Something I Said?

No sooner had I pointed out that the European Central Bank's balance sheet was, by international standards, comparatively unleveraged, and that this represented a relatively cheap and politically discreet way of European politicians keeping their Doomsday Machine ticking, than Jurgen Stark, de facto ECB chief economist, and German keeper of monetary virtue, packs his bags and offs.

First they came for the short-sellers, then the hedge funds, then. . . .

Shocks and Surprises. Week Ending Sept 10

This was a week in which by and large consensus won out, much good though that did world equity markets: Euro Stoxx lost 6.6%, the Nikkei lost 2.4%, both the S&P and the Hang Seng lost 1.7%, and the Shanghai Composite lost 1.2%. What was being priced in this week was something below and beyond what the evidence is currently describing.

Case in point: Europe's markets got the worst kicking, but it was in Europe that the consensus won most often this week: Eurozone GDP revisions, Eurozone retail sales, Eurozone Services PMI, Eurozone Sentix Investor Confidence index, and even the Eurozone Composite PMI all came in roughly as expected. So too did French business sentiment, German imports and trade balance and UK industrial production: modest deterioration was expected, and modest deterioration was what was duly recorded.

Europe even sprang a couple of upside surprises : both French industrial production (up 3.7% YoY) and Germany industrial production (up 10.1% YoY) showed up the consensus as too cautious. But evidently these exercised less impact than the repeated confirmation of an increasingly gloomy consensus, laced with a couple of nasty shocks. The worst of these was the 2.8% MoM sa fall in German factory orders. This one got worse the closer you looked at it: capital goods orders fell 7% MoM, and export orders for capital goods were down full 12.8% MoM.

The US market hasn't yet recovered its poise from the Sept 2 non-farm payrolls shock (seasonally adjusted, there were no new jobs). I was sceptical about that number, and this week brought an answering upward surprise in the Job Openings and Labor Turnover data, which bust through the upper range of estimates, mainly on a sharp rise in manufacturing hirings, and also revised up the previous month's data. There were other pleasant surprises, including a the trade deficit which came in about US$5 billion lower than anyone expected, mainly owing to a 3.6% MoM rise in exports. Still, it's that Sept 2 labour market number which continues to set both the political and financial agenda.

The other story emerging from the week has yet, I think, to be fully appreciated: Japan's heroic recovery phase is over, to be replaced by an everyday series of mild disappointments. There were loads of these this week: monetary aggregates were noticeably weaker than anyone expected, machine tool orders growth slowed sharply (to 15.3% from 34.8% in the previous month), and machinery orders overall fell 8.2% YoY. When you look at the details, you find export orders for Japan's machinery collapsed 13.5% YoY. This is the same story in suspended or collapsing investment spending that saw Germany's export orders for capital goods falling 12.8% MoM.

And so to China, where investment spending accounts for 48.6% of GDP. By this stage, I hope it won't come as a surprise that the negative shock in China's August monthly data was the way in which investment spending came in far weaker than expectations (up 25% YTD, vs 25.4% in the previous month). There is a specific problem here: after the multiple scandals which have engulfed China's railway ministry – of which the Wenzhou high-speed rail disaster is only the most high-profile – this is a ministry which can no longer invest. Spending on railway infrastructure actually fell 15.5% YoY in August, whilst as recently as June it was rising 18.3% YoY. Much of the rest of China's August data so far has been roughly in line with expectations: retail sales (up 16.9%), industrial production (up 13.5%) and the HSBC/Markit Non-manufacturing PMI (50.6) – non of them surprised.

And yet, the week withheld one of its biggest surprises until today: China's trade data for August was much better than expected. In the case of exports (up 24.5% YoY), this mainly reflected how cautious the consensus has become – since the monthly gain was only slightly better than historic seasonals. But the growth of imports – up 30.2% YoY – was not only way out of line with consensus (which expected 19.1% to 23.1%), but was also a full standard deviation above historic seasonals. Such an appetite for imports strongly suggests that, at the very least, China's inventory cycle is on the turn.

Is it enough to challenge a gloomy consensus which got a lot of confirmation this week? We'll see on Monday morning.  

The Super-Sub in Frankfurt

I was challenged this afternoon to think of something that could yet buy time for the Eurozone – by definition something that didn't require Europe's politicians either to understand their catastrophic error, or to act with coordinated and effective purpose, but change market sentiment in the short and possibly even medium term.

And there is something.  Sometimes I hear fears that the European Central Bank is bust – that, put simply, it has bought far too many bonds from places that either aren't going to repay (Greece), or more banally would look ugly if they were ever marked to market (Portugal etc).

On the face of it, that's a reasonable worry: the ECB has capital and reserves of approximately Eu81.5 billion, upon the shoulders of which it carries Eu2.037 trillion of assets, of which Eu514 billion is lending to Eurozone banks, and Eu 523 billion are eurozone securities. It doesn't take an awful lot to go wrong with the underlying credits on those assets to wipe out the ECB's entire capital base – a 12% haircut would do it.

Looked at more closely, however, and it looks less worrisome. First, it is extremely hard to bankrupt a central bank. They go bust only if they carry huge net foreign liabilities which are suddenly withdraw. This isn't going to happen to the ECB, since it holds a net Eu 203 billion in foreign currency assets. About the only other way they could bankrupt would be if their licence to issue money or banking reserves was revoked by the governments of the jurisdiction in which they operate. And that's about it, really.

This has the following consequence: that, uniquely, the concept of marking-to-market the value of its domestic securities doesn't mean too much to a central bank, since in duration terms it can outlast any possible competitor. Just as you don't start a libel war with someone who buys ink by the barrel, so you don't play Bankruptcy Poker with a central bank. Even now, the ECB could stave off (the effects of) Greek sovereign bankruptcy by buying unqualified amounts of Greek sovereign debt in perpetuity.

Which leads directly to the question: we've established that the ECB has a financial leverage ratio of 25.4x (total assets/equity and capital). For a private company, that's way too much (even Goldman scrapes by with financial leverage of only 11.6x). But how does it compare with other central banks?

The answer is: extremely well. It turns out that among the world's central banks, the ECB is indeed the reincarnation of the Bundesbank. It's 25.4x leverage has to be compared with the US Fed's 45.8x (end 2010), or Bank of Japan's 52.6x (August 31, 2011).

What's more, as the chart shows, the ECB has tended to manage this ratio down when it can, taking it from a June 2010 crisis-peak of 27.6x to an April 2011 low of 23x (glad confident morning, that was).

Which leads to two conclusions and a suggestion. First, by international standards, the ECB is still on the sidelines in this crisis: it could buy about another Eu1,700 billion worth of dodgy Eurozone sovereign paper, and still be less leveraged than the Fed. And, excitingly, it wouldn't demand a raid on any particular European taxpayer's wallet to do it, and it could probably do so without exciting the outrage of Northern European electorates.

Second, it reminds us that a modest amount of new capital subscription for the ECB is a really great bargain for politicians  – every Eu 1billion subscribed buys possibly Eu 45 billion of new sovereign debt!

If I were a European politician unwilling/unable to face the electorate with a bill for bailing out Southern European governments, but keenly aware that current policies can lead only to disaster,  I'd be looking at the ECB's balance sheet with great interest. 

And the suggestion? Central banks don't just buy government debt – they can help recapitalize banking systems too.  In the aftermath of, say, a sovereign default? 

Funding Eurozone Banks? Nein Danke

I had intended to go into some detail about the technical and political difficulties in sustaining a complacency about China's growth in the next 12-18 months, but it will have to wait – until tomorrow most likely.

For today, this is what we need to think about: the average CDS price for 5yr European banks has risen to 473 basis points. In other words, the average price of insuring against default risk is 4.73% a year. Meanwhile, 5yr sovereign euro yields have fallen to around 1.43%, so with the best will in the world and a following wind, the average European bank can expect to have to pay around 6.2% for five year money. That's more than double the 2.9% a year that the Eurozone's nominal GDP rose during 2Q11. Anyone think it's about to grow faster?

But remember, that's an average only of those to whom the market is open at any price. You won't for example, find any prices for Irish banks, and precious few for Greek banks.

For those for whom the market is still open, here's what CDS markets are demanding:

Bank	5yr CDS Rate	Nationality
Banco Comercial Portgues (sub)	1825	Portugal
National Bank of Greece	1558	Greece
Banco Comercial Portues	1542	Portugal
EFG Eurobank Ergasias	1429	Greece
Alpha Bank	1414	Greece
Banco Espirito Santo (sub)	1308	Portugal
Banco Popolare (sub)	1225	Italy
Banco BPI	1117	Portugal
Caixa Geral de Depositos	1002	Portugal
Banco Espiritu Santo	995	Portugal
Kazkommerts	925	Kazakhstan
WestLB (sub)	863	Germany
Banco Monte dei Paschi di Siena (sub)	820	Italy
UniCredit SpA (sub)	722	Italy
RBS Plc (sub)	702	UK
Dexia	700	France
Banco Popolare	653	Italy
Societe Generale (sub)	652	France
Commerzbank (sub)	651	Germany
Lloyds Bank (sub)	643	UK
Banca Intesa (sub)	615	Italy
RBS NV (sub)	590	UK
Caja de Ahorros y Monte de Piedad de Madrid	585	Spain
SNS Bank NV (sub)	584	Netherlands
BBVSM (sub)	580	Spain
Halyk Savings Bank	570	Kazakhstan
Santander (sub)	545	Spain
HBOS (sub)	538	UK
Credit Agricole (sub)	517	France
Arab Banking Corp	510	Bahrain
Unione di Banche Italiane	507	Italy

At what point does the insurance become so expensive as to represent a market which is effectively closed? I'd say pricing would be painfully prohibitive for pretty much all of those in the table. This tells us that there's a profound reluctant to taking a credit risk on the subordinated debt of even French, UK and even German and Dutch banks. And the market is closing for the head-office of even some French and Italian banks, as well as the more predictable Spanish and Portuguese banks.

How much does it matter right now? Over the last week, there's been fairly widespread attention drawn first to the fact that no European corporates, let alone banks, have managed to issue bonds since August, and also to research showing European banks it doesn't matter too much, since European banks have completed 90% of their financing this year already. I think I know what the first of those means, but who knows what that second observation may actually mean? Are the financing plans those of dire necessity, or of an ambitious business plan? If the latter, are those business plans the same as they were four months ago?

I am thrown back onto two observations. The first of them is this: as of end-July, ECB data shows Eurozone banks have a loan/deposit ratio of around 113.1%, or 105% if you look just at the position with the private sector. This is barely lower than the 113.9% recorded in July 2010, although the private-sector LDR has come down during the same period from 106.6%. To maintain the current level of loans, European banks either need to attract more deposits, or take on other liabilities – essentially bonds or foreign liabilities. Neither look likely. The bond markets, as we have seen, are unwelcoming. And good luck with attracting foreign liabilities: as of July, they were down 7.6% YoY, or by around Eu 304 billion.

One alternative is to cash in foreign assets, of which the Eurozone's banks have a gross Eu 5.025 trillion, but falling (down 0.5% YoY in July).

The second is to hope, or ensure, that the LDR comes down faster, since a falling LDR amounts to a positive cashflow. It seems impossible to expect that this cashflow can come from the public sector, so it's private sector cashflows which will have to bear the burden. And the problem is, that cashflow is drying up very fast too. Take a look at this: 

What I'm measuring here is the difference between the rise in private sector deposits (cash in) vs the rise in loans made to the private sector (cash out). In the 12m to July, this calculation shows a net cash inflow to the banks of Eu 88 billion. This is chicken-feed compared to the previous crisis-peak of Eu 522 billion in the 12m to September 09. And things are getting worse: in the 6m to July, the net cash inflow was . . . just Eu 1 billion. In the three months to July, there was a net cash outflow of Eu 48 billion (though part of this outflow is seasonal).

From this, we can draw the following conclusions. First, we must expect another severe credit squeeze for Europe's private sector, starting right now. Second, we must expect Eurozone banks to sell-down foreign assets, starting right now. So far as I can tell, these are the only way to square the circle.

Adjustments for the New Normality

What's normal these days? You need to make your mind up about this today because as I write, equity markets across the globe are down two to three percent, and last Friday's US labour market figures are getting the blame. You know, the one that showed that 'the US economy had generated no new jobs in August'.

The question of normality arises because actually last Friday's job data showed nothing of the kind. What the US Department of Labor data showed was that the economy added 118,000 net new jobs in August. You can find the data, and the details here. To spare you the suspense, I can report there were healthy employment gains in construction (up 39k MoM), manufacturing (up 50k) ; and professional & business services (up 101k).

The problem is that this pattern of job growth was recorded before the seasonally adjustment process got to work. After it had completed its work, all net new the jobs disappeared from the data.

Now I don't want to impugn the US seasonal adjustment process unnecessarily, because it is trusted. That's not always the case: in some countries, seasonal adjustment regularly conjures up strange results, and sometimes fail the most basic tests of coherence. And in some emerging markets, the underlying structure of the economy is changing so quickly and radically that one shouldn't seasonally adjust at all. But in the US, neither is true.

But its readings now do and must intrinsically reflect a conviction that the historic data is the 'normal' against which today's data is judged and adjusted. Sometimes that doesn't seem right, and Friday's labour market data was one of those times. For August 2011 added 118K jobs;

• in August 2010 only 55K were added;
• in August 2009 125k were lost;
• in August 2008 116k were lost;
• in August 2007, 109k were added.

In other words, August 2011 was the strongest August for job creation since 2006.

The message, then, is this. If you think the US growth pattern is adjusting to a 'new normal' in which the urgent and successful desire by the private sector to adopt a lower financial-risk profile by deleveraging constrains the pattern of consumption and employment (see this piece), then August 2011 was a mildly encouraging month in the labour markets. If you expect a re-run of the post-1991 leverage-powered model of US economic growth, it was disappointing.

Either way, both adjusted and non-adjusted numbers agree, in August, non-farm payrolls were growing by 1.0% YoY – the fastest YoY rate since July 2007.

Shocks and Surprises, Week Ending September 2

Mostly the world took its cue from the US, where the shocks and surprises can be summarized as follows: during the first few days of the week,  a succession of measures tracking the industrial economy gave a series of modest and not-so-modest positive surprises (ISM PMI at 50.6). These were bolstered by surprisingly strong readings on personal spending (up 0.8% MoM) and factory orders (up 2.4% MoM), but were challenged by a series of shockingly bad readings on consumer confidence (from 59.5 to 44.5 in a single month!). Which did the market believe? Reluctantly, for the first three days it began to price-out some of the worst scenarios, perhaps on the basis that who, after all, could be expected to have retained their confidence during the final rounds of Debt-Limit Poker played during the first week of August?

All that was swept away on Friday by a set of US labour market data which were dark even by the standards of most economists’ worst projections (no rise in non-farm payrolls at all during August).  Personally, I suspect we will be revisiting that data and questioning the role of the seasonal adjustment process. However, for the time being, the lesson is very clear: it’s easier to believe that Shocks are not priced in, whilst pleasant Surprises probably might be. The wall of doubt is vertiginous.

Europe is following Wall Street’s cue, although with far less justification for optimism, given the combination of Europe’s debt problems (see this piece) and the audible ticking of the Euro Doomsday Machine. This week was entirely one-way traffic as far as Shocks and Surprises were concerned –  Eurozone PMIs and labour markets were far worse than expected, so were UK business readings.  Most worrying is the fact that Germany’s industry, built around its international trade in capital goods, is precisely exposed to just the sort of whiplash on capital spending which is an accelerating factor in all business cycle inflection points.

Asia is exposed to the West’s Shocks and Surprises at second hand, and at first glance the main news this week was the lack of negative shocks from China’s industrial sector. We had three separate readings on China’s industrial August, and all showed a modest uptick (within expectations), even though some of the lead indicators, such as new export orders, are deteriorating.

More worrying, perhaps, are signs from across the globe that input prices are once again rising: we saw this message coming from the US, from Europe, and from Asia, including China. This isn’t in the script for the second half of this year, and if it asserts itself, it will prove a complicating factor for Asian policy settings.  So far, the only confirmation of it in Asia has come from Korea, where a 5.3% YoY jump in CPI in August is the highest reading for three years, and was generated  rather worryingly not just by a jump in food prices, but also a 2.7% MoM jump in ‘misc’ goods and services. Well, there has to be a price for keeping your currency ridiculously low for ever to protect your exporters, I suppose. 

Japan's Noble Management

Every quarter Japan's MOF conducts a massive survey of private sector balance sheets and p&ls, collecting data from just over a million firms, large and small. This is closest anyone can get to seeing how Japan's economy really works in near real-time. It's doubly interesting right now because this is the quarter in Japan came face to face with the multiple disasters which followed the March 11 earthquake.

What's grabbed the headlines was a 7.8% YoY decline in capital spending during the quarter, which for some reason took Japan's economists by surprise. But forget that for a moment, because the survey tells us some other things about Japan, some of which are surprising in the best possible ways.

The first thing I do with these figures is look at what happened to corporate Japan's Dupont ratios. You know straight off these are going to be pretty nasty, given that the knock-out blow to the supply-side of Japan's economy pushed sales down 11.6% YoY during the quarter. Still, here's what happened:

1. Margins (operating profit/sales) fell from 3.31% in 1Q to 2.85% in 2Q. That compares with an average of 3.1% since 2000, and a reading of 3.27% in 1Q10. It's not even half a standard deviation below the long-term average.
   The details are surprising – uplifting even. There was no deterioration at all in the Cost of Goods/Sales ratio, which remained static at 77.3% - seemingly no profiteering at a time of colossal disruption and supply-pressure. The entire 46bp margin deterioration was owing to a rise in SG&A expenses (19.9%). And of that, there was a 117bp rise in total total personnel expenses/sales, offset by a 72bp fall in SG&A ex-labour costs.
   If we cut the jargon for a moment, this tells us that in the face of cruel disaster, Japanese management kept hold of its workers, and cut its own expenses in order to offset the cost of that benign policy. I think the word for that is 'noble'. More, management did it whilst maintaining margins with half a standard deviation of the long term average. The word for that is 'efficient'.

2. Annualized asset turns (sales/total assets) fell to 0.92 in 2Q, compared with 1.01 in 1Q and an average since 2000 of 1.05. This was, in fact, nearly three standard deviations below the long-term average. This is where the full impact of the disruption was taken – unavoidably.
   
   
3. Leverage (total assets/equity). Given that capital destruction fell on this economy in the most dramatic possible way, this is perhaps a little surprising. Total assets fell by Y50.8 trillion, and net worth fell by Y23.8 trillion – more total assets were destroyed than equity. So given a starting financial leverage ratio of 2.71X the net result was that Japan's financial leverage continued to fall, very marginally. If you want a more direct measurement, net debt fell by Y2.5 trillion QoQ, and net debt/equity picked up very slightly, to 63.8% from 1Q's 62.2%. The scale of this up-tick is barely distinguishable from the normal seasonal patterns.

In short, the interruption in supply-chains killed asset turns, but the impact on margins and leverage habits was far less pronounced than one would have expected.

All of which would tend to imply that the impact on corporate cashflows from this disaster were relatively modest. And that seems to be right. Japan's corporate cashflow is always significantly lumpy, but using a proxy of investment outlays + change in net debt suggests corporate cashflows came in around Y10.2 trillion in 2Q. This which was down from Y15.4 trillion in 1Q, but up from the Y3.3 trillion of 2Q10.

When we look at the secondary indicators of cashflow, the news is the same: there was no self-destructive rush to cut credit to the rest of the economy in order to bolster corporate cash coffers. Yes, accounts receivable fell by Y18.2 trillion during the quarter, but then sales fell by Y28.6 trillion – so accounts receivable as a percentage of sales was static (at 0.671). Meanwhile, inventories actually rose by Y2 trillion. If one looks at the combination of inventories and accounts receivable as a percentage of sales, as being an indicator of corporate Japan's extension of credit to the economy, it actually rose modestly during the quarter.

I don't want to over-react, and many words have already been written about the marvel of Japan's social cohesion in the face of disaster. What this quarterly survey illustrates is the role Japan's corporate managers in demonstrating and reinforcing that social cohesion under difficult circumstances. I believe that social cohesion is a form of capital (if you doubt it, consider how much capital was destroyed during London's riots). If so, although corporate Japan's investment in plant and equipment may have fallen 7.8% YoY during 2Q, in the long run, there was plenty of investment made during the quarter.