Britain's Long Upward Grind is in Trouble

The recent weakening of Britain's employment and retail sales data isn't a coincidence, but rather a sign of sliding productivity. With little in the way of credit expansion, the growth of payroll income has been the mainstay of the long expansion, supplemented recently by the private sector running down its savings surplus to a modest deficit. So in the absence of any other props, the long grinding expansion is entering a soft patch.

The UK and the US exited the Great Recession at about the same time, in the second half of 2009, but in both cases the recovery has been feeble compared to the recession, and has lacked in the usual cyclical accelerators. Rather, it has been a long upward grind, frequently threatening to ebb away out of inanition, rather than excess. In both cases, what has driven the expansion has been a slow and steady rise in employment, which in turn has been based on harder work - modest gains in output per worker achieved even in the absence of increases in capital per worker.

The hope was that eventually this grinding expansion would be sufficient to draw forth the sort of investment spending and/or credit expansion which usually act as accelerators on the upswing of the business cycle. In Britain, that hope has not yet been realized. By February 2016, bank lending in sterling to the private sector was growing only 3% yoy, but this was the highest since at least 2010, and the total loans outstanding were still 3.9%, or £60.6bn,  below their total five years earlier.  As far as investment is concerned, in nominal terms investment rose 4.4% yoy in 4Q15, and, depreciating all investment over 10yrs, capital stock was growing only 3.8% yoy in nominal terms, compared with a real GDP growth rate of 2.4%.

Without the usual contributions from these supports, the expansion continues to rely on gain in employment. However, the grounds for expecting continued employment growth are currently being undermined by falling productivity. After accounting for changes in capital stock per employee, real output per worker fell 1.3% in 2015, the biggest decline since the Great Recession, and extending a deterioration which had begun the previous year. As the chart shows, employment growth does tend to respond, albeit with a lag, to changes in this measure of labour productivity. 

This is the background to the weakening of Britain’s employment data, and consequently domestic demand indicators, which emerged in the data for February released this week. First, there was a sharp deterioration in employment gains, with only a net 20k new jobs added in the 3m to February, with 9k lost in February alone. There was no comfort in the details: the number of employees fell 23k, whilst the number self-employed rose 25k, the number of full-time jobs rose only 17k, and the number of vacancies were unchanged in the 3m to March.  In addition, average weekly wage growth slowed to 18% in the 3m to February, with wages rises concentrated in construction (up 8%) and wholesale/retail/hotels/restaurants +2.7%.  In other word, wages were rising fastest in the most pro-cyclical sectors of the economy even as the employment foundations of the expansion were being undercut. 

And in turn, that was reflected in March’s retail sales, which showed ex-petrol sales volumes falling 1.6% mom, whilst petrol sales rose 0.5%. In value terms, sales fell 1.4% mom and fell 0.1% yoy, with a monthly movement which was 1.6SDs below historic seasonal trends. This was a sharp enough fall to drag the 6m momentum vs trend to minus 0.4SDs, which is the biggest deflection against trend since the beginning of 2010. 

Not only are the employment foundations of Britain’s current expansion weakening, but so too are the financial foundations which would allow household consumption to outpace the growth of payroll earnings. First, by the end of 2015, Britain’s private sector was running a small savings deficit,  equivalent to approximately 1.1% of GDP. That deficit means that the private sector must be - and is - running down its net deposits with Britain’s banks. In fact, in the 3m to February, whilst bank lending was growing at 2.5%, sterling bank deposits rose only 1.1%. The result is that the private sector’s net deposits with Britain’s banks had fallen by an average £25bn yoy in the 3m to February. By February, those net deposits had fallen to £79bn,  

Most likely the current slowdown in retail spending signals the unwillingness to see the decline in net deposits continue or accelerate, particularly at a time when labour markets are souring. In short, whilst Britain’s long expansion may have been fundamentally acyclical, the spurs behind the current slowdown are developing their own cyclical features.

China's 6.7% yoy 1Q GDP - The Price and the Cost

China’s 1Q GDP result was good news, but was bought at a cost. If China is to maintain progress towards its stated structural goals, as I expect, then the front-loading of government investment and monetary accommodation which built this positive 1Q result will be reversed shortly after it becomes clear that the global trading environment is warming.

The 6.7% yoy GDP growth reported by China for 1Q16 neatly met the universal expectation, so sends the signal ‘nothing to see here’. So as polite guest commentator on China’s economy,  I will ignore it, and turn instead to the much more interesting nominal growth.

Nominal GDP growth accelerated to 7.1% yoy, up from 5.8% in 4Q, and with a very slight gain on underlying momentum. This was actually more impressive than it might seem, because the trade surplus is no longer a major contributor to growth. In 1Q China’s trade surplus amounted to Rmb 823bn, and rose only 8.3% yoy, adding only 43bps to the nominal GDP growth rate.  That compares with an average contribution to nominal GDP growth of 235bps during 2015. Subtract the trade surplus from China’s nominal GDP and we get some idea of what happened to domestic demand: it rose 7.1% yoy, which was the quickest nominal achieved since 2Q14.

This is the point at which to emphasize that even a modest growth in nominal GDP growth at this point is far better news than is generally acknowledged or realized. That is because the legacy of China’s extraordinary surge in investment spending during 2003-2011 has in its fifth year of retreat, allowing one to see on the horizon the long-lost possibility of profits growth.  If one depreciates capital investment over 10yrs, one finds the growth of China’s capital stock is slowing fast: .on this basis, I estimate that in 2015, China’s capital stock was growing by approximately 10% yoy in nominal terms, rather than the 15%-20% pace we’ve been used to since 2003.  My expectation is that capital stock will be growing even slower by the end of 2016. So if China’s nominal GDP sustains the very modest gain against momentum seen during 1Q, we begin to reach the time where nominal GDP is at least keeping pace with capital stock growth, and possibly overhauling it. At that point, asset turns are rising, dragging with it return on capital and profits. For many investors, this will be something they have never seen before.

So there is genuinely good news: but it was bought at a real cost, paid by fiscal policy, monetary policy, industrial policy, investment policy and overall strategic direction. Acknowledge these costs as real, but, crucially, do not be fooled into thinking that China’s authorities have abandoned their strategic goals. Rather, assume those goals will pursued with renewed intensity when the authorities think a suitable economic environment is encountered.

The first cost is a further downturn in the efficiency of finance. In the 12m to March 2016, each increase of 100 Rmb in bank credit was associated with a gain of only Rmb 33 in nominal GDP - that’s down from Rmb 44 during the same period last year, and is approaching the lows associated with the credit splurge of early 2009.  It gets worse: every Rmb 100 of new aggregate financing was associated with a gain of only Rmb 24.5 in nominal GDP in the 12m to March, down from Rmb 30.1 in the same period last year.  Improving the efficiency of financial allocation is absolutely at the heart of China’s longed-for structural reforms. It took a sharp backwards step during 1Q16.

The other obvious cost was the deterioration of the public finances. So far we have fiscal data only for Jan-Feb, which showed only a modest deterioration yoy (a surplus of Rmb 621bn in 2016 vs a surplus of Rmb 685bn in 1Q15). However, the underlying trends were worsening steeply, and if they were maintained during March, I expect the surplus one normally expects in 1Q will have all-but disappeared. If so, the published data suggests China is already running a budget deficit slightly above the 4% of GDP floated as a possibility in PBOC’s research. 

It is not difficult to see how central this fiscal spending is to the 1Q recovery. Also released today was Jan-March urban asset investment: stripping out March on its own, investment rose 11.2% yoy, but with private investment rising just 4.9% whilst public sector investment jumped 23.4%.  And it shows also in the industrial breakdown: the big gains were primary industries +25.5% yt, led by public facilities +31%, water production +26.8% and power & heat +20.9%. Meanwhile, secondary industries - that’s manufacturing - rose only 7.3% ytd. 

That’s not the sort of efficient investment pattern China needs if it is to make the epically-difficult traverse from a financial repression/capital building/surplus production model of economic growth to an efficient saving allocation/return on capital/consumer spending model. It is, in fact, a relapse. 

The danger, however, is to believe that China’s authorities have therefore forgotten or abandoned their strategic goals, or don’t appreciate how the rescue act of 1Q has put those goals in jeopardy.  It is much more likely that they view the 1Q retreat as necessary to safeguard the political environment needed to pursue those reforms in the medium to long term. If so, when the global economic temperature warms, expect the stimuli which supported 1Q to be withdrawn and reversed. 

US Wholesalers' Data Reflects Structural Change, not Cyclical Pressures

If the wholesale trade is the cyclical indicator it is traditionally held to be, then the US business cycle is in deep trouble. But fortunately (if you're not a wholesaler), what the sustained weakness of the wholesale data shows is not so much a cyclical downturn in the US economy, but rather major structural pressure on the wholesale industry as a sector.

During February, wholesalers' sales fell 0.2% mom,  the fourth monthly contraction in succession, whilst their inventories fell 0.5% mom, the fifth monthly fall in a row. In fact, things are a whole lot worse than that for wholesalers: sales have been gently sagging since towards the end of 2014, and the continued rise in the inventory/sales ratio suggests that wholesalers have been unwilling or unable to adjust their business strategies and balance sheets to reflect that fall. As a result, the inventory/shipment ratio has continued to rise practically unabated since the end of 2014, even though total holding of wholesale inventories peaked in September 2015.

To understand what's going on, it pays to contemplate the role of wholealers in an economy.  The point of wholesalers it that they absorb (buffer), and finance, the temporal frictions between suppliers and end-customers, with both ends of the bargain content to pay a fee to ensure more predictable supply, more predictable demand. Such a role cannot abolish business cycles, but will smooth frictions within the cycle. Indeed, it is precisely when wholesalers are faced with changes in business conditions which they can no longer absorb/finance, that they themselves become key indicators of a business cycle inflection point. The inventory/shipment ratio rises, and wholesalers move to cut their risk, passing on the market’s bad news to the manufacturer. This is a familiar feature of business cycles, seen both in 2000/01 recession and again, more spectacularly, in 2008/09. (It has its corollary in NE Asia when manufacturers’ inventory/shipment ratios are a regular bellwether for NE Asia’s export prices and industrial cycle.)

But as the first chart shows, wholesalers’ inventory/sales ratio has been rising almost continuously since the middle of 2014, and is now the highest it has been since early 2009, and above the peak levels seen during the 2000/01 recession. And yet there is no recession (despite the poor profits outlook), and the sustained strength of labour markets makes it very unlikely we’re about to see one now.  Moreover, unlike in 2000/01 and 2008/09, the problem is not an  unwanted build-up of inventories (they’ve been flat since the middle of 2015), but rather the sustained fall in sales.

There is a further reason to think something structural, rather than cyclical, is afoot. The second chart expresses wholesalers’ sales as a proportion of manufacturers’ and retailers’ sales combined. What is shows is that  wholesalers’ market share of total sales has been flat since mid-2011, and has been in steady decline since the middle of 2014. In January, wholesale sales’ market share fell to its lowest since December 2010.  No such extended period of market-share loss was seen either in 2000/01 or in 2008/09. No such extended decline was seen during the wild commodity gyrations of the last 15 years.

So wholesale ain’t what is used to be. Quite possibly, wholesalers’ difficulties are not this time a key cyclical indicator. Why? Once again, remember, the wholesalers’ role is to absorb and finance the frictions between supplier and end-buyer. If that role is under challenge, it is likely to be either because frictions have become easier to manage (ie, to predict and anticipate) and/or because they have become easier to finance. Or both. 

If information technologies are sufficiently distributed and trusted to cut the friction between supply and demand, and at the same time, financing conditions have improved post-crisis, the need for and role of the wholesale trade becomes smaller. If that is what is happening, today’s shocking fall in wholesale sales is poor news for the wholesale trade, but perhaps not quite so dreadful for the US economy as a whole.

Japan's Exporters Face Double Whammy - Currency & Margins

The two key factors which have allowed Japanese manufacturers to thrive despite the sharp deflation in their export prices are going into reverse. First, currencies movements against the dollar and the Rmb, are eroding Japan’s competitive position and will intensify the pressure on Yen export prices. Second, at the same time, the stabilization of commodity prices threatens to reverse the terms of trade gains which have compensated for loss of pricing power, and been the motor for margin gains over the last 18 months.

Large manufacturers have noticed: Bank of Japan’s 1Q Tankan survey of 1,087 large-scale manufacturers reported their outlook index falling 4pts to 3, which was the lowest since 1Q13. Only 11% expecting a favourable outlook, compared with 8% expecting an unfavourable outlook and the vast majority, 81%, thinking the future was ‘not so favourable’.  

This fall in optimism does not yet fully incorporate the scale of the currency whiplash now underway: today the yen is trading under 111 to the dollar, whilst the Tankan’s respondents still expect the yen to average 117.5 during FY16.

But the combination of a resurgent dollar and an Rmb determined to hang onto its coat-tails, which has handed Japan’s exporters considerable competitive advantage since 2H14, has reversed. Not only is China explicitly no longer willing to peg its currency to the dollar, but in addition, the US Fed gives every indication it does not wish the dollar to strengthen. Japan’s exporters are the principal competitive victim in these two policy reversals.

Let’s put some numbers on it:
i) between September 2012 and May 2013, the Yen lost 24.1% against the Rmb
ii) between July 2014 and June 2015, the Yen lost a further 19% against the Rmb. Between September 2012 and July 2015, the yen had depreciated by 39.2% against the Rmb.
iii) However, between June 2015 and April 2016, the yen has appreciated 17.9% back against the Rmb, and it has now lost virtually all the gains made during the 2H14 dollar rise

For Japan, this simply means both far tougher international competition from China, implying faster market-share loss and sharper downward pressure on Yen export prices. 

Which brings us directly to the second problem large manufacturers are worrying about: margins.  Looking at the detail behind the fall in the Tankan outlook index, there was no change in expected domestic demand/supply conditions, with the economy expected to remain solidly oversupplied, slightly offset by a small improvement expected in overseas conditions.  Rather, it is margins that are the worry. Currently a net 8% of large manufacturers are seeing their input prices fall, but this isn’t expected to last: only a net 1% expect input prices to keep falling. But the same moderation of deflation isn’t expected for output prices: currently a net 15% report output prices are falling, and a net 13% expect them to keep falling. Result, margins are going to fall. 

Ministry of Finance’s massive quarterly survey of private sector p&ls and balance sheets reveal just how central this is likely to be. The survey allows us to analyse how Japanese ROE has been sustained (and even raised slightly) over the last few years. The answer is simply that operating margins have risen from 3.2% in 2012 to 3.8% in 2013, 4.1% in 2014 and 4.5% in 2015. This has been enough to offset continued decline in asset turns (from 0.95x in 2012 to 0.89x in 2015) and financial leverage (from 2.82x in 2012 to 2.62x in 2015). 

Moreover, we can then disaggregate what is driving those margins. Over the last year, the story has been overwhelmingly one in which a 0.8pp decline in cost of goods sold/sales compensated for deterioration in other aspects of margins (principally SG&A expenses), which cut the margins gain to just 0.4pps. 

And that decline in the cost of goods sold/sales ratio is, in turn, a direct reflection of the rise in Japan’s terms of trade, generated by import prices falling faster than export prices. 

The final chart demonstrates how the trade-off between falling export prices and surging terms of trade has worked during the last 18 months. The very specific problem is that the combination of currency movements and commodity prices which generated this useful trade-off has gone into reverse. During the coming year, we can expect to see the red line (export prices) fall even steeper, but the grey line (terms of trade) also to fall. That in turn will begin to push up cost of goods sold/sales ratio, which in turn will drag down margins and return on equity.  The deterioration in large manufacturers’ outlook captured by the 1Q Tankan only begins to acknowledge that times are about to get a lot tougher for Japan’s exporters.