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.