory ratios have been almost entirely flat since 2010 and remain so. This week saw wholesalers’ inventories up 0.3% mom in October, as did total business inventories.  

Japan's 3Q GDP: Not Quite The Disaster It Seems

Although no-one anticipated the 1.6% fall in Japan's quarterly real seasonally adjusted and annualized GDP preliminary estimate, beyond the volatility, the underlying picture remains surprisingly still intact.

Let's start with the obvious: no-one knows how to forecast Japan's quarterly real annualized GDP results. The last consensus was 2.2%, my own pin-the-tail-on-the-donkey effort was 2%, and the result was minus 1.6%. Not one of the 28 economists contributing to the Bloomberg consensus forecast a contraction, and I'm not gloating: I've spent year trying and rejecting various ways to make this forecast, and, except upon request, no longer make the attempt.

In any case, it's not clear that the quarterly seasonally adjusted annualized 'real' GDP growth is any longer the most important measure for Japan:

1. with population declining by around 0.2% a year, arguably what matters more is the longer-term trend in GDP and GDP per capita. After today's estimates, 'real' GDP is growing around 1% pa on a 12m basis, and so, roughly 1.2% real GDP per capita.
2. Given Japan's history with deflation, and its overhang of public debt, nominal GDP is surely just as important as 'real' GDP. Now, nominal GDP was disappointing, rising only 0.8% yoy in 3Q (whilst the deflator rose to 1.9%), which cut the 12m nominal growth to 1.9% (with a deflator of 0.8%).

These perspective make Japan's 3Q GDP performance already seem rather less disastrous than today's headlines proclaim. Clearly April's tax rise introduced volatility not just into Japan's GDP numbers, but also into various aspects of Japanese economic behaviour. But if you're prepared to look beyond that volatility (and that's a big if – most people aren't), the picture looks to be improving in several important ways.

First, the capital cycle is probably still intact: non-residential investment rose by 3.9% yoy, almost holding historic seasonal trends, and by my estimates (depreciating all nominal non-residential investment spending over 10 years), Japan's capital stock is now finally rising for the first time since 1Q09. More, despite the volatility of the last two quarters, nominal GDP expressed as a return on capital stock is still rising, and is now approaching pre-crisis levels, which, incidentally, were the best since the bubble years. Beyond the tax-generated volatility, one would expect the historically high and rising return on capital indicator to perpetuate the investment cycle.  

Second, despite the poor headline GDP numbers, output per worker, when deflated by changes in capital stock per worker, continues to rise, which underpins continued employment gains. During 3Q, employment rose 0.7% yoy, and in the 12m to September total output per worker rose 1.3% when deflated by changes to capital per worker. Continued productivity gains should underpin continued employment growth, just as rising asset turns/ROC can be expected to underpin the capital cycle, despite the current volatility.

Third, compensation rose by 2.6% yoy in 3Q and was up 1.6% on a 12ma: this may not sound much, but these are the highest rises in so far this century. It pushed compensation as percentage of GDP to 51.8% in the 12m to September: this is not a record, but it is a full standard deviation higher than the average this century. And it is rising. What is more, the rise in compensation now exactly matches the rise in nominal private consumption, which also rose 1.6% in the 12m to September.

Using the Kaleckian idea of disaggregation elements of profits (Investment; Consumption minus Wage; Net government spending), it seems likely that profits inched up in the 12m to September, but with the pace slowing to a crawl. Those profits are underpinned by increased investment spending and, to a lesser extent, consumption minus wages, whilst they are being eroded by fractional fiscal tightening and the growing trade deficit.  Above all, however, the fact is that the source of Japan's profits are now more obviously aligned with likely sources of sustainable growth than they have probably ever been. The picture is almost classically 'normal'.

  

  

Finally, to return to the problem: the reason why it's rare to forecast Japan's quarterly GDP with any accuracy or certainty is that there appears to be no stable relationship between what is reported on a monthly basis, and what tumbles out of the quarterly national accounts.  For that reasons it is worth understanding what that monthly data is telling us. Here are my monthly momentum indicators for the industrial economy, for domestic demand, and for monetary conditions, showing the 6m trendline, which expresses how many standard deviations away from seasonalized trends the data currently is running:

These tell what I think is a coherent and plausible story: the industrial momentum trendline clearly shows the pre-tax acceleration which peaks in March and subsequently rapidly subsides. It shows a similar trajectory for domestic demand, which rallies up to February 2014 as purchases are brought forward to pre-empt the tax rise, only to slump proportionately afterwards. In both cases, there is a hint of stabilization visible by September (when the industrial and domestic demand momentum indicators end).  But already there is some response in monetary conditions, with a modest expansion opening up from July onwards, and still developing. (And since this indicator ends in October, it has yet to reflect the impact of Bank of Japan's expansion of QE, or the full extent of the Yen's depreciation). 

That hint of stabilization in industrial conditions and domestic demand shows up more clearly when one includes the monthly noise as well as the 6m signal line: 

In the case of industrial momentum, September produced the most positive set of data since April, with industrial production up 2.9% mom sa, which was enough to raise capacity utilization rates to 99.9 (0.4SDs above long-term average), whilst exports rose 6.9% yoy (in yen terms), which was enough to reverse the run-up in inventory/shipment ratio seen since April. 

Aggregate domestic demand indicators also produced the most positive deviation against seasonal trends in September since May's dead-cat bounce.  Employment rose 0.7% yoy, on a monthly movt which was 0.8SDs higher than historic seasonal trends, and average monthly cash earnings also rose 0.7% yoy, which was 0.2SDs above trend.  Retail sales rose 2.3% yoy, which was the highest since March, on a monthly movt which was 0.6SDs above trend, and vehicle sales fell only 5.5% yoy against a tough base of comparison and on a movt which was a full SD above trend.  Set against this, however, was a 45.2% yoy slump in private construction orders, which was 0.9SDs below trend. Overall, however, the continuing strength of labour markets coupled with renewed industrial momentum suggests there may be more to the strength of September's gains than the dead-cat bounce of May. 

My Firmest Conviction

'So what are your firmest convictions?'  What a question! My firmest conviction is that, all being well, the sun will rise again tomorrow – although even that has been subject to doubt from Hume onwards. More pertinently, I think Hayek is absolutely persuasive when he argued  that competition is justified only because it discovers information which can be discovered in no other way. Yes, this does undermine one's faith in economic forecasting, but  I can't see how it can be wrong, and what's more, our everday experience forces us to acknowledge it is right.

Nevertheless, one learns something from failure. And the failures which have pressed themselves upon me this year have been my efforts to anticipate swings in the business cycle. I spend a great deal of time looking at factors effecting returns on capital and labour, measuring swings in private sector savings/investment balances and the underlying cashflows associated with them. This year, this approach has not so much failed, as been largely beside the point. The expected dynamics of the business cycle have either not appeared, or have been so weak as to be only marginal drivers of economic outcomes.  Subcycle dynamics in investment behaviour, in inventory behaviour, in savings/investment choices, in credit totals,  in pricing, and in labour markets have all simply not driven economic cycles as one would expect.  Where expansions are obvious – and particularly in Anglo-Saxon economies – they have been resolutely a-cyclical.

For example, in the US the recovery of capital spending has been maintained, but has hardly accelerated beyond the 2010-2014 trendline, as one would expect. In US labour markets, the quit rate has remained stubbornly low despite the sort of rise in the openings rate that you would expect to get people moving jobs.  And wages have simply not responded to the rise in the net openings rate.  It's much the same in the UK, where investment spending has remained muted, wage growth negligible, inflation receding and credit growth negative even as economic growth accelerates.

Globally, movements in private sector savings surpluses, which can normally be relied on to super-charge domestic demand in the early stages of business cycles,  have generally moved only sluggishly. In the US, for example, the private sector savings surplus appears to have been relatively static around 1.6%-1.7% for most of the last year.  In the Eurozone, the surplus has fallen maybe 50bps over the last year to around 5.1%. In Japan, the fluctuations around 6.6% of GDP over the last two years has been historically muted.  Only in the UK (and China) have there been significant fluctuations, and in both cases, private savings surpluses have risen, muting domestic demand rather than expanding it.

Why this a-cyclicality has emerged and persisted, and what characteristics a-cyclical expansions might show are for a later post.  For now, however, the conclusion is this: that in the absence of  sub-cyclical dynamics, economic outcomes will be determined by something far simpler and more fundamental: what's happening to growth factors. That is 'my firmest conviction'.

Absent the accelerators and dampeners which usually shape a business cycles, growth patterns will be determined by additions or subtractions of factors responsible for production.  The two most important of these are capital stock and labour. In practice, growth can be (crudely) disaggregated as the change in labour employed plus the change in output per worker. Output per worker, meanwhile, can be expressed as a function of changes in capital per worker. This crude arithmetic can be almost infinitely elaborated, but the underlying idea remains the same:  what comes out (GDP) is a function of what goes in (labour & capital).

Neither are easy to measure properly (plenty of people would argue you cannot measure capital stock at all), and they are obviously not the only factors. In the examples which follow, I estimate capital stock simply by depreciating all nominal fixed capital investment over a 10yr period (after 10yrs of data, you get an estimate) – where possible I exclude real estate investment in the calculation.  This tally obviously changes only slowly. For labour, I take have simply accepted official employment statistics.

Without elaborating, I think the charts which follow offer a reasonably clear-headed guide into the likely growth of the world's major economies (except China), and some likely characteristics of that growth. In some cases, it will also suggest some challenges.  At this point, I'm keener on demonstrating the set-up than elaborating conclusions.

US 

Comment: With capital stock growth likely to continue rising smoothly,  there is a likely growth trajectory of 3%-3.1%. With growth in capital stock now beginning to outpace employment, we can expect recovery in labour productivity which leaves room for modestly rising real wages. 

Britain

Comment: Recovery of capital investment seems likely to continue, but the rise in employment is so fast that capital per worker is still stagnant. So productivity gains unlikely to accelerate, and wage growth likely to remain muted/disappointing. 

Eurozone

Comment: There are two problems here. The first is that since there's no sign that capital stock is likely to start growing any time soon,  the modest (but real) uptick in employment is unlikely to be accompanied by growth in labour productivity, so growth prospects are not good. The second problem is that the Eurozone is not best characterised as a single economy: rather, distinctly different fates would seem to await Germany and the rest.  We should expect this divergence of fates to hamper policy-making.  It is noticeable that official forecasts can barely acknowledge the underlying problem.

Germany

Comment: With capital stock growing at a healthy clip, and faster than employment, we should expect labour productivity to grow as well as employment.  Not only does that suggest a re-acceleration in GDP growth, but it also leaves rooms for real wage rises too.  It is difficult to share the official pessimism about this economy - I would expect upside surprises.

Eurozone Ex-Germany

Comment: The situation for the rest of the Eurozone could hardly be more different. Currently both labour and capital stock are shrinking, and even if employment does continue its tentative recovery, it is hard to expect labour productivity to rise when capital-per-worker is falling. As a result, it is difficult to expect much GDP growth, if any.  

Now, how does one set policy for 'the Eurozone'?

Japan

Comment: This is genuinely interesting: by the beginning of 2015, it is likely that both labour and capital stock will be growing, and the difference between the two will be narrowing. This forms a genuinely improving foundation for GDP growth. And given that downward pressure on labour productivity is likely to be the result of the rise in capital stock, that growth would at this point be likely to survive even a short-term downturn in hiring. It might be best to forget about the ability or inability of Abenomics to re-set Japan's economic assumptions, and just look at the improving growth-factors picture.

China's 3Q GDP - Nominal Conclusions

One popular reaction to China’s quarterly GDP announcements is simple disbelief: no statistical agency can hope to estimate quarterly GDP so quickly with any accuracy, so they must just be making it up. My approach is to acknowledge that China’s statisticians face a task which is not only logistically impossible, but also conceptually very difficult (because China is changing so quickly). Nevertheless, through herculean efforts and heroic assumptions, they produce a set of figures which need not simply be written off, but rather interrogated for what they might tell us about China’s trajectory.

The least-useful series is the one that generates the headlines: I have never managed to find any combination of reported monthly economic data -  demand or supply - that bears any statistically interesting relationship to the series of real GDP growth which in 3Q produced a growth rate of 7.3% yoy.  All one can say is that theheadline 7.3% yoy growth in real GDP continued the sequential slowdown vs trend which has been uninterrupted (except in 4Q) since 2010.  Officials seem resigned to a further slowdown in yoy terms in 4Q: if this happens it will represent a further genuine loss of momentum slowdown. If momentum stabilizes, however, we can expect a modest rebound in the yoy rate in 4Q - to around 7.5%.

Nominal Conclusions. However, the nominal GDP series is altogether more interesting, and has much to tell us about how China's economy is functioning.  In summary, it tells us is that the headline nominal GDP was boosted considerably by a doubling of the trade surplus and rather less by a modest fiscal relaxation. Private sector nominal domestic GDP growth (ie, excluding the impact of trade and fiscal balances) slowed sharply in yoy terms, but stabilized sequentially. The private sector’s caution, however, resulted in a rise in the private sector savings surplus to around 4.9% of GDP, which suggests the financial system’s underlying cashflows are slightly improved.   Overall the efficiency of finance within China’s economy remains miserable, but has stabilized, and possibly improved slightly.

If the aim of reforms is genuinely to remodel the economy away from investment and net exports, and towards domestic consumption, those reforms are emphatically not yet producing results. If the short-term aim of reforms is to improve capital allocation and drag China away a debt-dependent growth model, it is probably fair to say that 3Q represents a stabilizing first step on a long and difficult road.

Nominal growth slowed to 8.6% yoy in 3Q from 9.1% in 2Q, but in sequential terms this was actually a modest outperformance of historic quarterly patterns. If maintained, it means that the slowdown in yoy rates may well have hit bottom in 3Q, and be in recovery from 4Q.

The impact of trade. However, nominal GDP was propped up substantially by the trade surplus, which rose 108% yoy in Rmb terms during 3Q, and was equivalent to 5.2% of GDP, and added 2.9 percentage points to nominal GDP growth. Excluding the improvement in the trade surplus, domestic nominal GDP grew only 5.8% yoy,  the slowest since 1Q09. If China’s strategy partly involves weaning itself off the export sector, it failed in 3Q.

The impact of fiscal policy. Secondly, nominal GDP growth was also slightly improved by a slight relaxation in fiscal position, with a Rmb276bn deficit in 3Q up 36.7% yoy from 3Q 13, and equivalent to 1.8% of GDP (vs 1.5% of GDP in 3Q).  On a 12m basis, the deficit is running at 2.4% of GDP, up from 1.5% during the 12m to 3Q13, but the 12m total reflects, as it always does in China, the dominating fourth quarter deficit.   Still, subtracting the impact of the fiscal deficit from nominal domestic GDP leaves a private sector domestic demand growth rate of only 5.3% yoy, down from 5.9% in 2Q, and cutting the 12m to just 7.3%.   However, even after all these subtractions, it remains the case that sequential growth in this figure was slightly faster than historic seasonal trends, and that the fall in the 3Q yoy reflects the sequential slowdowns of 4Q13 to 2Q14, not the underlying dynamic of 3Q.

The impact of private savings/investment decisions.  Meanwhile, the private sector’s underlying economic caution continues to grow, with the estimated private sector savings surplus more than doubling in 3Q to around Rmb 960bn (vs Rmb 469bn in 3Q13), equivalent to 6.3% of GDP. This highly seasonal number is up from 3.4% in 3Q13, and pushes the 12m to 4.9% of GDP (vs 3.5% in the same period last year).  Whilst the rise in private sector savings surplus depresses growth, as it shows the private sector consuming and investing a smaller proportion of its income than at any time since 2010, it has the benefit that it alleviates underlying cashflow pressure in the financial system: the private sector savings surplus, after all, measure the net flow of cash from the private sector to the financial system.  

The impact of finance. Third, with M2 growth slowing to 12.6% yoy in 3Q, whilst nominal GDP growth slowed only to 8.6%, it is just possible that the collapse of monetary velocity (GDP / M2) seen in the immediate aftermath of the 2009 credit binge, and subsequently in the post-2011 slowdown, is stabilizing. This observation is tentative, provisional and vulnerable: however, the slight rise in monetary velocity in the 12m to 3Q reverses the (seasonally expected) falls of 1Q14 and 2Q14, and is slightly better than the stabilization normally encountered in 3Q.  Just possibly, the tighter credit environment is resulting in very slightly better credit allocation. However, please note the caveats. 

But if the efficiency of finance is improving, it is doing so only very marginally, and from historically very low levels. One can also track trends in the efficiency of China’s financing by looking at the relationship between marginal additions to bank lending and/or aggregate financing, to marginal GDP gains.  The chart does that, and it shows that over the last 12 months, one extra yuan of bank lending has been associated with 53 fen of nominal GDP, whilst one extra yuan of aggregate financing has been associated with 31 fen of extra nominal GDP.  In the case of bank lending, this relationship has been effectively unchanged since mid-2013, and whilst it shows an improvement from the credit-binge of early 2009, it remains substantially lower than the levels achieved in 2011-2012, and approximately only half pre-crisis levels.  The crackdown in aggregate financing has resulted in a slightly better story: the 31 fen level is up from 25 fen at the beginning of 2012, but, as with bank debt, if remains at a painfully low level, and less than half the normal pre-crisis levels.  

US Expansion - Still Perversely Non-Cyclical

Here's the problem: the 0.2% mom sa fall in US retail sales ex-autos reminds us that the current US expansion is almost entirely devoid of the cyclical accelerators we always expect from business cycles.

Right now this as a source of woe, since the  expansion simply refuses to develop in the way we are used to tracking. Or one can view it as potentially a source of strength: in recent history it is virtually unheard-of for developed Western economies to generate fundamentally disinflationary supply-led expansions, but that is what seems to be happening in both the US and the UK.  On this 'optimistic' reading, the fact that the economic news repeatedly subverts attempts by central bankers on both sides of the Atlantic to reassert a 'normality' which plainly isn't there, is the good news.

However, it obviously delivers a different set of problems: serial disappointment. Let's concentrate on that.

First, notice that September's retail disappointment probably shouldn't be viewed in isolation. If one looks at the trend growth since 2009, what stands out is that retail sales have never really recouped the losses inflicted by the harsh winter.  The rebound in 2Q never managed to restore current spending levels to the post-2009 growth trendline. September's fall widened that underperformance vs trend to around winter 2014 levels.

That disappointment didn't happen in isolation: average hourly wages were static in September as they had been also in July. Looked at before seasonal adjustments, average weekly wages fell 0.3% mom in September, which was 1.5SDs below historic seasonal patterns. Auto sales have risen more slowly than historic seasonal trends consistently between June and September, with sales rising just 1.9% yoy in the 3m to September.

Constructing a domestic demand momentum indicator which reflects deviations against seasonal trends for employment, wages, retail sales, auto-sales and construction orders reveals the pattern. It's not disastrous: September is revealed as a pretty ordinarily disappointing month, bad enough to depress the 6m trendline back to winter levels, but containing no threat of recurrent recession.

But here's the problem:  this domestic demand momentum indicator has been a reasonably useful guide to US GDP growth ex-inventory movements.  And what it suggests is that we should expect 3Q GDP growth, ex-inventories, to slow to around 1.9% annualized, with 95% boundaries at 1.2% to 2.5%. Right now, the Bloomberg consensus shows an expectation of annualized growth of 3% in 3Q14 and 4Q14.  Frankly, unless there are major inventory surprises ahead (and yesterday's total business inventories growth of 0.2% mom sa in August makes that slightly less likely), those forecasts are too optimistic by far.

Of course, it's only a model, and a fairly crude one at that: it is victim to war, chance, revisions, and the thousand natural shocks that data is are heir to. But the upside surprises  and revisions would have to be fairly dramatic to justify the gap between the data and the consensus.

China Fiscal & Monetary Volatility - A Short Guide to the Recent Past

The sheer extremity of the slowdown in China's monetary numbers in July remains startling, even three months later. July was the month aggregate financing dropped to just 273bn yuan, the lowest since October 2008 (which was the absolute climax of the last anti-inflation overkill, and which provoked such a dramatic response) and from 1.975tr yuan in June.  And, of course, all monetary aggregates slumped in sympathy.  

It raises the question: what the heck happened?  Was this financial suffocation actually intended, or was it just tolerated as it emerged? Or did it happen by accident, perhaps the result of some miscommunication between the various arms of government,  the actions of which each make an impact on financial conditions?

Since it's important, it's worth taking a short tour around the recent data, as a sort of financial battle-field trip. The crucial thing to understand is that the PBOC's open market operations, although closely watched, are not necessarily the largest factor determining monthly shifts in market liquidity. That honour quite often belongs to movements in the government's deposits in PBOC. These deposits currently stand at 3.914tr yuan, and whilst over the last year to August, they have risen by a relatively negligible 17bn yuan per month, they have huge volatility, with a standard deviation of 551bn yuan in their monthly movement.   Obviously, if these deposits are rising, that reflects not merely a net fiscal tightening (a fiscal surplus) but is also, ceteris paribus, something that will tighten monetary conditions.

In July, the monthly fiscal surplus was nothing exceptional: 240.6bn yuan, vs 249bn in July 2013 (with revenues up 6.9% yoy and spending up 9.6%).  But this probably understates the impact of government activity on private sector cashflows, because govt deposits in PBOC rose by 566bn yuan in July, up from 446bn in July 2013, and 1.2SDs higher than normal seasonal trends.  In other words, the fiscal tightening in July was greater than advertised.

Moreover, this reversed significant de facto fiscal stimuluses:

• in June, when government deposits fell 275bn yuan during a month when historically they tend to be near-unchanged, and 
• in May, when the 105bn yuan rise in deposits was less than a third of the c350bn yuan rise normally expected. 

What is more, this de facto fiscal tightening was not offset by PBOC market operations, which added on average only 74bn yuan per week, down from 204bn yuan in June and from 96bn yuan in July 2013.

At this point, it is tempting to believe that July's tightening had an accidental component, in which the monetary impact of Ministry of Finance's determination to retrieve a fiscal situation which had threatened to deteriorate beyond expectations was not fully appreciated by PBOC.

Moving to August, there are signs of a modest reversal: government revenues are still weak, rising 6.1% yoy on a monthly movement slightly below trend, whilst government spending also slowed to 6.2% yoy, which although below trend, represents a slightly recovery from July's stringency. The  monthly deficit of 109.5bn yuan is virtually unchanged since August 2013. More importantly, the marginal 20bn yuan rise in government deposits is 0.3SDs below the 84bn yuan normally expected in August and is slightly lower than in August 2013.

Meanwhile, there is no sign of relaxed accommodation from PBOC, with open market operations averaging an expansion of just 50bn yuan per week in August, falling to approximately zero in September.

Conclusions time: There is no sign that PBOC has significantly loosened policy in response to July's distress-signal. But both the overt and de facto fiscal squeeze which bit in July was not repeated in August - rather fiscal conditions were normalized.  My interpretation is that the July's financial squeeze was exacerbated, though not solely caused, by the unexpected diligence of the finance ministry in retrieving a deteriorating fiscal position.  

BOJ, ECB, Fed: Three Ways to Lose Credibility

The collapse of ex-US confidence beyond anything justified by current economic data is just one early ramification of the dollar's strength. Nevertheless, it focusses attention back on central banks, and in particular on their perceived ability to exercise sufficient influence or even control on financial conditions to head off trouble.  In other words, it puts central bank credibility at a premium, at the same time as undermining it.

And in each major economy, the challenges to central bank credibility have evolved differently. But in each case, the risks of lost central-bank credibility are suddenly more thinkable, and more visible, than they were a few months ago. In fact, the threats to central bank credibility may themselves form a new category of risk to the global economy.

BOJ – Classic currency/bond market/financial system meltdown

The credibility of the Bank of Japan seems the most immediately fragile: it is horribly easy to envisage a situation in which a run on the yen forces up interest rates (in the mild version, to head off inflation; in the alarming version, simply to underpin the currency temporarily), which in turn destroys the value of JGBs held by financial institutions.
Just to put some figures on those holdings:
I) public sector debt makes up 22% of the total asset base of Japan's commercial banks, and are equivalent to just under 30%  of their deposit base.
II) Public sector debt account for 48% of insurance and pension assets, and are equivalent to 61% of total insurance and pension reserves.
III) Public sector debt accounts for 79% of Bank of Japan's assets, and equivalent to 141% of the deposits made with the bank, and are 2.36x the currency issue.

More generally, with public sector debt as a percentage of GDP having sailed past 200% approximately a decade ago, any significant and sustained rise in interest rates would threaten to overwhelm almost any imaginable plan for fiscal consolidation.

So what can be said for Bank of Japan.  Well first, this: that the underlying government debt situation is so extreme, and the ticking of the bond-yield bomb has been so audible for so long, that worries about the Bank of Japan's credibility have themselves developed a credibility problem. The reluctance to believe in the doomsday scenario in which Bank of Japan 'loses control of the situation' isn't simply a matter of recoiling from the horror – it is also testimony to the regularity with which the anticipation of Japan's doomsday has cost investors money.

The best chance of defusing this bomb demands: a) an economy which is growing in nominal terms  but also b) inflation which is sufficiently positive to help foster nominal GDP growth, by changing ingrained deflationary expectations), but sufficiently suppressed in both absolute terms and in volatility, to keep the bond market calmly accepting of a life of modest but sustained loss of value. Tricky, very tricky.

Before the latest devaluation of the yen, however, the trajectory for inflation suggested that BOJ's attempt to rise the inflation rate to around a steady 2%, excluding tax rises, was on course.

So the question now is: what impact is the devaluation of the yen likely to have on CPI? The most obvious impact is on the price of imported fuels: overall, energy has a 7.7% weighting in Japan's national CPI, falling to 4.6% if electricity is excluded, with the largest components being gasoline (2.3%) followed by gas (1.8%). In other words, every 1 percentage point fall in the yen vs the dollar would be expected to raise the CPI by 0.05 percentage points.

Now, in September, the yen declined on average by just under 4% against the dollar, and has fallen a further 2.5% in the earl days of October. Were this to be passed through entirely to gasoline and gas prices, the combined fall would be expected to raise the CPI index by 0.3% during those two months.
But this, of course, isn't what will happen, since a) oil prices have been falling as the dollar has risen; and b) the bulk of Japan's oil contracts will not be priced in spot terms either for the commodity or for the fx rate.  In both cases, in the short term this is likely to mute any inflationary impact from rising yen oil prices.

More importantly, oil remains quite a small part of the overall index weighting: the things which weigh most heavily on Japan's CPI are food (25.3%), housing (21.2%), transport (14.2%, includes oil) and culture/recreation (11.5%) - and for most of these, the pass-through from oil prices is likely to be very small.

ECB – The Discovery of Impotence 

Meanwhile, over at the ECB, Mario Draghi increasingly looks like an honest man getting used to public deception. Too personal? His problem is that ever since his July 2012 willingness to to 'whatever it takes' to save the Euro,  his ability to change expectations, and thus savings/investment behaviour is linked to whether he can make good on this claim.  There are two major problems which would seem to restrict the scope of 'whatever it takes'. The first is simply political: German opposition to quantitative easing seems entrenched, and to have resulted last week in Mr Draghi being unwilling or unable to quantify the size of his earlier stated plans for the ECB to start buying private sector assets in the aftermath of the ECB's latest policy meeting. 

 The second is legal: Article 21 of the ECB's constitution forbids 'overdrafts or any other type of credit facility . . . in favour of Community institutions or bodies, central governments, regional, local or other public authorities' and bans 'the purchase directly from them by the ECB . . . of debt instruments'.  On October 14th, the European Court of Justice will be hearing arguments from Germany academics on the legality of ECB's current bond-buying plans.  

But does it matter just now if confidence in Mr Draghi's ability to deliver the ECB to full-blown quantitative easing gradually ebbs away? Arguably, it matters less that confidence in his promises of ECB largesse is now waning, than that it was present first in July 2012 ('whatever it takes') and again 2Q2014, since then it helped rally bond and equity markets. In the first instance, confidence in Mr Draghi's intentions helped cut the premium of 10yr BBB bonds from roughly 200bps to around 120bps; in the second, it helped push it down further, to around 95bps.   More dramatically, it was part of the circumstances which allowed the premium on 10yr Spanish bonds to fall from c500bps in July 2012 to  slightly more than 100bps now. Arguably, Mr Draghi's ability to buy time then was more important than the possibility that some of the currency in which he bought it may yet turn out to be lacking. 

In turn, this provokes the wider question of what quantitative easing can be expected to achieve in the first place. Whilst it seems likely that quantitative easing, and indeed the prospect of quantitative easing, can and does move asset prices in a way which can be very useful to extremely-stressed financial systems, it is altogether more uncertain that it can effectively change saving/investment decisions in a way which makes a clear impact on the economy. Studies by the US Fed found that the required internal rate of return demanded of corporate investment decisions were extremely 'sticky' and so likely to be surprisingly little encouraged by falls in short-term rates or even long-term bond yields. The results of this are there for all to see: years of quantitative easing in both the US and UK have brought forth expansions which are surprising mainly for their almost complete lack of normal cyclical 'accelerators', or indeed, of any noticeably cyclical structure.  

Fed – The Nostalgia for Normality

And this brings us back to the Fed, which now faces a challenge to its longer term credibility which reflects the curiously a-cyclical nature of the expansion currently underway: a nostalgia for 'normality' which seeks to re-instate a policy-making structure which simply is no longer available. Almost all commentary on the Fed's policymaking in one way or other amounts to attempts to re-interpret, re-state, or (most ambitiously) re-calculate the Taylor Rule conditions. When John Taylor first suggested the 'rule', it was simply put forward as a way of interpreting what had actually been the revealed policy of the Fed – that rate changes had been made to reflect deviations in both the actual rate from the targeted rate, and changes in the output gap (or, more loosely, how far actual output was deviating from potential output). In practice, this output gap was estimated by measuring the deviation over a long-term growth rate which had been stable enough to measure and extrapolate with confidence. 

The problem is that the financial crisis has left the economics profession profoundly uncertain as to the size of the output gap, and similarly unsure as to the potential growth rate of the US.   This ignorance and uncertainty was neatly illustrated by Friday's labour markets release: the 248k mom rise in non-farm payrolls suggested relatively buoyant growth, but the  shocking renewed fall in the labour participation rate suggested this growth was not drawing people back into the workforce as had been expected. If that is the case, the potential supply of labour must be smaller than appreciated (and so the output gap smaller than expected). But, finally, the market doesn't seem to be tightening, since since hourly wages were unchanged on the month.  As far as wages are concerned, it seems that even the mild upward pressure seen earlier in the year is abating. The paradoxes of the report point directly to the impossibility of using Taylor Rule metrics to structure monetary policy in current conditions. 

In these circumstances, the credibility issue the Fed faces is twofold: the the ability to make the right decision; and the ability to persuade the rest of the world that the FOMC knows why it is making it in the absence of a credible rationale. The worry is that the 'nostalgia for the normal' will tempt them to grab for a  solution which looks 'normal' – in this case, by raising interest rates – before any sort of cyclical normality is in fact re-established.

Northeast Asia Gets Ready to Cut Prices

Before the striking weakness of August's industrial data the region seemed to be avoiding the usual fate it meets when the dollar strengthens: export prices were not falling sharply, international terms of trade were holding up, underpinning margins, profitability and cashflow.  It was different this time.  But this week's industrial news from Japan and South Korea changes the picture for the worse: not only did industrial output slump in China (output rising 6.9% yoy only), Japan (output down 3.1% yoy) and South Korea (output down 2.8% yoy), but this slowdown was insufficient to stop inventory ratios blowing out.

The desire to cut inventory ratios, coupled with the accelerated depreciation in the yen, sets the stage for a renewed period of deflation coming primarily from Japan and South Korea. That pricing pressure is likely to radiate out to China and to Southeast Asia, and we're likely to feel its effects very soon.   

First, let's remember that the last few years (since when?) have been a period of exceptional pricing and margins stability for most of Northeast Asia. Deteriorating terms of trade had been a way of industrial and trading life for most of Northeast Asia for as long as most managers can remember: between 1994 and 2011, terms of trade fell almost uninterruptedly for both Japan and S Korea; Taiwan held out a little longer and a little better, but was unable to escape, with a sharp and seemingly unstoppable slide between 1998 and 2011. However, since 2011, the pattern has been near-stability: between 2Q11 and the 3m to August, Japan's terms of trade fell only 5%, whilst they improved 1.7% for S Korea and rose 2.7% for Taiwan.

This new stability wasn't just the result of commodity price movements favouring Northeast Asia's industrial commodity-consumers – though that certainly helped.  But in addition, there had been no repeat of the bouts of savage deflation in dollar export prices experienced in 1997-2002, again in 2006 and once again, briefly in 2010. In its place has been a period of unusual pricing stability for NE Asian exporters. 

It is this stability which August's shockingly weak industrial data puts under threat. To recap:

• China's industrial output growth slowed to 6.9% yoy, on a monthly slip that was 0.7SDs below trend
• Japan's output fell 3.1% yoy, and was 1.3Ds below trend
• S Korea's output fell 2.8% yoy, and was 1.1SD below trend.

Now, this could perhaps be dismissed as a shared blip – and what's more, a blip in the month of the year which matters least as far as industry is concerned.  And it remains the case that momentum trends in G3 imports and Northeast Asian exports remain sufficiently robust to allow a yoy acceleration through the rest of the year (although perhaps slightly less than expected six months ago). It also remains the case that global domestic demand remains in reasonable shape.

However, the problem is that at least for Japan and South Korea, August's slowdown has left  both with an inventory problem which managements will want to address quickly (particularly in Japan).  Japan's inventory/shipment ratio has spiked up to the sort of levels seen in the immediate aftermath of 2011's triple disasters, and again in the angst-ridden period which brought PM Abe to office. Getting rid of these inventories will demand either further cuts in production, or significant price-cuts to get the inventories off the books. Since the end of August, the yen has fallen  more than 5% against the dollar, so the temptation simply to slash dollar prices will be hard to resist.

That then throws the pressure back onto Korea, where the inventory turnover ratio  (total inventories/sales) has been climbing since 2011, and in August reached record heights. 

And, of course, that pressure will also be felt in China.  China's August industrial data was awful too: not only did output growth slow to 6.9% yoy, but the slowdown in the topline crushed profits, which fell 0.6% yoy in August (if the data is to be believed). Once again, if China's data is to be believed, mainland companies have spent the last 18 months or so successfully protecting their margins, and this was still the case in August's slowdown.  However, as the chart also shows, China's margins are highly cyclical and tilted sharply towards the year-end. It is the fattening of these year-end margins which would be directly threatened by Japan and S Korea's efforts to offload inventories by cutting prices. 

Conclusion? It's price-cutting time for Northeast Asia: there will be bargins this Christmas.

The 'Fragile Eight' and Terms of Trade

Another day, another warning of possible global implosion. This time it's from the Geneva Group: as lofty a  bunch of European financial and economic practitioners as you're likely to come across. Entitled 'De-leveraging, What Deleveraging?' the report is for the most part a detailed explanation of why high levels of indebtedness can be dangerous. It also attempts to identify the difference between simple recessions and various types of debt-triggered disasters (an attempt which hinges on a touching faith in the ability to identify 'potential GDP'); and finally it focusses on the build-up of debt in emerging markets, warning of the possibility that the next financial crisis may be bubbling up in China and/or a group they identify as 'the Fragile Eight.'

The 'Fragile Eight' are: Argentina (129% debt/GDP in 2013); Brazil (121%); Chile; India (120%); Indonesia (65%); Russia (43%); South Africa (127%) and Turkey (105%).

In this article, I'm going to ignore China, and instead focus on the 'Fragile Eight'.  Or rather, I want to focus on one of the key factors which can turn an underlying fragility into a genuine crisis. the Geneva Group identifies three main types of crisis: banking crises; sovereign debt crises; and external crises, which they describe as an inability to rollover existing debt or obtain funding to cover current account deficits.  But each of these need a trigger - a shock which catalyses the crisis, of whatever type it may be. And in my experience, one key trigger which is almost always present, but which almost always gets ignored until it's too late, is a deterioration in a country's terms of trade - ie, a rise in import prices it must pay relative to the export prices it can command.

Big shifts in a country's international terms of trade really matter.  In terms of debt crises, they matter particularly because;
i) in practical terms, a deterioration in terms of trade usually results in a deterioration in underlying cashflows within an economy, which in turn  can expose latent financial vulnerabilities both to, and within,  a country's financial system;
ii)  since a country's terms of trade signal an international ability to price its goods and services, it is also a reflection on its potential growth rate. Put simply, if a country's terms of trade are rising, the world wants what it has to offer; conversely, if they are falling, the world's appetite for its goods and services are in relative decline.  And, of course, even though experience warns us that attempts to pinpoint a country's potential growth with any useful accuracy usually fail, a shift in the terms of trade is a useful indicator of which way the wind is blowing.

For each of the Fragile Eight, I have looked at movements in the Citi Terms of Trade Index since the beginning of 2006, and tracked where September's index is relative to the long term average, and also at the change during the last 12 months.  In both cases, I'm interested in both the extremity of the current position, and in the speed at which changes have happened.  In order to capture this, I have expressed the current deviation in terms of standard deviations from the post-2006 average.

This table reveals the Fragile Eight are not as coherent a group as the Geneva Report assumes.
i) For Turkey, Russia and India, the story told by the terms of trade are either positive or neutral, with the implications for improved cashflows that implies. These are the the Not-So-Fragile Three.
ii) Conversely, there are two, and possibly three, clear losers. Brazil is the biggest loser both in terms of how far from the post-2006 average September's position  has fallen (2SDs below) and the speed at which this fall has occurred (2.3SDs over the last 12 months).  South Africa and Indonesia also look like major losers, with Indonesia's terms of trade currently 1.7SDs below its l/t average, and South Africa's 1.4SDs below. Of these two, however, South Africa looks the more vulnerable, because it starts with a much higher leverage (127% of GDP vs Indonesia's 65%), and because Indonesia's terms of trade appear to have virtually stabilized over the last 12 months, whilst South Africa's has deteriorated quite sharply (down 0.5SDs).
iii) Finally, whilst both Argentina and Chile are suffering a modest deterioration in terms of trade, the current position and the speed which which current deterioration has arrived look relatively unexceptional.

Finally, it is worth remembering that terms of trade are a global zero-sum game: one country's terms of trade loss is another country's terms of trade gain.  What may yet prove the most important factor in the world's cycle is the unusual strength and resilience in terms of trade which developed markets are now showing. This phenomenon embraces not just the US and Europe, but also most of Northeast Asia, including economies who's histories have for years or even decades been suffered incessant terms of trade problems.  More on that later. . . .  

Eurozone - Expansion Despite Policymakers Best Efforts

There are very good reasons why the Eurozone is identified as a major drag on the world economy: its policymakers have managed to distil a formula of strategic policies which are fundamentally toxic.  The mix tightens fiscal policies whilst at the same time demanding bank recapitalization, all within a single-currency framework which imposes on approximately half the continent the wrong international pricing for locally-produced goods and services.  The resulting slide towards deflation isn’t an accident, it is policy (sometime referred to as ‘internal devaluation). To that must be added a studied lack of enthusiasm for supply-side reforms, and in certain cases (Italy, Spain, Portugal at least) an inherited public sector debt problem which, without a return to vigorous nominal GDP growth, must eventually end in default.

None of this is news to those outside the policymaking environs of the EU.  What is more surprising is that the Eurozone continues to grow at all (albeit 2Q GDP was virtually unchanged qoq, annualizing to just 0.1%), and might be expected to accelerate mildly over the coming year. And yet embedded in the misery, there are developments which would, in other circumstances, herald a cyclical recovery.  The good news shows up in rising productivity of the two key factors of production: capital and labour.

The first chart attempts to identify directional trends in return on capital by considering nominal GDP as an income from a stock of fixed capital. Movements in that capital stock are estimated by assuming a 10yr depreciation of all gross fixed capital formation (as identified in quarterly national accounts). The chart shows a pattern in which capital stock has been shrinking since the beginning of 2013, and is currently now shrinking around 0.6% a year in nominal terms.  Since nominal GDP is currently rising at approximately three times that rate, asset turns are rising sharply, which in turn generates a rise in return on capital.

This cyclical dynamic of capital spending stalling sufficiently to allow a rise in asset turns is a familiar feature of economic cycles, and the corollary of rising asset turns is, of course, a resurgence of investment spending. The problem is that elsewhere in the world,  in this cycle the gap between return on capital rising and capital stock beginning to be replenished has been extraordinarily long.  For example, in the US, the ROC directional indicator bottomed out in 2Q99, and recovered to its pre-crisis levels by 3Q10, but it took until 2Q11 for capital stock to stop shrinking.  And then the recovery has been exceptionally muted: by 2Q14, although the ROC directional indicator was at its highest since the early 1980s, capital stock was growing at only 2.1% yoy.   One can guess at the reasons for this relative dislocation between ROC and capital spending: a fundamental lack of medium-term commercial confidence; an underlying deflationary expectations; a failure financial intermediation. Whatever the reason, ROC may be rising, but it seems obviously premature to expect any sort of sustained recovery in Eurozone investment spending.

The news is less bad for the second factor of production: labour. The cyclical dynamic plays out in much the same way as it does for capital: in the early stage of a recession, employment falls sufficiently to allow labour productivity (deflated by changes in capital per worker) to rise. When productivity begins to rise, labour markets begin to recover.  And here the trends in the Eurozone are slightly encouraging: real output per worker, adjusted for changes in capital per worker, are rising at approximately 1.7% yoy (output per worker up +0.6% yoy, capital per worker down c1% yoy). And in response, employment in the Eurozone is actually rising, by around 0.5% yoy in 2Q. This rise in employment is currently concentrated in two economies: Spain (up 2% yoy) and Germany (up 0.8% yoy). However, there is no reason not to expect this employment gain to be maintained, and gradually strengthened. In both the UK and (to a lesser extent) the US, the sustained rise in employment, backed by rises in labour productivity (deflated by capital stock) has been the key to the sustained and generally non-cyclical expansions currently underway.   And this is the key, the Eurozone’s recovery, though tepid, is unlikely to show signs of becoming self-supportingly ‘cyclical’ any time soon. 

Two final charts illustrate the point. The first is of the Eurozone’s private sector savings surplus: this I estimate at approximately 5.2% of GDP in the 12m to 2Q. The private sector savings surplus shows, of course, the balance between private investment and savings, and self-evidently, strong changes in the balance of these decisions are a key dynamic of investment cycles. Hence in 2008-2009 the financial crisis produced a very sharp jump in the PSSS from a savings surplus of around 0.7% at end-2007 to a high of 6.6% in  1Q10. The current dynamics are not similarly cyclical – since 4Q12 the surplus has wandered between 5% and 5.6% of GDP, and is currently drifting downwards, to around 5.2%: savings and investment decisions show no signs of dramatic movement.

The private sector savings surplus is also a measure of the fundamental vector of flows of cash between the private sector and the financial system – a savings surplus ends up as a net flow of private sector cash into the financial system, whilst a deficit will have to be funded by a flow of cash from the financial system to the private sector (for example, by bank lending and a rising loan/deposit ratio).  In a bank-dominated financial system, the positive flow of cash associated with a savings surplus will accumulate in bank deposits, and thus in the money aggregate M2.  It is therefore crucial to determine how effectively the banking system can recycle these savings back into the economy. One measure of this is monetary velocity (GDP/M2).  And as the chart shows this is showing a small but continuing decline.  Consider what this means: in the 3m to July, M2 grew at 2.3% yoy, and if monetary velocity continues to fade whilst monetary growth remains stable, nominal GDP growth must sink below the 1.8% achieved in 2Q14.

The ECB plainly understands the impact of the continuing inability of the Eurozone’s financial institutions to improve its recycling of private savings flows.  However, there is little evidence that even a fully committed policy of quantitative easing can reverse this fall in monetary velocity. In the US, all the Fed’s quantitative easing, coupled with a convincing expansion, has not yet managed to reverse the fall in monetary velocity. In the UK, quantitative easing has not stopped the long-term decline of M2, and, of course, in Japan, monetary velocity has been falling virtually without interruption since 1993.  The message seems to be that central largesse cannot make commercial banks into efficient recyclers of private sector savings – it can only attempt to overwhelm that inefficiency with sheer scale.

Where does this leave the Eurozone as a contributor to global growth in the short and medium term? Surprisingly, perhaps, leaves us with grounds to expect that a modest expansion can be maintained, despite the slowdown of 2Q, simply on the basis that rising labour productivity in the absence of net positive capital spending, will allow for a modest but sustained rise in employment, which in turn can provide some modest expansion in demand.   But there are two caveats: first, there is no reason to expect any obvious acceleration in pro-cyclical behaviour; second, there is no reason to expect that nominal GDP will match levels of M2 growth any time soon; and third, there is no reason to expect that any relatively modest steps towards quantitative easing by the ECB will succeed in inducing any pro-cyclical behaviour in the short to medium term. The Eurozone will remain a drag on world growth, but in the short to medium term, probably not more so than we are currently used to. 

This is an excerpt from the Shocks & Surprises Global Weekly Summary for the week to 19th September. Please email me if you would like to see a copy.