Shocks and Surprises, Week ending September 24th

The week's news and markets were once again dominated by the Euro-crisis – a Three Act Tragedy in which I think we're in the middle of Act Two, where the Princes of Europe continue not to notice that the palace they have built over the last 50 years is on fire, and the portcullis still down. It's in the nature of these dramas that Act One is largely taken up with the technical business of scenery setting, Act Two is largely taken up with argument, and Act Three is all about the body count.

Outside the Euro-palace gates, the noises-off continue to be discouraging. There was a parade of nasty shocks where things turned out worse than Euro-economists had expected: these ranged from industrial orders (down 2.1%, and dreadful downward revisions from Italy), consumer confidence (worst for two years), French consumer confidence, and PMI readings for both manufacturing and services, and, outside the Eurozone, UK orders. Actually things could have been worse – readings from Germany were at least no worse than expected, and neither was the fall in the Eurozone Composite PMI (though it showed an actual contraction at 49.2, and the new orders reading fell the steepest since July 2009). But everyone's now waiting for Act Three.

Nonetheless, Europe is not the whole world, thankfully, and there were significant surprises out the US last week which got sucked under to oblivion in the tail-wake of the Euro-crisis. One cannot judge the likely near-term course of US household deleveraging cycle without taking into account the housing market, because that's at the centre of the whole issue. And last week, there were two major upside surprises: sales of existing houses jumped by 7.7% MoM, which was almost double the most optimistic reading in the normal level of expectations, with purchases of single-family homes up 8.5%. Now, it's true that prices are still falling (down 1.7% MoM and 5.1% YoY), but when you're looking for the bottom of the market, it's volume that matters. Builders also seem to feel some sort of a bottom is being reached: building permits jumped 3.2% MoM, which again was outside the range of expectations by some considerable distance. In fact, expectations for MoM results remain immovably negative even though three out of the last four months have shown significant growth (May up 8.2%, June up 1.3%, July down 2.6%, August up 3.2%).

So tomorrow's new housing sales data, also for August, will therefore be worth watching. Consensus is looking for only 294k, a fall of 1.3% MoM, still conservative. Even so, it would represent a rise of 5.2% YoY. The balance of last week's data suggests we can't rule out an upside surprise on this one. So to do bank balance sheets, where the Fed data tells us closed-end residential loans rose 5% YoY in August, after rising 5.3% in July.

In Asia, the main 'shock' is that the strength of the yen is catching up with Japan's exporters. As usual, the J-curve effect, in which the initial lack of trade balance response to a sharp currency appreciation is suddenly and dramatically reversed, caught us us economists out. We can walk the J-curve drill in our sleep, but it still gets us every time – I have no idea why. Well, the data for August showed export growth achieving less than half the bottom end of analysts' expectations, whilst import growth exceeded even the top end of the range of consensus. China looks to be the main beneficiary – exports to China rose only 2.4% YoY, but imports from China leapt to 16.3% YoY, and Japan's trade deficit with China almost tripled on the month.

And the data from China this last week suggested it will welcome all the benefit from the strong yen it can get. I think there were three data-series from China which were distinctly disappointing this week: the MNI Flash Business Sentiment Survey, the HSBC/Markit Flash Manufacturing PMI, and Taiwan's export orders. Since there's only a published consensus on Taiwan's export orders we'll start there: they rose 5.3% YoY in August (vs 11.1% in July), which was below the bottom end of expectations. The main reason for the slowdown was growth in orders from the US, which fell to 9.1% YoY from 16.8% in July, but orders from HK/China didn't help – they fell 0.4% MoM, and grew only 3.4% YoY (vs 6.5% in the previous month).

The shock from the HSBC/Markit Manufacturing PMI is less in its headline (it fell to 49.4 from 49.9 – but this just takes us back to July levels) than in the details – sharp falls in new orders, particularly export orders, and stocks of purchases all suggest more slowdown is on its way, whilst inflation in both input and output prices continues to accelerate. Similarly, the shock from the MNI Flash Business Sentiment Survey isn't immediately obvious – it rose to 59.27 in September from 55.4 in August. Not bad – except that this reading of how listed firms are feeling isn't seasonally adjusted, and that 7.9% MoM rise is frankly pallid compared with, say, the 11.9% recorded last September. In fact, on a YoY basis, the reading was down 14.8% YoY (vs a fall of 10.9% in August).

Euro-Deposits on Both Sides of the Pond

A quick follow-up on a couple of stories I've been following. First, the flight from foreign banks operating in the US. The US Fed's data tells us that between the end of May and September 7^th, foreign banks operating in the US lost US$233.3bn in deposits – that's 20.3% of their total – with nearly half of that exiting since the beginning of August. As I reported earlier, they remain super-cautious, holding US$943.2 bn in cash, which is slightly more than they'd need were every single depositor to demand his money back today. And yet in response to this shrinking deposit liabilities base, they have not yet started shrinking their loan book: rather they are supporting their loan book by a) selling other securities and b) taking in US$174 bn of net liabilities from branches overseas. But clearly, sometime soon that loanbook (currently standing at US$619 billion) is going to start shrinking.

Back across the Atlantic, what's happening at the ECB? Well, it continues to pump in money. Its holdings of Euro-area securities rose a further Eu8 bn in the week to September 16^th, and its total balance sheet expanded by Eu 48.3bn on the week. The overall balance sheet continues to add leverage: total assets were 26.2x the size of the ECB's capital as of Sept 16 – the highest leverage ratio the ECB has enjoyed/endured since June last year.

But I don't think that's the main story for the ECB just now. Rather, I think the thing that needs watching is the build-up of fixed-term deposits on its balance sheet. These fixed deposits have jumped from a steady Eu74bn in mid-August, to Eu143 billion at the latest reading. 

 What are they? They are exactly what they say they are – fixed deposits. What's happening? Well, earlier this week, the FT reported that Siemens had withdrawn Eu500m+ in cash deposits from large French banks and transferred it to ECB, partly on lack of financial confidence, and partly because ECB is paying higher interest rates. In total, Siemens now has Eu4-6bn parked in ECB, mostly through one-week deposits.

In other words, not only are American depositors are quietly withdrawing deposits from foreign banks, but European corporations are also quietly withdrawing deposits from Eurozone banks. The Eurosystem of central banks and the ECB really do seem to be acting as a banker of last resort. Since mid-August, the build-up of time deposits held in ECB has risen at a fairly steady Eu14 bn a week. So far, it 's a pinprick – just half a percent a month of the Eurozone's total private sector deposits. But with an average loan/deposit ratio of 105%, the Eurozone's banks need every Eurocent in deposits they can muster.

IMF and CDS both Finger China's Banks

Which banks have been de-rated the most since the latest Euro-explosion at the beginning of August? Easy question, that – European banks, of course. But China's banks are running them an uncomfortably close second.

The latest bout of Eurocrisis broke raging from its cages at the beginning of August – I know because I was worried I was flying into a banking collapse in Cyprus for my holidays - and since then the average CDS price fo 5yr European bank bonds has risen by 150bps to 517. Despite rating agencies' downgrades, we're seen only a pale echo of that rise for US banks: during the same period CDS rates rose only 90bps to 225. There has been roughly the same rise for Asian banks (including China) – they've added 93bps to 250.

But CDSs for China Development Bank have risen 149 to 305, and for Bank of China they've risen 142bps to 288. This re-pricing isn't generic, and isn't typical of the market – it seems it is specifically pointing to a previously unacknowledged leveraged vulnerability in China's banks to the risks posed by the Eurozone. Since neither of these banks is known or expected to have anything significant in the way of direct exposure to the Euro-threat, it needs some explanation.

And yesterday, we got the clearest possible explanation from the IMF in its latest Global Financial Stability Report. A good deal of that report wraps itself around Europe's problems, of course, but China's situation gets a full page box all of its own (here – Chapter One, Page 40). It's a must-read. 

It points out that during 2009-10, China experienced one of the highest rates of credit expansion in the world, as authorities boosted investment spending – in fact, an accompanying chart shows it surpassed only by Vietnam and Belarus. (Interesting factoid: since then, the Vietnamese Dong has fallen by 15% vs the dollar, the Belarus Ruble has lost 60%, and the yuan has risen 8%.) 'Many of those investment projects are thought to lack longer-term commercial viability, putting the repayment of the underlying debt in doubt.' Recent policy tightening has slowed headline loan growth, but other forms of credit have surged. . . . These include;

• bank acceptance bills and trust loans, now also regulated more tightly;
• inter-corporate lending and credit from small loan companies; and
• funding from banks based in HK and offshore bond markets.

'Based on the authorites total social financing data, the stock of domestic loans reached 173% of GDP at end-June. This places China well above the levels of credit typically observed among countries at the same income level. . . . '

'A long-running real estate boom . . . adds another layer of risk. . . . In this environment, the authorities' current efforts to cool the market might induce a sharper-than-expected correction in prices, depressing collateral values. A weaker property market could also put further pressure on local governments, which rely heavily on revenue from land sales.'

What to do? I think the IMF's conclusions are absolutely on the money. 'While they believe it will be costly, most analysts consider that the likely fallout from China's credit boom will be manageable. One key source of confidence is China's strong fiscal position, including a large stock of public-sector assets and low central government debt. Nevertheless, even those buffers do not preclude significant bouts of uncertainty as to how losses will ultimately be allocated among the banks' private investors and local and central government. To the extent that the government needs to step in, the consequence could be a substantial worsening of China's public debt metrics and a narrower scope for future fiscal stimulus.'

Those two last points – about the scrap to avoid holding the losses, and the extent to which the hangover from 2008-2010 will constrain Chinese government policy choices over the next 18 months – should be carved in stone above every asset-allocators desk.

 

US Now vs Japan 1990s - Part II, Real Estate

This week's river-drift of data from the US is all about the state of the property market – so it's time to post the second part of how the US's deleveraging cycle looks fundamentally different from that of Japan in the 1990s.

It's no longer breaking news to anyone that the US has embarked on a private sector deleveraging which constrains its business cycle, and from there it's easy to conclude, as some very smart analysts have, that the US is at the end of its debt super-cycle. (Though what's a debt super-cycle anyway? Is it just a demographic cycle in heavy disguise? Discuss later.) And from there it is but a short step to seeing the US now in much the same state as Japan in its immediate post-bubble years.

But I think that's a step too far. Debt deleveragings come in at least three different flavours: corporate debt de-leveraging, household debt deleveraging, and government debt deleveraging. These must necessarily play out in different ways. Unless the bond markets have you by the throat (a la Eurozone currently) policy choices define the scope and pace of government debt deleveraging. With politicians calling the shots, this means they are usually achieved without noticeable pain, via growth outstripping the pace of government spending. Quite often, countries don't even notice they're doing it.

Deleveraging led by corporate deleveraging is far more painful, particularly in capital-intensive economies. As long as it goes on, corporate deleveraging will necessarily depress returns on capital, and thus delay the arrival of a new business/investment cycle. That isn't the whole of the story of Japan's lost decade(s), but it is probably the single most important plotline.

Thankfully, as we've seen, the US's deleveraging isn't driven by the corporate sector, but by the household sector, and, associated, by the financial sector which abetted the build-up of debt in the first place.

I've run this chart many times, and doubtless I'll be updating it next week when the US's latest flow of fund tables are published. It makes two simple points: first that there was a dramatic change in financial behaviour by the household sector starting in 2001, when the traditional desire to build up net deposits with credit markets reversed. Second, that this behaviour reversed dramatically in 3Q07, since when the US household sector repaid over US$1.5 trillion in net debt. During the same period, the banking system's loan to deposit ratio has fallen from a peak of 102% to 82% now. That's the lowest rate of bank leverage since the mid-1980s.

Now the key driver of household debt deleveraging (and the associated bank deleveraging) is the housing market, since mortgage debt is the biggest single financial liability any household is ever likely to take on. (This is also why the waxing and waning of this 'debt super-cycle' may turn out to be inextricably linked to the underlying demographics.)

So it is to the housing market that we must turn for evidence of the state of the cycle, and comparisons between the US now and Japan in the early 1990s. The next chart looks at the growth in volume of housing construction starts in the period before the financial crashes of 1Q90 (for Japan), and 4Q08 (for the US).  

The experience of Japan then and the US now are utterly different. In Japan's case, the realization that the housing market was in trouble really didn't become active until a year before the crash (hardly surprising this – in Japan, the leverage was concentrated in the corporate sector). In the US, the housing market had been in stall for fully 12 quarters before the financial collapse arrived. Consequently, whilst in Japan, the bursting of the housing bubble was met with a disbelief which died very long and very hard (I remember meeting Japanese property investors in Hong Kong in the early 1990s looking for a market 'like Japan, where prices never go down'), there's no such illusion in the US now.

Both countries discovered culturally specific ways to delay dealing with the consequences to the financial system of bad mortgage assets; the Japanese by a long period of extended government and bank collusion in denial; the US by discovering a Gordian knot of legal and regulatory malfeasance which at one point threatened to strip away any clear concept of ownership or liability.

Nevertheless, after five years during which housing construction has fallen by around 75% in volume, and – with a lag of a year – prices have fallen by around 25%, the main feature of the housing market is depressed stability. New home construction has been running around 600,000 since the beginning of 2009, sales of new homes have been similarly static (give or take the a-seasonal impact of housing-related tax breaks arriving and departing) during that time, as have the prices paid for them.

Most crucially, it no longer matters very much: residential housing investment has fallen to just 2.5% of GDP, the banks have deleveraged, and so has the household sector. The housing sector's already done the damage it's going to do. If it ever picks up, it will be a pleasant surprise at the margins. If it doesn't – well, I guess we'll have to look to the corporate investment as the key cyclical driver (it's about 10.4% of GDP).

Which leads to a final point: there's absolutely nothing incompatible between household debt-deleveraging and sustained consumption growth, just as there's nothing incompatible between government debt-deleveraging and GDP growth. In terms of the maths, there's likely to be a big jolt on consumption when households change from adding debt to paying it down, with an echo heard in Year Two's data. By Year Three, the other normal cyclical factors return to dominate patterns of marginal consumption – ie, the state of the investment cycle, and the impact that has on labour market conditions.

In short, the US right now doesn't really look much like Japan in the early 1990s.  

Shocks and Surprises, Week Ending September 17

Summing the shocks and surprises this week is pretty easy: the financial world may be teetering on the brink, but industrial sectors around the world are holding firm, even as developed world trade and current account balances continue to improve. The world doesn't need to downgrade its expectations of the US, Japan's recovery is stabilizing, China isn't crashing, and we've stopped worrying about inflation threats for the time being.

So all we need to worry about is the financial and political implosion of Europe. For neurotics, that's plenty.

There were few shocks or surprises out of the US this week, as bulk of the major indicators of the real economy arrived in line with the depressed consensus: industrial production (up 0.2% MoM), capacity utilization (77.4%), the Phily Fed survey (-17.5), business inventories (up 0.4%), retail sales (flat), and three confidence indicators (the U of Michigan, the Bloomberg consumer comfort index, and the NFIB Small Business Optimism Index).

What shocks and surprises there were therefore made little impact on markets, and are unlikely to demand much of a trimming of views from the Street. The Empire State manufacturing index declined very slightly again, to minus 8.8, but the details were equivocal, with a sharp fall in shipments offset by much better news on unfilled orders, for example. Probably the worst news continues to come from the labour market, with both initial and continuing claims rising beyond the range of expectations. But there were similarly marginal nice surprises, from the current account deficit , and from the IBD/TIPP economic optimism index, both of which printed slightly better than consensus expected.

There are obviously no shortage of political and financial shocks and surprises in the Eurozone this week, but in contrast to this, the economic and industrial data provided something of a refuge. As with the US, the industrial economy is holding up reasonably well, with eurozone industrial production up 1% MoM – mainly on the back of Germany (up 4.1%) and capital goods (up 3%). Germany's still rising output offset falls of 1.7% MoM from both Spain and Italy. On the fringes of the eurozone, UK average weekly earnings rose faster than expected (by 2.8% YoY), and this allowed retail sales to fall no more than the depressed consensus expected (0.1% MoM).

Again echoing the US experience, external balances are improving. The US current account deficit continues to shrink slightly faster than expected, and the Eurozone's trade balance surged into a surplus which, for some reason I find statistically inexplicable, sprang a surprise on the posse of Euro-economists detailed to get this right.

But economists in stabilizing Japan seem to have found their range, where industrial output, capacity utilization, machine tool orders, business confidence surveys and even Tokyo condo sales all managed to come and go without disturbing the consensus or the markets.

China's monthly data tapestry was woven mostly over last weekend, and we remarked last week that the trade outcome for August was far better than expected, with exports up 24.5% YoY and imports up 30.2% YoY. Around the rest of Asia this week brought faint echoes of this positive surprise, both in a rise in Korea's terms of trade (yes, you read it right, a rise in Korea's terms of trade), and a surprise 8.3% YoY jump in Singaporean non-oil domestic exports. Don't get too excited about that, since the surprise seems to have been generated by exports of ships – more representatively electronics exports fell 19.4%, and pharma was down 7.1%.

Back in China, the monetary data contained both surprises and shocks to balance each other out. The positive surprise came in the 548.5b yuan in new loans made in August – some 16b yuan above the range of expectations. But this was offset by a slowdown in M2 growth to 13.5% from 14.7% - below the range of expectations. China's M2 growth has swung quite wildly from June to August, the best explanation for which lies in the scramble for deposits in June – during which expiring wealth-management products were channelled very briefly into on-balance-sheet deposits. In July those deposits scarpered once again, and August's 0.9% MoM growth probably represents a return to the underlying seasonal patterns.

Finally, whilst central bankers around the world try to work out how high they need to build the buttress of printed money in order to keep the Euro-cathedral from collapsing under the weight of its own dogmas, they were at least not disturbed by any significant inflationary shocks this week: Eurozone CPI , US CPI, US PPI and US import prices, UK CPI and even Japanese corporate goods prices all behaved as expected.  

Why the US Now Isn't Japan Post-Bubble

In November 2009, I was talking to a hedge fund conference in London about the Japanese post-bubble experience, trying to answer whether Japan's posts-bubble experience was coming America's way.

It took 45 slides for me to conclude 'probably not', on the grounds that there was a big difference in how deleveraging cycles played out, depending on whether your debt overhang was concentrated in the corporate sector or the household sector. And I still think that's important. In Japan's case, the debt overhang was in the corporate sector, and as corporate Japan deleveraged, the process inevitably crushed corporate ROEs. The result of that was that the capital investment motor to the business cycle spluttered indefinitely without ever really coming to life.

In Japan's case, too, the complex and all-pervading financial repression which had been such a vital structural support to Japan's corporate debt habit at first delayed the message getting through to corporate Japan, and also, of course, discouraged the sort of household spending which could have moderated the impact of corporate deleveraging.

In the US case, I said, the debt overhang is in the household sector, which can come down very quickly. Meanwhile, unlike in Japan post-1990, ROCs in the US were rising sharply, so we could and should expect to see an investment cycle begin to kick in.

Well, that's what I thought, and two years later, the same questions are still being asked, and the assumption that the US might well be in for a Japan-type experience is becoming ingrained. And I still think 'probably not.'

So here are three charts comparing the underlying cyclical trajectory of Japan, starting 1Q90, and the US, starting 4Q08.

The first shows the difference between the direction of ROC, calculated in my normal manner of expressing GDP as a flow of income from a stock of capital estimated by assuming 10 year straight-line depreciation on all gross fixed capital formation. The problem for Japan was that even 17 quarters after the Bubble burst, ROC was still declining, and when it stopped declining, it barely ticked up. That, overwhelmingly, was the impact of sustained corporate deleveraging. Meanwhile, in the US, the decline in ROC bottomed out within a year of the financial crisis, and continues to rise quite vigorously. One should expect this rise in ROC eventually to give rise to a recovery in capital spending, which in turn becomes a motive source for a positive business cycle. Confidence may ebb and flow, but if ROC is rising, it's very safe to assume that capital spending will too.  

In fact, that's what's happening – in sharp contrast to Japan.As the chart shows, it took corporate Japan a couple of years to reverse the build-up of capital stock, and start a long drawn-out slowdown from which it has barely recovered. For the US there was less corporate delusion from the get-go, with the stock of capital shrinking within 18 months, and very quietly beginning to show signs of sustained recovery.

And the third chart helps explain why: the average age of the US capital stock was already significantly higher than Japan's then (or Europe's now). As capital ages, the argument for re-tooling becomes increasingly urgent.

Now the US has its problems, and household sector deleveraging isn't a painless experience. But, crucially, it does not by itself take out the capital-spending cycle – a key accelerator of any business cycle. However the US's deleveraging plays out, it's not going to be a carbon copy of Japan's experience.

  

ECB - What A Mistake to Make

You'd think the ECB would tread carefully, given that they're dancing around a Doomsday Machine. But, as I'll show you, they haven't been. Rather, they've been stomping around the market to clumsily that history may well regard them as a direct catalyst for this latest and most dangerous round of financial destabilization.

If you've seen it mentioned before by the press or by the Street, I apologize – I must have missed it. Possibly it's just too awful to mention.

To understand what happened, you need to reacquaint yourself with the timeline of the meltdown of peripheral European sovereign bonds. Here, then, is what happened to the average premium of 10yr bonds for Eurozone vulnerables (for this purpose: Greece, Ireland, Portugal, Spain, Italy), relative to generic 10yr Euro sovereigns.

What was happening as those premia surged higher? Cast your mind back to late-June to mid-July – it's a quaint and safe time compared to the horrors we confront today.

Risk premia for the Eurozones vulnerables had been rising since April, mainly because it wasn't at all clear that Greece would warrant the Eu12b tranche of bailout funds needed to keep them going through September. In a pattern with which we are now familiar, the ECB and Germany are squabbling, and across the full range of European institutions, no-one can agree on just what degree of necessity and/or coercion of financial institutions would constitute a Greek default. During June Eurozone finance ministers met and failed to act, waited a fortnight, then met again and failed to act.

By the second week of July, bond market panic has spread to Italy, pushing the premium on Italian bonds to a then-unheard-of 2.73% (it's just under 3.5% now). This is the point at which the European Banking Authority releases the results of this year's new and improved bank stress tests. By their calculations, eight out of 90 banks surveyed need more capital: when private analysts rework the numbers marking to market bond holdings, they think probably 27 banks fail.

Finally, on July 21, a emergency summit of Eurozone leaders agreed a second bailout for Greece, carrying the headline total of Eu109 billion. As the Europols headed for the beach, it seems in hindsight very unlikely any of them really understood what they'd agreed. Still, no matter, the deal's the thing and within a week the premium on 10yr Eurovulnerables had fallen from 8.2% to 6.5%.

Very roughly, that's the background to the ECB's cock-up. Publicly, there was the July 7^th decision to raise rates by 25bps to 1.5%. (Possibly they were distracted by the succession struggle in which the French government was blocking confirmation of Mario Draghi as the successor to Trichet unless it was guaranteed a seat on the ECB's six-man exec committee.)

However, a more destructive mistake was to come. It is sometimes said, and in print, that the ECB doesn't disclose details about its bond-buying. That's true inasmuch as we can't see exactly what it's buying. But you can track the overall amount weekly through changes in its financial statements (which you can find here).

Anyway, here's what happened: as the chart showed, the ECB took advantage of the decline in premia during the next couple of weeks to start dumping bonds. In the week to August 5^th, the ECB sold a net Eu14.6 billion of their bond position. As the chart below shows, this level of selling was absolutely unprecedented in the ECB's recent history. It represented a sale of 11.2% of the entire amount of bonds bought since the start of the bond-buying exercise in May 2010. The ECB was getting its retaliation in first.  

 think that decision to take advantage of the post-agreement relaxation to quietly reverse out of its bond position is a mistake of historic proportions. One can say either that the effect was catastrophic, or one can say that the timing was stupendously unlucky. During the week in which the ECB was extricating itself from its bond position, European equity markets imploded. While the ECB was selling, the Euro Stoxx 50 lost 11.1%, and in the next three days lost a further 9.3% - the biggest crash since Lehman Brothers, and about one and half times the crash suffered by the S&P during the same period. The subsequent loss of economic and financial confidence of course makes all policy options much worse, since the Eurozone's debt problems are also, more fundamentally, a growth problem. Who knows what price will ultimately be paid?

And, of course, it was an expensive mistake also for the ECB purely in terms of protecting their bond position. In the next week (to Aug 22) they bought Eu22.1b, the week after than Eu12.7b, the week after that Eu5.7b, the week after that Eu12.7billion. At which point Juergen Stark resigned 'for personal reasons'.