Bulletin of Broken Dreams - With Two Grounds for Hope

'Let's go'
'Yes, let's'
They do not move as the curtain falls. 

It is nearly midsummer, so time for taking stock of how the first half of the year has developed. Musing over this, it struck me that the hopes and expectations commonly held at the end of 2013 have receded so rapidly that even recalling them requires an imaginative effort.  

Do you remember when China's Third Plenum was going to usher in a new and energetic phase of reform in which an improved capital allocation would lay the foundations for a shift towards consumption-led demand and rising return on capital?  What we have got is a tremendous amount of political energy diverted into an anti-corruption campaign and a host of mini-measures aiming to fine-tune the economy to ensure that the same old broad GDP targets are met . . . anyhow, it seems. That Xi Jinping may turn out to be China's Brezhnev remains an awful possibility. 

Do you remember when Abenomics was going to rejuvenate Japan? The core of that strategy was a hope that sufficiently dramatic policy initiatives from both the central bank and the government could fundamentally re-order Japanese expectations – which is to say household and corporate financial and economic behaviour. So far the devaluation of the yen has produced a mild and belated upturn, but close examination of corporate behaviour shows no deviation whatsoever from the tactics and strategies hard-learned during deflation. It is still not clear that what 'third arrow' policies will be adopted, but currently it seems that the most that can be hoped for is a snail's pace  scaling down of corporate tax rates paid for by closing other tax breaks.  It seems unlikely to fundamentally change corporate expectations or behaviour. 

There were, perhaps, no great expectations of the Eurozone, except that a pickup in the rest of the global economy might mitigate the damage done by policies aimed only at extending the Euro's half-life as a viable currency.  Nothing has changed there, except a quiet backsliding on measures to underpin a banking union, and a quiet backsliding on some of the excesses of the destructive fiscal compact. Voters turned in unprecedented numbers to elect members of the European Parliament opposed in a variety of ways to the EU institutions' agenda. But it seems likely the new head of the European Commission will be a man who's main qualification is a lifetime's unthinking and unbending devotion to 'the project'.

So our anticipation of reforms which might help re-boot the global economy were ill-founded and are probably best forgotten. Despite all that, the outlook for the world economy has actually improved, and will probably continue to improve during 2H, even if the reasons are altogether more mundane (see previous comments on prospects for G3 imports and NE Asian exports). 

At the centre of this is the US recovery, which continues to accelerate without really threatening to reach escape velocity. Two indicators give a pretty clear visual idea of where we are: employees' willingness to quit their jobs; and small businesses' intention to expand capex.  Both are grinding higher, but at such a slow pace that there's no short or even medium term likelihood of reaching their pre-crisis cruising altitudes any time soon. The quit rate is a good indicator of how employees think about the state of  labour markets – the higher the quit rate, the greater the quitting employee's confidence that an alternative job awaits. Latest data shows it has risen to 1.8%, which is up from the 2009 lows of 1.3%, but  still far off from the 2.2%-2.3% sustained pre-crisis. In other words, we're halfway there.  The small business capex intentions rate is self-explanatory: pre-crisis it typically ran at about 31%-32%; during the crisis it bottomed out at around 17.5% and has since recovered to 24%.  In other words, just as with the quit rate, we're about halfway there. 

And there is an unexpected second factor allowing encouragement: it seems that Britain has stumbled on a form of recovery driven by a rise in employment which probably reflects human ingenuity responding to dire necessity. It seems wrong to credit any of Britain's policymakers with discovering this course – indeed, there is little sign they understand how and why it is happening.  And since such a supply-led recovery is a genuine novelty to Britain's policymakers, there's still every chance that they will snuff it out by tightening monetary policy in order to head off a 'overheating' which exists nowhere outside London's property market.  Nevertheless, if it is allowed to live, a supply-led recovery can be extremely durable, and it has been born and already reached its early years without the benefit of productivity-enhancing investment spending or any significant supply of credit. 

It is also possible that Britain's labour-led recovery may be replicated elsewhere in parts of Europe where there are few other grounds for hope – Spain for example. 

But the problem is that almost everywhere the world's cycle remains hostage to a financial system which, for varying reasons, remains profoundly dysfunctional. The key measurement here is monetary velocity – or GDP / M2.  It is worth taking a moment to imagine what this measures. M2 can be seen as the cash and bank deposits of households and corporations. A new deposit can be created essentially in only two ways: either they represent the balance sheet result of a new bank loan; or alternatively, it can represent what happens when you liquidate a real asset (a house, a diamond necklace) for cash.  The bank's function is to act as an intermediary to allocate those deposits to a purpose sufficiently productive to allow it to pay interest.  If monetary velocity is falling whilst M2 is growing, it means either that the banks are not distributing the savings at all, or they are allocating them extremely badly. 

It's still happening virtually everywhere. In the US, monetary velocity has sunk to lows not seen since at least 1959 (when my data starts), even as M2 rises to around 6.5%. The reason; in the 12m to May, deposits in US banks have risen by $783bn, but their loan books have risen only $324bn, which has cut the loan/deposit rate by 2.5pps to 75.6%. 

In the Eurozone, the decline in monetary velocity has slowed, but only because M2 growth has slowed so fast that nominal GDP has yet to catch up:  by April M2 growth had slowed to just 1.9% yoy, and unless positive momentum is restored, it will sink below 1% by the end of the year. Deposits in Eurozone banks fell by 0.8% yoy in April, or by Eu 95bn, whilst banks' loans books shrank by 3.3% yoy, or Eu402bn during the same period.  Such contraction managed to cut 2.7pps off the loan/deposit ratio, but it still stands at  104.7%. 

Where will it stop? US banks' pre-crisis loan/deposit ratio topped out in early 2008 at just over 102% - they are now 75.6% and are still falling. UK banks' ratio peaked out in late 2007 at 117.9% and have fallen to 92.6% and are still falling. Eurozone banks' stood at around 123% in early 2008, and have come down only to 104.7%.  They have a very long way to go. The Eurozone has a very long way to go. 

Britain's monetary velocity also continues to fall as banks continue to deleverage: in the year to April, banks' loans to the private sector fell £68bn whilst deposits rose £14.5bn, cutting banks' LDR by 3.4pps yoy to 92.6%.  

Where else are monetary velocities falling? Practically everywhere one looks: Japan, China, S Korea, Taiwan,Hong Kong etc. Perhaps the baleful truth is that in a global economy which is dominated by global capital flows, no economy entirely escapes unscathed when the developed world's banking systems are dysfunctional.  

Ever since encountering the idea in John Greenwood's Asian Monetary Monitor (then of GT) in the late 1980s that a universally-distributed system of money market mutuals might allocated capital more effectively than commercial banks, it has seemed to me that commercial banks are a fundamentally unnecessary form of commercial activity. It has also been my belief that something like that must arise out of the ashes of this crisis. We are waiting. 

NE Asia's Inventory-Related May Export Blip

The surprisingly weakness of NE Asia's May trade data is the result of a long-maturing unwanted inventory build up meeting Chinese financial constraints, and is happening despite the emerging improvement in underlying Western demand.  It's a temporary phenomenon which is likely to be answered later this year by a sharper-than-expected rise in NE Asian output and exports. 

The positive momentum which has been building quietly for months in both Northeast Asia exports and G3 imports, has taken a blow from May's NE Asia trade data.

• China's exports rose 6.9% yoy, which was only 0.1SD above historic seasonal trends; 
• S Korea's exports fell 0.9% yoy, which was 0.5SDs below historic seasonal trends; 
• Taiwan's rose 1.3% yoy, which was 0.7SDs below historic seasonal trends; 
• Japan's 20-day data points to a likely fall of 6.5% yoy in dollar terms, a full SD below trend. 

Taken together, this suggests NE Asia's exports rose only 2.8% yoy in May on a monthly movt which was 0.3SDs below historic seasonal trend. This is a considerable disappointment, and is a noticeable check to the build-up of momentum which had been emerging.

But it is an unusual weakness, because it is centred almost exclusively in inter-Asian trade. Thus, the real weaknesses in China's exports were in HK down 38.7% yoy, Asean down 5.4%, S Korea down 5.2%, Japan down 1.1%. But exports to the EU jumped 13.4% yoy and to the US exports rose 6.3%.

For S Korea, exports to Asia fell 6.5% yoy, with China down 7.5% and Asean down 9.1%, whilst exports to the EU jumped 23.8% yoy and rose 7.6% yoy to the US.
For Taiwan, the weaknesses were in Thailand down 8% yoy, Singapore down 3.6%,  S Korea down 0.2% whilst Japan rose only 2.6% and mainland China +3.1%. Meanwhile, exports to the UK rose 19.6% yoy, to Germany rose 9% and to the US rose 1%.

The check to inter-Asian trade is also the reason why, though exports were weak, they were much stronger than imports: China's imports fell 1.7% yoy on a monthly move which was half a standard deviation below historic trends; S Korea's imports rose just 0.3% yoy, which was 1.2SDs below trend; Taiwan's imports fell 2.3% yoy,  which was 1.7SDs below trend. Result? Northeast Asia's trade surpluses have burgeoned even as trade volumes slowed noticeably.


Now growth of G3 imports and NE Asian exports usually move in lockstep and have done so for years, with NE Asia's exports growing slightly (and predictably) faster than G3 imports. It is most unusual for them to underperform G3 imports, as the chart below shows – and when it happens it's normally a signal that Western demand is about to slow.  Yet it's happening now, at a time when the performance and prospects for G3 imports are the strongest they've been for two years, and accelerating.

So what's happening? What's happening in Qingdao Port's bonded warehouses gives a big hint. There, the inspectors are on the trail of allegedly fraudulent receipts for inventories of metals,  which are used as collateral to borrowing from Chinese and foreign banks.  There are suspicions that the same stock of inventory has been pledged for multiple loans. This is not what's surprising – frankly, one assumes this is standard operating procedure, with the only person pretending not to know being the banking officer authorising the loan. No, what's important is that the scandal has surfaced now, telling us, as it does, that the loans have defaulted.  The story, then, is that financing conditions are tight – so tight that inventories are being liquidated in order to raise cash.  

It's difficult to get the data to prove this is what's happening generally in China, but perhaps the weekly iron ore inventories tell the correct story: inventories built up sharply during the latter part of 2013 and the first half of 2014, but now appear to be peaking.

If this is the position in the mainland, then it is hardly likely that Taiwan's mainland operations are exempt from the practice or the financial pressure. And if so, one would expect less enthusiasm among Taiwanese suppliers to load their mainland operations with more supplies. 

South Korea provides the clearest example of a long-maturing build-up of inventory which is now reaching its peak. S Korea's inventory turnover index is a near-cousin of the more popular inventory/shipment ratio. As the chart shows, this ratio has been rising steadily since late 2009, and by April this year had reached a new peak. At some point, Korean companies will wish to stop that build-up: the trade data suggests that by May that point had been reached.

The one NE Asian country which quite clearly doesn't have an inventory problem is Japan, where conservative balance sheet management is sufficiently ingrained to provide a vigilant patrol on inventory levels. 

Conclusion? After waiting years for a pick-up in Western demand, and allowing inventories to build-up as they do so, Northeast Asia's industrial base has given up waiting, and, partly under pressure from China's financial constraints, have started liquidating those inventories just as Western demand is finally beginning to return.  For NE Asia this is resulting in a blip in trade. If Western demand continues to emerge, however, it is likely to be revoked later this year with accelerated production and inter-Asian trade. 

Japan 1Q Duponts: What's Changing, What's Not

The easiest bull argument to make for Japan in the Abenomics era has been that if the economy can generate some nominal topline growth, whether achieved by currency depreciation or by a successfully aggressive monetary policy, or simply by overturning deeply ingrained deflationary expectations, then the resulting rise in asset turns would power a spectacular rise in return on capital.

The MOF's quarterly survey of private sector balance sheets and p&ls shows  accelerating topline gains and also sharp upturns in ROE and ROA, but for not for the reasons expected. Topline gains there have been – sales rose 5.6% yoy in 1Q - but corporate Japan's response has been to prioritize continued deleveraging over re-investment, and to focus profits-generating efforts on wage control.

Investment in plant and equipment rose 7.4% yoy, a sharper rise than expected, and the strongest since 2Q12. However, in absolute terms, the Y12.231tr spent on plant and equipment was rather less than the Y14.485tr fall in net debt during the same period, and only slightly more than the Y10.569tr in depreciation expenses. Whilst the rise in investment spending is of course to be welcomed, it is probably not the turning point in corporate behaviour which Abenomics is looking for.

Gains are certainly being made in ROE & ROA: operating profits rose 18.8% yoy whilst net worth rose only 4.3%,  which pushed ROE for the quarter reached 3%, the highest it has been since 1Q08.  Similarly, with total assets rising only 1.8% yoy, it was the strongest quarter for ROA since 1Q07, and the best on a 12m basis since mid-2008.

At the core of this was an improvement in operating margins: sales rose 5.6% yoy whilst operating profits rose 28.8%, which pushed OPM to 4.5%, the highest since the bubble years, with the 12m rise similarly spectacular.

How did it  happen? On a 12m basis, OPM rose 68bps yoy to 3.98%. This happened despite cost of goods sold actually rising by 7bps during the same time: the whole of this was counteracted by a 75bp fall in SG&A.  And drilling down further, the whole of that was accounted for by a 79bp fall in personnel expenses/sales to 12.6%. 

Essentially it boils down to this: on a 12m basis, sales per employee rose 7.2% yoy 12ma, whilst total expenses per employee rose only 5.5%. This took the multiple of sales/expenses per employee to 7.94x in 1Q14, and to 7.71x on a 12m basis.  As the chart shows, this multiple is still below its pre-crisis peak, and we should expect corporate Japan to continue to strive to raise this ratio, even if this means that wage growth is suppressed beneath inflation rates. 

The rise in sales also lifted asset turns (sales/assets) mildly, but at only 0.952x this remains extremely low by any standards, including Japan's own recent history – the average since 2000 is 1.03x.   Balance sheet management remains remarkably conservative, with financial leverage falling to a new low of 2.7x, with net debt falling 2.6% yoy, and net debt/equity falling to a new low of 55.2%. There is no sign of any change in this aspect of corporate behaviour. 

So, Mr Draghi, What Will It Take Now?

Having talked up the ECB's willingness to exert itself to drag the Eurozone away from the deflation danger-zone, it is difficult to imagine what Mr Draghi and colleagues can come up with this week which the markets have not already discounted. (If so, perhaps the ECB's best bet is to do nothing and watch the currency slide in disappointment.)
The two most widely trailed proposed actions are:

i) to slap negative interest rates on deposits which the Eurozone's commercial banks keep lodged with the ECB;
ii) to engineer some sort of funding program for banks, in which preferential interest rates are linked to specific lending targets. 

Both sound good, but both have problems which will render them disappointing and even if not absolutely ineffective.

Imposing negative interest rates on commercial banks' deposits kept with the ECB sounds good, with the promise that these funds will necessarily be driven into risk assets which would otherwise be unfunded. But the policy faces two problems. First, it is mostly too late, because banks have already run down these deposits. Looking at the ECB's weekly balance sheet, we find that banks have only Eu161.2bn of deposits in the ECB which are not needed to cover their reserves ratios. That may seem a lot, but in fact the total has retreated right back to pre-crisis levels:  in January 2010, for example, the average was Eu189.5bn.  The belief that these deposits are a large source of idle funds which may be mobilized stems back to the months of the immediate crisis, when the topped Eu1tr. But those days are long past: that bird has flown. 

But even if this were not the case, the policy would face a second difficulty: were ECB to impose punitive negative interest rates in a bid to drive this money into risk assets, the simplest and safest response by commercial banks would simply be to cut their borrowing from ECB by a similar amount. The latest weekly data shows ECB is currently lending Eu640bn to the Eurozone banking system, a total which has already fallen by Eu195.4bn, or 23.4%, during the last 12 months. Rather than pay interest on those deposits, why not use the money merely to repay the ECB? If commercial banks chose that path, there would be no first order impact on risk assets at all. 

The second proposed policy, offering banks preferential funding rates tied to lending targets, sounds more promising. More, the Bank of England has trialled one of these schemes in the UK, under the Funding for Lending Scheme (FLS), so is not a complete leap into the conceptual dark, and some may assume that it has contributed to the UK's recovery (almost certainly wrongly). But the British experience highlights why any similar Eurozone scheme is likely to labour hard to achieve little. The FLS was launched by the Bank of England the UK Treasury in July 2012, initially for a period limited to end-2013, but subsequently extended in 2014 for a further year. By the end of 1Q2014, some £43.3bn had been lent under this scheme, equivalent to just 2.2% of the UK total sterling bank lending to the private sector. But by now, the scheme is actually shrinking: the total lent fell by £2.66bn during 1Q. More, the scheme has not stopped Britain's deleveraging: in the 12m to March 2014, total lending, including FLS, fell by £67.97bn.

The problem, as the Bank acknowledges is that the problem which FLS was meant to deal with – prohibitive credit spreads – has disappeared in the UK. At its launch in July 2012, the Bank assumed that household and corporate credit spreads would tighten by around 100bps; in fact, by the end of 2013, spreads for households had tightened by about that, but spreads for corporates had come in around 150bps. Since then, spreads have continued to tighten.

The Bank comments: 'It is difficult to assess the Scheme's contribution. . . because of the impossibility of knowing what would have happened in its absence. In the year prior to the launch of the FLS, UK banks' funding costs had risen, in large part because of developments in the euro area. As well as the FLS, subsequent falls in banks' funding costs are likely to have reflected other economic developments and policy initiatives at home and abroad: in particular, comments made the President of the ECB in July 2012 and the subsequent announcement of Outright Monetary Transactions are likely to have played a role, and so reduced UK banks' need to access funding through the FLS; in their absence, it is probable that the FLS would have been more heavily used'.

In other words, the FLS itself was stymied by actions already taken by the ECB.  How much more true will this be for any similar scheme launched by the ECB now. Credit spreads have tightened so dramatically since 2012 that it is difficult to imagine that the ECB's offer of preferential funding can be made to appear sufficient incentive to alter banks' lending policies – even in the event that they can discover an appetite to borrow. In fact, right now, the spread between Euro 10yr sovereigns and BBB credits has closed to under a percentage point – the lowest since at least 2008.  That bird, too, has flown.

The fundamental problem Mr Draghi faces, of course, is that there is a limit to what monetary policy alone can do to address problems caused by economies having both the wrong currency, and the wrong fiscal policy. Sadly, that bird cannot be asked to perform.