US: The Best Way to Shrink

If you've got to have a ghastly downward revision that puts US 1Q GDP shrinking at an annualized 1%, this is probably the best sort you have any right to expect. Three things stand out: I) the central role of inventories; ii) the upward revisions for the core private spending categories; and iii) this sort of slowdown does little damage to the grounds for expecting a cyclical acceleration in investment spending. In addition,  monthly data suggests this capital goods cycle is already quietly underway.

Inventories. The bulk of the downward revision, enough to account for the entire contraction, comes from a single source –  inventory adjustments. The slower pace of private inventory build-ups stripped 1.62 percentage points from GDP growth, compared with 57bps in the advance estimate. By itself, this change is responsible for the entire GDP contraction.  Now the thing about inventory movements is that they regularly do have a significant impact on quarterly GDP results, but that their volatilities tend to be answered rather quickly by equal and opposite volatilities.   Since 2000, the average contribution of private inventory movements to quarterly annualized GDP growth has been a fall of just 1bp, but the standard deviation of such movements is . . . 1.48 percentage points.   We can and should expect private inventory movements to rebound, and quickly, at least in terms of its contribution to GDP growth.

It should also be said that the inventory fall recorded in the GDP data is surprisingly large: additions to wholesalers' inventories slowed 12.7% qoq ,  whilst additions to manufacturers' and trade inventories slowed 19.5%, whilst the GDP estimates record a 52% qoq slowdown in nominal terms, and 56% in real terms.

Revised Up: Investment & Consumption Spending. Meanwhile, the core private sector spending categories were revised up, narrowly. Non-residential investment spending was revised up to an annualized fall of 1.6% from an initial estimate of 2.1%, and residential investment was revised up to minus 5.1% from an initial minus 5.7%.  To put these falls into context, they stripped only 36bps from growth.  Private consumption spending was revised up to 3.1% from the initial 3%, and added 2.09% to growth.  

The third thing to emphasise is that this blip in 1Q's GDP has had virtually no implications for the US cycle: even factoring in the 1Q decline, my ROC directional indicator (which expresses nominal GDP as an income stream from a stock of fixed capital, which in turn is estimated by depreciating all fixed capital spending over a 10yr period), continues to be at the high end of the range of the last 30 years.  Even after factoring in the declines of 1Q, private gross fixed capital formation is still running at 5.5% a year in nominal terms, and 3.2% in real terms. There is no reason not to expect this to re-accelerate throughout the year.

The Capital Goods Cycle is Turning. In fact, April's monthly data for orders and shipments of capital goods (nondef ex-air), provided some evidence  that this acceleration is already underway. This was not immediately obvious, since orders fell 1.2% mom – which was worse than expected. But that fall disguised an underlying  recovery which looks distinctly like a turning point. In fact, both orders and shipments of capital goods nondef ex-air are currently rising more rapidly than they have since around 2011, once one strips out the early 2013 rebound from the orders slump in 2H12.  That's partly because of the size of the revisions: March's total for orders, for example, was revised up to +4.7% mom from a preliminary 2.2%; the total for shipments was upped to 2.1% from the original 1%. Previous months were also upgrade, albeit less dramatically. The upshot is that when you look at the nominal dollar numbers, the breakout from previous levels for both orders and shipments is quite unmistakeable. 

And it is backed up by a further indicator: constructing a book-to-bill ratio for these capital goods, you find a sharp reversal from the rather threatening decline seen between Sept and Feb. Right now, the 1.03x ratio is 0.6SDs above the long term average and has recovered back to levels commonly held pre-crisis. 

Regardless of this, it will be hard for the the annual GDP growth tally for 2014 to recover to the 2.7%-2.8% which seemed likely at the beginning of the year. Nevertheless, whether you forecast GDP by looking at the various expenditure categories, or whether you take a production function input-based approach, the swing factor in this year's US GDP (ie, the difference between 2.7-2.8% and c3%+) was always going to be a long-predicted and long-overdue capital goods cycle. And it seems likely that, once this weather-afflicted quarter is stripped out, a modest acceleration can still be expected.  

US Employment and GDP Tolerances

One of the lessons from the UK recovery is that sometimes employment is not simply a lagging indicator responding to changes in identifiable changes in consumption or investment, but also the source of those changes. This is no very striking or original insight, perhaps, but it is quite often overlooked or forgotten. Does this have any lessons for the US – particularly in the light of the shocking slump in 1Q GDP to just 0.1% annualized, and disappointing April data from retail sales (+0.1% mom) and industrial production (down 0.6%).  Consensus GDP forecasts have subsequently slumped to 2.5% for 2014.

But if we treat employment as being the main determinant of GDP growth, does that still seem reasonable?

Non-farm payrolls are currently rising at a rate of 1.7% a year, and have been doing now for two and a half years, and though there's no sign that this is resulting in any acceleration of wage growth, there's also no no sign that it is peaking out. The rate of job openings has not yet recovered to pre-crisis levels, but is steady at  around 2.8% (vs 3%+ pre-crisis), whilst the quitting rate (thought to be indicative of labour  market confidence) continues to plod slowly but steadily higher.  Meanwhile, initial jobless claims have fallen to their lowest levels since mid-2007.  So despite the shocks of the last few weeks, there appears no immediate threat to labour markets.

What would we expect from GDP growth if non-farm payrolls continue to rise around 1.7%-1.8%?  Here we confront the difference between the economy pre-crisis, and the economy now (the 'new normal'). Prior to the crisis (1992 to 2007),  a simple regression would associate a 1.7% non-farm payroll growth rate with a GDP growth rate of 3.4%. Since the crisis (2007 to the present) that growth rate would slip to 2.6%.  Unless there is a substantial upward revision in 1Q's dismal 0.1% rise, that would imply an acceleration during the rest of the year to 3.4%. It seems a stretch from here, but it's not impossible – annualized growth averaged 3.1% during 2Q-4Q13. 

But to get much beyond the 2.6%-2.7% range of growth, and into the 3%+ levels expected for 2015 and 2016 will demand either a sharp acceleration in employment growth or a rise in the productivity of those who are employed.   And here we get to the point: there's no mystery why the current level of employment growth is associated with a far lower rate of GDP growth than prior to the crisis: the fall in productivity is simply a reflection of the lack of investment spending, and an actual fall in capital per worker deployed.  I estimate changes in capital stock by depreciating all nominal gross fixed capital formation over a 10yr period. 

By that reckoning, capital stock grew just 1.9% in the 12m to 1Q14 – and that was the highest growth rate since the start of 2009.  But it also means that capital per worker is now growing by only 0.2%, and that the average amount of capital deployed per worker is currently 2.5% below its 2009 peak.  It also compares to an average growth rate of 4% during the 1992-2007 period.

So the conclusion is this: at present, the 1.7% employment growth is compatible with a central growth rate of around 2.6%. But this is likely to edge upwards provided growth of capital stock continues to outpace growth of employment. After all, it turns out that the prospects for 2015 and beyond depend above all on the emergence of a recognizably robust investment cycle. 

Britain's Strange Recovery . . . Part III: Bricks Without Straw

In parts 1 and 2, I’ve tried to show that various popularly-entertained models of britain’s recovery are inconsistent with the economic facts as I find them. plainly, Britain’s recovery is not credit-fuelled consumer boom; it is not a recovery predicated on a widespread property bubble; it is not London-centric it is not explained by a a Keynesian rebound after a retreat from fiscal austerity; and it is not unbalanced in the sense of bringing with it a renewed imbalance in external balances; and finally, it is happening without significant investment and without a noticeably functioning banking system.

It is also, as we shall see, not a recovery based on either a Hakeyian working-out of malinvestment, or, alternatively a recovery in which a willingness to keep interest rates unusually low via quantitative easing has managed to avoid  and reverse the consequences of malinvestment.   Britain’s recovery is emphatically not investment-led, nor is it certain that it will become so in the short to medium-term.

Rather, Britain’s recovery has arrived despite the lack of resolution of previous bad investments, and despite the continuing dsyfunction of its financial system, signalled in this case by the continued decline in monetary velocity (GDP/M2). In that, it looks like much of the rest of developed world. 

So we are left with a puzzle: what is allowing Britain’s economy to recover a growth trajectory? The clue lies in the way we have looked for, and been unable to find, the source of extra demand.  We are so used to approaching the question from a basically Keynesian demand-led view of the cycle, that it is puzzling to discover that certain recoveries can be supply-led. We are so used to seeing employment as a lagging indicator that it comes as a shock to discover that in Britain’s recovery employment is the leading indicator. In fact, I would go further - the rise in employment is Britain’s recovery.  The chart below shows that employment began to rise, and sharply, in mid-2011, nearly two years before GDP began to show a similarly obvious recovery.

But in fact, there’s nothing logically difficult about employment being a leading, not lagging, indicator of this cycle. The assumption that unemployment must reflect a lack of general demand is difficult to uphold in a globally-open economy (and particularly when the local economy in question has a structural current account deficit).  And even Keynesians will agree that Say’s Law holds most of the time: that, as JS Mill paraphrased it, ‘the production of commodities creates, and is the one and universal cause which creates, a market for the commodities produced.’

Bricks without Straw: Some-employment vs Un-employment At this point, the discussion becomes difficult - distasteful even. For it seems to me that the reason employment began to rise in mid-2011 was that British were positively driven into it - even if that employment is part time, or marginal self-employment, or only marginally-productive employment. The various goads driving coralling the population to seek or invent a job are both deliberate and accidental: 

i)  government restrictions on the welfare state; 

ii) the consequences to household finances of the financial crash and subsequent dysfunction of the financial system; 

iii) the deterioration of the UK’s pension system; 

iv) the longer-term consequences of the mass immigration, particularly from Europe.   

This list is hardly complete, but already contains enough for nearly every politician and politically-involved commentator to loathe. Yet all these phenomena are visible not only to common experience, but also in the economic data.  And all lead to a single message from the economy to the population: get a job!  Some employment is better than unemployment!

And here we finally reach the crux of Britain’s recovery.  For the unexpected reinvigoration of the labour market had at least two immediate impacts. First, such supply-side flexibility (desperation?) has made it easy and cheap for companies first to hoard labour and secondly, to substitute low-risk, low-cost labour for high-risk, high-cost capital in the early stages of recovery.  And, estimating movements in capital stock by my usual method of depreciating nominal gross fixed capital formation over a 10yr period, this is what has happened. 

Second, it has brought forth a new layer of what might be called low-level protean capitalism, as the ranks of the part-time employed and low-level self-employed have risen to 41.7%. Prior to the recession, that proportion was steady at about 38%Self employment contributed 2.2 percentage points to the rise since Jan 2007, and part-timers have contributed 1.3 percentage points.  

What lessons one might draw from this must wait until the next instalment, as must consideration of the London property bubble’s role.  For now, I want to leave with two observations. First, Britain’s recovery is real and likely to be sustained, but it is unedifying, and it leaves crucial strategic questions absolutely unanswered.  Second, unedifying as it is, Britain’s labour-led recovery is genuinely surprising given the difficult other major economies have had, and are having, in finding a exit-route from financial disaster.  'It's a recovery, Jim, but not as we know it.'

US Workers: Working, Earning, Quitting

What we really need to know, we don't know: the data we have is not the data we need. 

The issues and confusions clustering around the US labour market hold the key not just to the sustainability of the US recovery, but to its medium term trajectory, and the development of monetary policy. If labour participation rates rebound, so too do estimates of potential output and the current output gap, with major implications both for monetary policy, and asset pricing.  But if the post-crisis fall in participation rates are not reversed, how soon will effective full-employment be reached, and when should monetary policy tighten to head off potentially inflationary consequences?  And if the c12mn gone missing from the labour market are never coming back,  can policymakers be satisfied with the current recovery? 

Every facet of this debate is muddied by the chaotic divergence between the two main monthly assessments of labour markets: the establishment survey, which is responsible for the non-farm payrolls data, and the survey of households, which is used to tally movements in the labour force, employment and unemployment. Over the last 18 months, the divergence between these two, and the sheer volatility of the household survey, defies easy analytical interpretation – frankly, it looks chaotic.  To take the latest data: April's non-farm payrolls survey reported jobs expanding 288k mom, whilst the household survey found employment falling by 73k mom.  And that's by no means the most dramatic of the deviations between the two found over the last 18 months, as the chart shows. 

Such wild an unexplained volatility directly undermines the credibility of the household survey – ie, the credibility of data on unemployment and labour participation. But it also indirectly compromises the credibility of the establishment survey too. As a result, on the most important question about the US economy, we are effectively flying blind. 

In particular, they no longer seem a reliable guide to how tight, or loose, labour markets really are.  

One way of assessing the tightness of the market may be to look at the extent to which people are changing jobs, and the difficulty of replacing them when they do change jobs.  There are two linked ideas here. The first is simply that people are keenly aware of the state of the job market, and are noticeably more reluctant to leave their current job if they think it will be difficult to find another.  If so, the rate at which people quit their jobs might turn out to be a good indicator of labour market conditions.  

This thought was elaborated (some time ago) by Fed governor Yellen, who thought the state of the job market – including the extent to which it needs to attract new entrants – may be examined by looking at the length of the 'vacancy chain'. The idea behind the 'vacancy chain' is that when a person quits a job,  it creates a vacancy. If that vacancy is filled by someone else who moves jobs . . . .  the vacancy chain grows. 

The logical extension to this is that the longer the vacancy chain, the more people have to be persuaded to move jobs, and since that often involves bidding up the price,  consequently the greater the upward overall pressure on wages. 

Every month, the Bureau of Labor Stats releases a further survey, of job vacancies (the JOLTs survey). Because it is released rather later in the month than the non-farm payrolls and household survey, it tends to get filed under 'old news'. But it tracks the number and rate of vacancies, and the number and rate of quitting, with the quitting rate calculated as the number of quitters as a percentage of total employment.

What does it tell us? The quit rate has clearly risen slowly but quite steadily since the nadir of 2010, but has not yet recovered to its pre-crisis levels. In fact, March's 1.8% rate is still 1.7SDs below the 2001-2007 average: the labour market has not returned to 'normal' levels, with employees' confidence that their prospects may be improved by moving job still historically depressed. 

We can get an idea of changes in the length of the vacancy chain by comparing changes in the vacancy rate with changes in the quit rate.  The higher the vacancy rate relative to the quitting rate,  we may assume the longer the vacancy chain, and the greater the likelihood that wages are raised in order to encourage people to switch jobs. In the next chart, I compare the 12m changes in vacancy minus quitting rate (which I'm calling the net openings rate), and the change in average wages. 

Several things about this chart are worth noting:  

• First, between 2001 and 2011, the changes in the net openings rate (which I am using as a proxy for the length of the vacancy chain) did indeed march amost in lockstep with changes in wages. The relationship held both during recession and recovery.
• Second, the recovery in the net openings rate has been sharp, and has now topped levels seen at the pre-crisis peak. 
• Third, nevertheless, from mid-2011 onwards there has been a complete and unexpected divorce between this measure of labour market tightness, and wages. Why this happened is unclear: the Fed has argued that it reflects companies attempts belatedly to compensate for wages 'stickiness' during the recession. Since  nominal wages did not actually fall during 2008-2009, so during the recovery they will now rise less than expected. 
• Fourth, the openings minus quitters rate now seems to have peaked, and in fact seems to be rolling over. 

Of these, the last two are obviously the most important. If the net openings level continues to stay at the currently elevated levels, it seems reasonable to expect that upward pressure on wages will eventually emerge.  After all, the Fed's explanation of why wages remain relatively depressed isn't completely convincing: before the crisis compensation as % GDP peaked out above 55%, before dropping to around 53% in 2010. But the fall hasn't stopped there: by 4Q13, it had fallen to 52.5% - it is the lowest in recent history.  

But set against that, the fact that the net openings/quitters rate now seems to have peaked may be a warning that the recovery of the labour market may be in question. 

These measures, then, don't directly answer the questions that need answering. But they do suggest that labour markets have tightened in a way which is not yet expressed in rising wages – to an extent which is genuinely puzzling.  Perhaps the market is anticipating a cyclical recovery in the participation rate?  Second, however, the topping-out of the net openings rate also suggest that we should treat the recent rise in non-farm payrolls with some caution – labour markets may not have been as robust over the last six to nine months as that survey suggests. 

Britain's Strange Recovery - Part II: A Keynesian Interlude

If Britain's recovery doesn't conform to the various explanations popularly offered about it, we are faced with the need to develop an alternative narrative that isn't contradicted by  the available data.

One solution offered simply retorts that there's no mystery, simply another demonstration of Keynesian economics: Britain was subjected to a bout of fiscal austerity which only now is being lifted.  As it is lifted, so growth renews. It is a tempting explanation, because as the chart shows, the fall in the fiscal deficit which took place between 2010 and 2012 has subsequently stabilized, and this has indeed coincided with the growth recovery. (The measure of the deficit I'm using is the public sector net cash requirement, ex-interventions). The deficit was cut by 1.1pp in 2010, 2.2pps in 2011 and 1.8pps in 2012, but by only 0.1pp in 2013, and it was only in 2013 that the recovery began to be felt.

It seems quite clear that the economy recovered during a lull in the fiscal headwinds, and that this was and currently is an encouraging factor.

But there are several reasons to doubt that this is the major factor driving Britain's recovery. The first is simply statistical: even comparing changes in the 12m movement of fiscal deficit and GDP growth since 2010 – a test so friendly to the Keynesian interpretation that I felt guilty doing it – finds no statistically significant correlation between the two. That's discouraging but doesn't doom the explanation.

But the second does: the timing simply doesn't fit with the recovery in the UK labour markets: the sharp and sustained rise in UK employment started for earnest late in 2011, a full year before the fiscal squeeze was relaxed. Normally, employment is considered a lagging indicator, not a leading indicator. Actually, the mismatch is more dramatic than that: , the recovery of private sector employment started no later than mid-2010, and continued even as public sector employment was cut – the divergence between the two continues to this day. Between 1Q 2010 and end-2013, public sector employment fell by 816k whilst private sector employment jumped by 2.145mn.

No matter what school of economic thought you bend to, it is absolutely fundamental that a cause must precede its effect – and in this case, it doesn't.

And the third reason is simply the failure of the world's Keynesian modellers to call it right: step forward Olivier Blanchard, the IMF's chief economist, who, in cutting the forecast for UK GDP famously warned just over a year ago that Britain's fiscal policy was 'playing with fire' and that there was 'the danger of having no growth, or very little growth, for a long time.' Nobody's perfect, and no economist looks smart when faced with his forecast failures. Nevertheless, if the explanation for Britain's recovery is Keynesian, it's fair to say that the Keynesians didn't spot it. 

Britain's Strange Recovery - Part I

It's a strange thing: one of the world's larger economies, almost uniquely exposed to the financial crisis and wrestling (albeit half-heartedly) with a super-sized state and super-sized fiscal deficit, looks about to escape the clutches of the dour 'new normal'.  Yet it is not clear how or why Britain is managing such an unlikely feat.

None of the common/popular explanations are consistent with the available data; but neither are explanations featuring malinvestment resolution followed by a re-investment cycle. Even more extraordinary, despite a quantitative easing program, the recovery is happening despite negligible broad money growth, if any.  It also features employment soaring at a time when labour productivity is plunging.  

So Britain's recovery is a challenge to a large number of economic (and political) assumptions. Despite this, I believe that although the recovery has some rather unusual features, it is economically explicable and, although hostage to policy mistakes, sustainable. If so, it is worth investigating to see if it contains any features which might be useful to other countries.  Alternatively, it may be that the recovery is based on features which are not easily replicable elsewhere.

The first job, however is to sweep away various popular views of the recovery.

It's a credit-fuelled consumer boom Every part of this assertion is contradicted by the available evidence. First, credit is not soaring – it's not even expanding. In the 12m to March, bank lending to the private sector contracted by 3.4% yoy, or by £68 billion. Nor is this new: at the onset of the financial crisis, the British private sector owed the banks a net £293bn (ie, that was the surplus of private sector loans minus private sector deposits). By March 2014, that had turned into a net £155bn deposit position, with £82.5bn being added in the last 12 months. The British private sector has repaid an amount equivalent to £448bn in net debt, equivalent to 21% of the current gross outstanding loans by banks to the private sector.

Is this situation challenged by lending outside the banks? Hardly: consumer credit (ie, unsecured debt) extended by non-banks rose by 3.5% yoy in the year to March, with the stock rising by £1.78 bn during the year, but it is still £11.8bn lower than its peak in Dec 2008.

And is it a consumer-boom in the first place? Retail sales rose 4% in the 12m to March, with the 6m momentum trendline exactly in line with the trends established during the previous five years.  The latest GDP data breakdown by expenditure is for 4Q13, and it reports household consumption rising by 0.4% only,  underperforming the total 0.7% GDP rise, and contributing only 0.3pps to that growth.   Household expenditure's contribution to 4Q;s GDP growth was no larger than that of gross fixed capital formation, and less than the contribution made by net exports.

Whatever else it may be,  the UK is not undergoing a  'credit fuelled consumer-led recovery.'

It's a housing bubble Whether you are British or not, if you work in the financial services industry the chances are that when you think of Britain, you think of London.  (One of my earliest memories in the business was listening to David Roche – then Morgan Stanley's strategist – talking about the British economy to a Canary Wharf room full of the firms' London best.  'Has anyone actually ever been outside London?' he asked – and I don't think it was a rhetorical question. Anyway, the room giggled nervously).  If your view of Britain is in fact a view of London, then you will believe, correctly, that you are in the middle of a housing bubble.

If you live outside London or its immediate surroundings, you will know this is simply untrue of Britain.  There are various indexes tracking regional price movements, but the Nationwide survey is the one to hand. It shows London prices up 18.2% yoy in 1Q, whilst for the UK as a whole the rise was 9.2%. In the North the rise was 5.9%, in the Midlands around 7%,  the South West 7.4%, Scotland 7.6%, Wales 5.2%, Northern Ireland 5.4%.   Whilst London prices were 19.4% above the UK 4Q07 peak, prices in the UK, including London, were still 3.2% below that peak.  For considerable parts of the country, prices remain below peak levels by around 10% or more.

All things consider, it should not now come as any surprise that we don't have a recovery 'fuelled by mortgage debt.' In fact, the total amount of outstanding debt secured on dwellings (ie all sort of mortgage-debt) rose by just 1.03% yoy in March.

One of the chief policy dangers Britain faces is the seeming inability of London-centric policymakers to understand that whilst London has a rather obvious property problem, the country as a whole does not. The clear danger is that if policymakers are unwilling to adopt policies specific to controlling London's property problem, it will be left to the central bank alone to tackle the problem. Not only will that unnecessarily burden the rest of the country with London's problem, but since London's problem is evidently not primarily being financed by mortgage lending (as the mortgage data shows), raising interest rates is unlikely to deal with it anyway.

Actually, I think the London property market is playing an important role in the UK's recovery. But the role it plays for the rest of the country is anything but obvious.

All the growth is in London Once again, this is an assumption made by commentators who rarely find themselves straying outside the M25, and is then foolishly yoked together with the 'property bubble' error.   But once again, it is clearly not true.  The key here is in the employment data.  Since early 2010, the UK has added 1.56mn jobs, a rise of 5.4%. London's employment during this period rose by 8.6%, but it was closely followed by East England 7.2%, Yorkshire 6.9% and even the South West +6%.   During the last year,  London has no longer seen the most rapid increase in employment: rather, London has been outperformed on job-creation by the South East (up 3.5% yoy), North East (up 3.4%), the South West (up 3%), Wales (up 3%) and even Northern Ireland (up 2.8%).  In fact, fully two thirds of the new jobs created in the UK during the last year are located outside London and the Southeast.

Growth is 'Unbalanced'  I suspect this is a derivative of the 'it's all to do with London's financial services and property' error.  It is, however, worth noting two things which this vague critique overlooks. First, the 4Q13 GDP estimates show manufacturing growth keeping pace with overall GDP growth (both at 0.7% qoq). Second, traditionally, the measure of Britain's 'unbalanced' economy is the way its trade balance deteriorates as growth accelerates.  Except that during this recovery, Britain's trade position is improving, not deteriorating, in both nominal and proportionate measures.

I hope I have established that the current UK recovery is not a credit-fuelled consumption-led recovery; that it is not primarily a property bubble, that it is not a recovery confined to London, and that it is not 'unbalanced' in the sense usually applied to the UK economy.  But if it is none of these easily-recognizable things, and if, moreover, quantitative easing has largely sabotaged the tough resolution of dissolving the malinvestment of the previous cycle, we are left with a puzzle. Just what is allowing the UK to reach something approaching escape velocity?

If we're going to find an answer, we will have to reach back to more fundamental questions involving inputs to growth.  And we shall also have to consider the mechanics of money creation in a time of effectively zero credit growth. Of which more next time. . . .