The New Normal and Global Flattening

Much has been written about the ‘new normal’ as the long, grinding and stubbornly acyclical expansions which have characterised the US, the UK and to an extent Europe in the aftermath of the implosion of Western financial institutions. For Asia, the acyclicality of the West’s post-crisis expansion, at a time when central banks have deployed extraordinary policies in attempts to spark a recognizable business cycle into life, has resulted only sharp volatility of capital flows. During the initial period of near-zero Western interest rates, the result was a flood of capital into Asian economies which bore no relation to underlying trade flows. But since the recovery of the dollar in mid-2014, this flood abruptly reversed, with the outflows again fundamentally divorced from any underlying trade dynamic.

The new and seemingly purposeless volatility of capital flows, unrelated to savings imbalances either in Western or Asian economies (since the private sectors were almost universally running cashflow and savings surpluses), has distracted attention from a development in trading patterns which, in time, is likely to have a lasting impact.

But since the beginning of this year, a new stage of quasi-stabilization has been emerging, both in terms of capital flows (as shown in the stabilization in Asian fx reserves), and in terms of the reversion roughly to trend growth of both G3 imports and NE Asian exports.

So it is time to start thinking about the likely implications of this new stabilization. I think one of its key characteristics will be a global flattening of pricing opportunities, which will gradually result in the unexpected rediscovery of Western inflationary pressures,  as well as unexpected upward pressures on Asian currencies. (Perhaps this is how the reversal of the great Western bond bull market is finally discovered.) In addition, we ought to expect something of a convergence in rates of growth and return on capital. In fact, the ‘new normal’ may turn out to usher in a great flattening.

A major part of the dynamic powering globalization has been a sharp discovery of regional comparative advantages, in which Asia discovered a its comparative advantage was for low-cost mass manufacture, whilst the West discovered it retained comparative advantage in higher value-added manufacture.  As this discovery was a dynamic and expansive process drawing in ever-larger pools of labour, so the terms of the deal underpinning this aspect of globalization were that although Asia’s (in particular) share of trade in world low-cost manufacture rose inexorably, the growth in volume of exports was offset by a fall in prices.  By contrast, although the West lost volume, it’s ability to price its remaining exports was retained.

This underlying equilibrium generated a familiar divergence in the terms of trade (ie, movements of export prices relative to import prices) between the West and NE Asia. The chart below shows how, typically, whilst terms of trade for the US and Germany have remained roughly stable since 2000, NE Asia’s slid by approximately 40% between 2000 and 2011.  NE Asia’s exporters (including here Japan, S Korea and Taiwan) could win market share, but at the cost of emphatically being unable to price their goods.

However, looking again at the chart, it becomes clear that the long-term sustained fall in NE Asia’s terms of trade relative to those of the US and Germany has stopped - and in fact if we re-base terms of trade to Jan 2010 =100, it turns out that after the final fall in 2011, NE Asia is no longer losing out in terms of trade. Rather, it is at worst holding its own, and arguably, is now raising its terms of trade relative to the West. In global terms, it seems either that NE Asia has finally won or lost the ability to price its goods according to market dynamics in ways which are no longer very different to those of West. Either way, the fundamental pricing dynamic which underpinned the globalization to which we are accustomed no longer applies. 

UK Economy's Vulnerability and Resilience

The impact of Brexit on the UK economy in the long term is, obviously, incalculable, and will remain so, since it is currently a world of infinite hypotheticals. But in the short term, it is possible to outline the template upon which will be printed a likely fall in consumer confidence, a hiatus in investment spending, and a c10% devaluation of sterling against the dollar.  It is also possible to measure the current pressures on private sector cashflows, and the cyclical pressures being experienced by business and labour markets.

In general terms they suggest that the current UK expansion, which has been fundamentally acyclical, is finally becoming a bit ‘leggy’: cashflows are slightly strained, return on capital has peaked, and labour productivity is falling.  None of these deteriorations are extreme, and within the context of an acyclical expansion this would raise the prospect of a ‘soft patch’ of slowing growth marked by slowing consumer spending, slowing investment growth and slowing employment growth.  Since the cycle has not been generated, accelerated or even supported by increases in credit, one would not expect that ‘soft patch’ to degenerate into a recession.

The uncertainties generated by the Brexit vote, however, are likely to intensify all these current mildly negative trajectories, and consequently the chance of a recession have increased.

By contrast, the c7% fall in sterling against the dollar almost certainly does not generate the potential for an inflationary break-out of any importance for monetary policy. Currently, consensus expectations for UK inflation are unrealistically high, and one cannot read any positive relationship between sterling/dollar rates and changes in inflationary momentum in the history of the last 20 years.

Current Momentum
Consider first the momentum indicators which seek to track the story told by monthly data releases.  In fact, these have little compelling to say. In 6m momentum terms:
i)  domestic demand momentum is being sustained on roughly the same course as it has for the last two and a half years;
ii) after a modestly soft patch during 4Q15 and 1Q16, industrial momentum is currently being modestly regained. There is a problem with the data, however, since the current recovery is hostage to extremely volatile results for April which stand every chance of being significantly revised down in months to come;
iii) monetary conditions have been very significantly relaxed during the last six months, helped mainly by a weakening of sterling against the SDR, a fall in real interest rates and, to a lesser extent, and acceleration in broad money supply.  In the past, there have been occasions when such a loosening of monetary conditions has been followed by a modest strengthening of domestic demand momentum, but the relationship is not compellingly strong.

Private Cashflow Pressures

Rather, to gain insight into Britain’s current position in the business cycle, we need to look first at current private sector cashflow stresses, and then also at trends in returns to capital and labour. 

There are two indicators which track Britain’s private sector cashflows: 

i) the quarterly private sector savings surplus/deficit, obtained by subtracting public sector net borrowing from the current account balance; 

ii) the flow of cash between the private sector and the banking sector.  In theory, the movements of these two should be closely related, but of course, the more complex a country’s financial system, the more  frayed that relationship will be.

In the immediate aftermath of the financial crisis, Britain’s private sector moved negligible net surplus savings flows to a surplus peaking out eventually at around 6% of GDP in year to early 2010. This financial caution has been very steadily eroding since then, with the surplus fully eroded to the start of 2015, and moving to a deficit of approximately 2% of GDP by 1Q16. The gradual but sustained erosion of the savings surplus was one element which supported domestic demand during a time of net de-leveraging and negligible real wage growth. 

Any severe or extended spike in financial caution can be expected to reverse these trends, with the private sector moving back into savings surplus and in the process depressing domestic demand. 

The second indicator of cashflows tracks the net movement of private sector cash directly into or out of Britain’s banks: specifically, the chart below looks at the 12m change in private sector sterling deposits minus the change in private sector sterling loans.  It finds the same dramatic deleveraging undergone in 2009/09, followed by a gradual relaxation since then. As with the PSSS chart, it suggests that by the 12m to early 2015, net cashflows between the private sector and Britain’s banks turned negative, and have remained slightly negative since. 

Neither the PSSS chart nor the private sector/bank cashflow chart suggest current private sector economic behaviour is particularly extreme. Another way of seeing this is in the changes of private sector sterling bank debt/GDP, which fell from a peak of 144% in 1Q10 to 104% in 2Q15. The subsequent net rise in debt (implied also by the emergence of a private sector savings deficit) has raised that debt/GDP ratio, but only to 106%, which would still be the lowest since 2004.  

Nevertheless, since 2010 domestic demand momentum has been underpinned by a gradual easing of financial caution. If that caution is now reversed as a result of Brexit, we can and should expect a negative impact on domestic demand momentum. This is a medium-term vulnerability. 

Cyclical Underpinnings: Returns to Capital and Labour

But there are also longer-term vulnerabilities which suggest that the underpinnings of Britain’s current business cycle are already deteriorating in ways typically seen towards the end of a cycle.  Namely: returns to capital have peaked, and labour productivity is now dropping. The normal cyclical response to these two late-cycle phenomena are i) to slow investment spending and ii) to slow employment growth.

First, my return on capital directional indicator peaked at the beginning of 2015, and has been in steady decline since then. (The indicator expresses nominal GDP as a stream of income from a stock of fixed capital, with that stock being estimated by depreciating nominal capital investment over a 10yr period. It can be seen as proxy for asset turns in a Dupont analysis.)  Capital spending tends to react fairly predictably to changes in this measure, accelerating when returns on capital are rising, but slowing some time after ROC peaks.  

The lag between the peak of the ROC directional indicator and the slowdown in investment spending is not stable, however: investment mistakes get made at the top of the cycle when animal spirits are particularly inflamed and bank credit freely available. However, the post-crisis UK expansion has been unusually non-cyclical (reflecting the negligible impetus given by the crippled banking system), with animal spirits remaining cautious and a complete lack of net new sterling bank lending. So the reaction to ROC peaking arrived quickly, but has so far been mild.  In 2014, immediately prior to the peak of the ROC directional indicator, nominal fixed capital formation grew at 7.9%; in 2015 that slowed to 4.7%, with the sharpest slowdowns arriving in 4Q15  and 1Q16.  

It is more difficult to draw similar linkages between changes in labour productivity and employment, if only because of the impact of essentially uncontrolled immigration can be expected to constantly lower the supply curve in a way which will allow employment growth to survive falls in labour productivity.  Despite this, the general expectation survive that rises in labour productivity (here shown as real GDP per worker, less the change in capital per worker) are followed by rises in labour demand, whilst falls in labour productivity undermine demand for labour.  Currently, this measure of labour productivity has been in modest decline since 2014, and that decline has been followed by a slowdown in the rate of growth of employment. 

With both return on capital having peaked, and labour productivity declining, in cyclical terms, the stage is set for a downturn. However, note that in both cases, the deterioration is very moderate in historic terms: the return on capital indicator is still higher than the pre-crisis peak; in pre-crisis terms, the modest fall in real output per worker would be seen as a qualified success.  As the UK expansion has been fundamentally acyclical and unaccompanied by credit excesses, so these typical late-cycle phenomena are hardly grim enough to trigger an outright recession.  Rather, absent the uncertainties caused by Brexit, they would suggest nothing much worse than a ‘soft patch’ of slowing growth. 

Sterling Weakness and Inflation Prospects

By the end of July, sterling had fallen 7.8% from the May average valuation against the US dollar. If this devaluation is assumed to not be reversed in the coming months, might this generate a sufficiently sharp rebound in inflation to dictate a tightening in monetary policy, rather than the loosening currently being suggested by Bank of England chairman Mark Carney? 

The first thing to realize is that prior to the Brexit vote, there were negligible inflationary pressures to be found in the UK’s CPI data.  May’s CPI rose only 0.3% yoy, and in 6m momentum terms, there was still negative momentum. The chart below shows the spread of likely possibilities, based on extrapolating 5yr seasonalized trends, and deviations from them (current 6m deviations as well as 1SD above and below).  

They suggest inflation rates averaging around 0.2% yoy in 2Q, staying roughly around there for the next nine months (with a range of 0.1% to 0.3%).  This is far below current market consensus, which foresees a rebound in inflation rates to around 1.5% yoy by 1Q17. Such a rebound would represent a deviation above 5yr trends of approximately 1.5SDs - possible but unlikely. 

Moreover, weakness of sterling against the dollar is no good indicator that such a deviation against trend is likely. The chart below shows the relationship between sterling strength/weakness against the dollar and underlying 6m CPI momentum.  Generally, if sterling weakness against the dollar reliably generated inflationary forces, one would expect to see these two lines moving predictably in different directions. Rather, to the extent that they are at all synchronised, the correlation appears to be positive: a strong sterling seems to have been associated with above-trend inflation, whilst a weakening sterling looks to be associated with weak inflationary momentum.  But in neither case is the relationship statistically interesting.