A Bracket for the US 'Soft Patch'?

(This post was mostly written before the IMF's downgrades of its 2012 and 2013 economic forecasts, blamed on 'continuing financial problems in Europe and slower-than-expected growth in emerging markets'. I have no particular desire to be contrarian, but it may be that the IMF's top brass – Euro-boosters to a man/woman – are too closely focussed on the death-throes of the Euro to consider that other non-European dynamics may be at work.*)

Despite the dismal crop of media headlines, it's time to look once again at the US 'soft patch'. Over the last three weeks, US data has gradually lost its capacity to shock, and has sprung enough positive surprises (like today's housing market data) to sketch the still-dim outlines of the 'soft patch's' closing bracket.

Now we had a 'soft patch' last year, and we've got another this year, and such regularity disguises how odd they are, and tempts us to view them as somehow normal and inevitable. But 'soft patches' are neither simply anomalous, nor an entirely exogenous event, like a sun-spot. Although the economics profession doesn't seem to be able to forecast them usefully, that is not a reason simply to throw up one's hands and not think about them.

I've offered three strands of observation about the soft patch. The first is that there were, and are, good reasons not to expect it: return to both capital and labour are rising, which almost always deliver rising capital spending and rising employment – the very basics of a business cycle. And monetary velocity remains staggeringly low whilst monetary growth is sharply positive, which suggests the risks to nominal growth should be on the upside. Well, those observations were correct . . . . but clearly have not been the determining factor in the last six months.

So, looking more closely, I have two strands of explanation, which inevitably are interwoven.

The first simply observes that there's been an unexpected outbreak of financial caution: after falling pretty much uninterruptedly since 2009, the US Private Sector Savings Surplus (PSSS) rose 0.5 percentage points yoy in 1Q, and based on the data currently available looks to have risen by a further 2.4 percentage points yoy in 2Q. If this is correct (and it's unlikely to be dramatically wrong), then the US PSSS is at its highest level since 1Q11 on a 12m basis.

A rising PSSS simply means that households and corporations are consuming (and investing) a smaller proportion of their income (and profits). And this in turn saps domestic demand, and acts against those fundamental forces which should be sustaining the domestic cycle.

This then raises the question of why it's happening. And it's easier to identify those factors not at work, than those which are. For example, it is not a matter of interest rates or monetary policy, since bond yields have been far lower than 'fair value' models would lead us to expect – previously this has tended pretty reliably to result in PSSS's falling, as saving is discouraged, investment encouraged. Not this time. (See this and this.)

So if the reason is not policy-based, we are thrown back onto the headline candidates for increased financial caution: the Eurozone crisis, the fear of a China hard-landing, and – let's not forget – this year's iteration of the Middle East Crisis (whatever it may be). Fear itself, in other words.

But that hasn't got us much farther with how the internal dynamics of the soft patch are likely to play out. This is where the second strand of explanation comes in. Earlier this year I tracked the relationship between momentum changes in output, sales, inventories and exports. The idea is that if the momentum of output is significantly different from the momentum of sales & inventories then a domestic disequilibrium is either being created or dealt with. In this version, one can see exports as potentially a balancing item in a system which is plausibly always seeking equilibrium. Or more simply, firms playing catch-up after under or over-estimating demand provide a key dynamic to these mini-cycles in a way which is simply an extension of the inventory-adjustments which we're familiar with.

The long-term chart emphasises two basic truths: when output momentum is sharply higher than sales and inventories, and there's little in the way of countervailing demand from exports, the industrial economy is way out of equilibrium, and recession threatens. Second, after the financial crisis, firms struggled until late 2010 to find the right level of production, but from mid-2009 onwards were sustained partly by a recovery of export momentum. The 'soft patch' of early 2011 can be seen first as a learned reaction to those previous difficulties – a reaction made much more intense by the news from the Eurozone and from the Middle East.

And so to this year's soft patch. The context is very different: during the second half of 2011, output momentum was rising relative to domestic and external demand, as industry once again found itself playing catch-up. But – and this is the crucial point – by mid 1Q12, momentum of output was once again threatening to outpace momentum of demand. In other words, a new disequilibrium was on the non-too-distant horizon: industry would have felt competition intensifying, buyers less eager than previously. And at just that point, export prospects looked suddenly menaced by the intensification of the Eurozone crisis. In response, production schedules were adjusted, and the data duly soured.

But now look again at the short-term:

This chart incorporates data up to May, and what it shows is that the 'soft patch' has already been sufficient to head off a more dangerous disequilibrium between output and domestic demand – the pink line has inflected and has returned to approximately zero. This suggests to me that companies are finding no immediately intensifying, or extraordinary, deterioration in their markets. This doesn't necessarily mean that we'll see an early acceleration to any particular level of growth. But it does suggest that we need not expect the unusual disturbances to production schedules that we've seen in this year's 'soft patch' to persist.

So can one blow the all-clear? I've got to be careful how I put this.

• If one believes that the economic, financial and political news over the next six months will be sufficiently bad to accelerate further the rise of the US private sector savings surplus, then there are further production adjustments to come and the soft patch will be extended.
• If one believes the economic, financial and political news is merely as bad as expected, so the PSSS continues merely to rise at current rates, or stabilizes, then we should expect a stabilization of growth rates (at whatever rate) and an end to the 'soft patch'.
• If one believes that the economic, financial and political news has some upside, relative to current expectations, then one obviously the soft patch has run its course, and the upside surprise will be a function of how fast the PSSS retreats.

* (Too harsh? Full disclosure on today's reports: i/c the World Economic Outlook is Frenchman Olivier Blanchard; i/c the Fiscal Monitor, former Bank of Spain dep gov Jose Vinals; i/c Global Financial Stability Report, former Bank of Italy man Carlo Cottarelli; head of the whole shebang, French lawyer Christine Lagarde. Apart from high office in the IMF, what they share is a career-investment in Euro-project.)  

How to Account for the US 'Soft Patch'

The shocks to consensus on US industry keep coming: this week we've already had disappointments from April's Empire State Manufacturing survey (just 6.6 vs a consensus of 18), and a second consecutive month where industrial production flatlined (and manufacturing fell 0.2%). The previous couple of weeks saw shocks from regional manufacturing surveys in Milwaukee, Kansas, Richmond and Dallas. It's time to start asking what ails US industry right now: why is another 'soft patch' materialising in the data?

We do not have the dramatic excuses of last year: we've had no environmental catastrophe punching holes in global supply chains; and though WTI oil prices have risen, the movement from around US$100 a barrel in 2H11 to a rapidly fading peak of US$110 is no repeat of the 2010-2011 jump from around US$85 to US$112+. What's more, banks are once again lending modestly (up 5.1% YoY in March and early April) and commercial paper markets are open to non-financial domestic companies (up 17.8% YoY). Finally, throughout 1Q we've got used to housing markets and labour markets, perennial bear-factors, are regularly delivering more positive surprises than negative shocks.

With none of the usual suspects fitting the frame, it's time to try to account for the soft patch from the bottom up – ie, by looking carefully at where US industrial output ends up. And it turns out that this step-by-step accounting approach does yield some answers.

Industrial output must either be bought by someone directly, be added to inventory, or written off. When we look at monthly data for manufacturing and trade sales, we find they remain relatively robust (latest data February), rising 7.6% YoY, and with a positive underlying sequential momentum which remains unchallenged (the 6m trendline for sequential movements is 0.21 standard deviations above the 10yr average). So sluggish domestic sales by themselves don't look to be the problem.

Output which isn't immediately sold to the end user can end up as inventory temporarily: there's a measurable lag of about four months. Total business inventories are matching sales, rising 7.6% YoY in February: there's no story here, since inventory/sales ratios have been essentially unchanged now for a full two years. No pressing inventory adjustment is likely to be generating a 'soft patch'.

But now let's consider the difference in momentum between what's being produced (industrial output) and where it ends up in the domestic economy (sales and inventory). In the chart below the blue line tracks momentum of sales, and the pink line tracks momentum of output minus inventories. In a closed economy which typically operates somewhere near equilibrium, the two lines would track each other closely – as indeed they do usually.

What if they don't match, however? Let's look at the difference in momentum between the two. In the chart below, the thing to remember is that if the line is in positive territory it tells us that the momentum of output is greater than the momentum of end sales plus inventories – in other words, one can and should expect a correcting retreat. Conversely, if the line is below zero, sales and inventories additions have greater momentum than domestic production, and one should expect a positive correction from industrial output.

More, the direction of travel helps us understand the mini-cycles which bubble up in the data. Thus by late 2010 the US had reached a point where for the first time since the financial crisis hit, momentum of sales and inventories was stronger than momentum of industrial output, heralding the unexpectedly strong growth in output during 1Q11. So it's really not surprising that the 'soft patch' of 2011 caught everyone by surprise, nor is it surprising that commodity markets reacted so strongly to the upturn. The shock of supply-side disruptions distorted the picture even more, and it was not until well into 2H11 that output momentum began to catch up once more with sales and inventories.

Notice what's happening now, however, is that that catch-up period has ended – all other things being equal we would expect a modest step-down in pace, unless the pace of sales and inventory momentum lifts.

So far, we have considered US industry operating in effectively a closed economy. But that's wrong. International trade can be seen as a balancing item: when output is rising faster than (sales + inventories), then one possibility is that the surplus output can be exported. Similarly, when output is lagging (sales +inventory) the shortfall in supply to the domestic economy will be made good by imports. As our final chart shows, it doesn't always work out like that – there's more flex in these arrangements than our accounting methods acknowledge.

However, what is clear is that the signals for trouble come when momentum of output minus (sales + inventories) is positive and rising, whilst momentum of exports is negative and fading. That's the point at which you must expect cuts in output – an industrial recession in other words. This was the situation in 2001-2002, and much more intensely in 2008-2009.

Obviously, US industry is not in a similar position now – but it could be getting there. If the trends seen in the last nine months were simply to be extended for a further nine months, the position would become similar: output momentum would be rising significantly faster than (sales + inventories), whilst the ability to export the surplus dwindles as export momentum turns negative. It is precisely to avoid this dynamic that the 'soft patch' is emerging.

What conclusions can we draw from this?

First, the industrial 'soft patch' is no simple mistake or data-blip: rather it is a slowdown necessary to secure something like industrial equilibrium. It can be expected to maintain downward pressure on bond yields, downward pressure on commodity prices (both of which are already manifest) but also, if it lasts, downward pressure on the dollar.

Second, the US industrial cycle is not self-contained, and is not insulated from trends in world trade. In fact, fluctuations in world trade play a crucial role in finding, keeping and maintaining the balance between domestic supply and demand. Right now, that means the US industrial cycle is exposed particularly to potential downturn in Europe, as well as to potential reflation in China.

Third, the imbalances are only just emerging, and industry is acting to ensure they don't curdle into a recession: the modest shocks now ought to prevent worse shocks later. But the exit from the soft patch is likely to need positive momentum surprises in sales, or inventories, or exports – and preferably a combination of the three.