Shocks and Surprises, Week Ending March 4th

Over the last few months, the US, Europe and China have provided a steady series of view-adjusting shocks and surprises, whilst Japan's sustained moderate misery has surprised no-one. Until last week, when first Japan reported a 4,1% MoM jump in retail sales in January, then followed up the next day with a surprise 2.0% MoM rise in industrial output.

But these two were then eclipsed by a surprise 7.6% YoY rise in capital spending reported for 4Q in the Ministry of Finance's enormous quarterly survey of balance sheets and p&ls. This was far removed form the 6.5% YoY fall expected. The details showed manufacturing investment rose 5.7%, whilst non-manufacturing rose 8.6%. There were big jumps in capex in construction (88.7%), wholesale/retail (24.6%), real estate (35.7%), but also in machinery (83.1%), business machinery (25.3%), and chemicals (10.5%).

It's tempting to get rather excited by this: after all, by virtually every measure 2011 was a rotten year for Japan, with currency strength compounding the misery already perpetrated by earthquake, tsunami, nuclear accident and political uncertainty. The same quarterly data shows sales fell 3.7% YoY, operating profits fell 8.6%, operating margins fell from 3.26% in 2010 to 3.09% in 2011, ROA fell to 3.01% from 3.32%, and ROE fell to 8.2% from 9%.

So why is capital spending up 7.6% YoY? There are two possible levels of explanation, of varying cheeriness. Let's take the cheery explanation first. One can argue that increased capex is simply the dividend now being paid for decades of corporate balance sheet restructuring. This chart takes two interpretations of leverage: financial leverage (total assets/shareholders equity), and net debt/equity ratio. And yes, they have both finally stabilized, a mere 22 years after they the bubble imploded.

That in itself is potentially a game-changer. But there's more – after deleveraging comes a cash build-up. And here it is:

So, after completing deleveraging and building up a cash horde, the logical next step is to start spending/investing once again. And so, we have the third chart. . . 

But at this point, the observant will see that the headline 7.6% YoY growth in capital spending is rather more impressive than the actual amount, compared with past spending plans. And in fact, such spending hardly breaks out of the investment slump we've seen since 2008. There is an awful lot of sustained investment spending to be done before we can describe a new era of Japanese industrial investment is underway.

At which point, we look at a fourth chart, which expresses current spending on plant and equipment with depreciation allowances. And the key point here is that even the 7.6% YoY rise in spending during 4Q still leaves total investment only very marginally higher than the depreciation on existing capital stock. In short, this surprise isn't (yet) telling us Japan is expanding its capital stock – it is still merely treading water.

Eurozone: In Denial

Elsewhere, for the most part, the data-run from the Eurozone continues to suggest that economists are strangely reluctant to acknowledge the unfolding recession. German retail sales fell 1.6% MoM, with pretty much everything falling – furniture was down 3% MoM, infotech donw 2.2%, autos down 1.7% and even clothes/shoes were down 0.9%. Similarly, French household consumption fell 0.4%, buoyed only by a 2% rise in spending on energy and a 1.4% rise in food spending. Elsewhere, French spending on durable goods fell 4.3%, and autos fell 7.6%. Why should this be surprising? Despite economists' unanimous expectation that the unemployment ratio would remain unchanged at 10.4%, it jumped to 10.7%. There are some absolute horror stories in that data – most notably Spain's ratio rising to 23.3%. Dreadful though it is, that is expected. But Germany's ratio is also now rising, to 5.8% from previous 5.7% (that's the EU count – Germany's own count puts its unemployment ratio at 6.8%). This month, only Austria bucked the trend of rising unemployment.

But there was one surprise – Eurozone M3 growth rose 2.5% YoY in January, recouping most of the ground lost in December's 1.6% YoY shock. The key statistics in all the monetary and banking data for January, in my opinion, was the 0.3% MoM rise (not seasonally adjusted) in bank lending to the private sector – this followed consecutive falls of 0.8% MoM in December, 0.1% in November, and 0.3% in October. In other words, January saw a modest and very probably temporary brake on the pace of household deleveraging. On the other side of the banking system's balance sheets, total deposits rose 0.6% MoM (nsa), up from 0.2% in December, allowing the YoY to rise to 2.7% in January from 2.1% in December. That's the good news. The less good news is that the rise in deposits was almost entirely the work of governments: government deposits jumped 23.1% MoM, whilst everyone else's stagnated at 0.1% MoM. Yes, there are strong seasonal patterns at work in December and January differentiating government private sector deposits – but they are not normally this strong. January's partial recovery in Eurozone monetary data will not be long-sustained.

US – Softer January, Harder February

From the US came an unexpected raft of worse-than-expected data – made all the worse because the shocks came from hard data, rather than surveys of intentions or dispositions. First durable goods orders fell 4% MoM in January, with capital goods orders, ex-defence and air down 4.5% MoM. Orders for machinery collapsed by 10.4% MoM, primary metals fell 6.7%. Shipments of capital goods did better – they rose 0.4% MoM, and both unfilled orders rose (up 0.5% MoM) and so did inventories (up 0.7%).

This was followed later in the week by unexpected weakness in personal income growth (up 0.3% MoM – wages up 0.4% MoM, but transfer payments fell 0.2% whilst social insurance costs rose 1% and taxes rose 1.6%). Personal spending also disappointed, rising only 0.2% - and within this demand for goods rose 0.6% but services stagnated entirely.

Finally, the roll-call of bad news was completed by an unanticipated fall of 0.1% MoM in construction spending, mainly reflecting a 3.9% MoM fall in hotel-building.

All of which was more grim news than we've seen from the US for a number of months now. However, there was solace in that all those negative indicators reflected reports of activity in January. Meanwhile, hard data was arriving from February which painted a far stronger picture. ISCM Chain Store sales jumped 6.7% YoY, even though sales of luxury goods were flat. And total vehicle sales topped an annualized 15mn for the first time since early 2008. The Conference Board consumer confidence index also jumped to its best reading since February last year , as readings both on current circumstances, and future expectations jumped.

2012 - A Summary

In 2012, the major economies of the world will find their business cycles are less synchronized than any time over the last ten years. The fate of the world's major economic power-houses will rest on the underlying fundamentals of return on capital, financial leverage, terms of trade and policy-development.

The reason for this is that domestic imbalances of savings and investment (recorded in current account surpluses and deficits) are less pronounced globally than at any time since 2001.

As a result, these economies will also be less hostage to international capital flows and their volatilities. Investors will gradually discover that we're exiting the 'risk-on, risk-off' world, and backing blindly into a world where asset discrimination once again begins to matter, a lot.

US – Accelerating Recovery

Chief beneficiary of this is the US, where we expect the recovery to continue to accelerate throughout 2012, and we expect both the current consensus forecast of 2.2% in 2012 (up from 1.7% in 2011), and the US Federal Reserve's band of 2.2% to 2.7% will prove to be excessively conservative.

By my estimate returns on capital are around their highest since 2000 and are still rising, which will continue to foster investment spending; labour productivity continues to grow (adjusted for changes in capital stock), which will underpin the slowly- accelerating addition of jobs; and, most importantly, I believe that the net develeraging of the economy which started in 2008 is now complete. I do not expect significant re-leveraging to take place this year, but the mere fact that deleveraging is no longer the key dynamic will shift the economy out of its modest 2.4% annualized growth trend which it has sustained since the end of the recession in 2009 and towards a 3%+ rate.

As this faster growth path becomes acknowledged I expect to see bond yields rise from their current excessively-low level (roughly 180bps below 'fair value' in our models). For now, it is faster growth, not higher inflation, that will do the damage to the bond markets.

This scenario faces threats from both the upside and the downside. On the upside, if monetary velocity (GDP/M2) even stabilizes at its current precedent low levels, then somehow we have to expect double digit nominal GDP growth. On the downside, the cycle could be choked off by a sustained rise in commodity prices sufficiently strong to erode the US terms of trade sharply. What would it take? Oil at US$140 a barrel would be threatening but not conclusive; oil at US$165 a barrel would trigger a 'soft patch' to disrupt the recovery.

Eurozone – Not Eurogeddon, but Recession

The ECB's willingness to supply Eurozone banks with cheap long-term funding, coupled with the US Federal Reserve's willingness to supply ECB with enough dollars to plug the hole left by financial institutions' capital flight from Europe (Eu135bn in December alone!) makes it likely the Eurozone can avoid financial implosion this year.

But it is unlikely to avoid recession. All three main ratios underpinning the business cycle point towards recession: nominal GDP growth is now so slow that asset turns and return on capital are falling – which usually triggers a downturn in the investment cycle. Europe's terms of trade have deteriorated back to their 2008 lows. And the pace of bank deleveraging, which has been the most gentle of headwinds during the last five years, is picking up dramatically. Falling returns on capital, rock-bottom terms of trade, and accelerated deleveraging dictate a private sector recession. And that's before the impact of tighter public sector budget discipline is taken into account.

Nor is it easy to expect an early exit from this recession, since the underlying problems of competitiveness within the Eurozone are ignored entirely by the current attempts to 'save the Euro'. Yet these issues will eventually be addressed in one way or another. The bullish view is that eventually Germany will reconcile itself to very rapid nominal GDP growth, including a bout of inflation and a current account deficit rather than watch deflationary forces consume southern Europe. This may, in the end, be correct. But it won't be in 2012.

China – No Hard Landing, but Hard Choices

The expectation that a hard landing will be forced on China by combination of disappearing export growth plus mounting bad debts in the banking system, linked both to local government and property projects, is wrong. The Chinese government has spent two years taking stock of the problem and trying to work out precisely who should pick up the bills coming due. It's a fraught political problem, but at least the money is there to pay them.

But this is not the main worry. Rather, the wildly-successful growth strategy pursued by China pursued in earnest since the mid-1990s is reaching exhaustion point. Policymakers have been extremely clear in their repeated assertions they wish to move China from an investment-led conomy to a consumption-led economy. But to make that transition is extremely difficult since it involves a complicated and sensitive re-modelling of China's financial system. China has had the best economic and financial advice on the topic that exists, but no-one really knows what will happens when the re-modelling gets underway in earnest this year.

Because of this radical uncertainty, our expectation of Chinese growth slowing to around 8% is best interpreted as an assertion that a hard-landing will be avoided, but that the environment for all involved in China's economy is likely to be unusually difficult and unpredictable.  

2012 China - The Wild Card

The expectation that a hard landing will be forced on China by combination of disappearing export growth plus mounting bad debts in the banking system, linked both to local government and property projects, is wrong. The Chinese government has spent two years taking stock of the problem and trying to work out precisely who should pick up the bills coming due. It's a fraught political problem, but at least the money is there to pay them.

But this is not the main worry. Rather, the wildly-successful growth strategy pursued by China pursued in earnest since the mid-1990s is reaching exhaustion point. Policymakers have been extremely clear in their repeated assertions they wish to move China from an investment-led conomy to a consumption-led economy. But to make that transition is extremely difficult since it involves a complicated and sensitive re-modelling of China's financial system. China has had the best economic and financial advice on the topic that exists, but no-one really knows what will happens when the re-modelling gets underway in earnest this year.

Because of this radical uncertainty, our expectation of Chinese growth slowing to around 8% is best interpreted as an assertion that a hard-landing will be avoided, but that the environment for all involved in China's economy is likely to be unusually difficult and unpredictable.

The most likely trajectories of the US and the Eurozone are not too difficult to determine: getting China right, however, is a far harder task both for economists and, much more importantly, for policy-makers. The bad news is that the situation is complicated, since China's economy is beset with both cyclical and structural difficulties. The better news is that there is no-one more keenly aware of the fact than China's policymakers, and they have the financial resources available to act effectively.

If those resources are deployed cleverly, China should avoid a hard landing (which is generally defined as growth falling below 8%). If they don't – well, there are easily enough cyclical and structural problems to drag the economy down. One is given confidence by the the extreme attentiveness with which China's policymakers have tracked and measured the build-up of problems over the last two and a half years, and the clarity with which they explain what they are attempting to do. Nonetheless, the cyclical and structural problems are complicated and interlinked, and economic history offers many examples of promising economies which have flunked similar tests.

Cyclical Problems

The most obviously element of China's cyclical problem is easily stated: as one of the world's largest exporters, China is exposed to any major cyclical downturn in world trade.

This vulnerability is easy to overstate: in recent years the surge in domestic demand has cut the overall importance of exports to China's economy. Back in 2007, exports were equivalent to 35% of GDP – this proportion had fallen to 26% in 2011. In net terms, China's current account surplus peaked at 11% of GDP in mid-2007, but had fallen to 3.9% by the end of 2011. Moreover, if one models carefully, the scenarios under which China's exports grow much less than 10% this year require some quite extreme assumptions about the US and Eurozone demand. A rise of 10% in exports during 2012 would be half the 20.3% recorded in 2011.

The external sector will be a modest drag on growth, but China's domestic economy has more worrying cyclical problems – most particularly the overhang of (probably bad) debt from local government spending during 2009 and 2010. Last year, the National Audit Office put the amount of outstanding loans to local governments at Rmb 10.7tr, equivalent to 23% of 2011 GDP. Local governments almost certainly wasted a lot of borrowed money on projects which will struggle to generate the cashflow to make repayments. This puts the onus back directly onto local governments themselves. But their revenues are also linked to property sales: in 2010, income from property sales amounted to no less than 27% of total local government revenues. Since the central government is quite determined to deflate existing property bubbles and deflate any that it suspects might be forming, this compromises the health of those local government loans even more.

No doubt these problems are not overstated, but China's bureaucrats - world-class worriers by inclination - have been assiduously tracking them since at least early 2010. If the Chinese government had not resources with which to bolster both local government finances and/or the capital of the banking system, they would be as dangerous as they are regularly described. But they have. Between 2007 and 2011 China's central bank raised reserve ratios on deposits from 8% to a peak of 21.5%, mainly to sterilize net capital inflows. By the end of 2011, the 'reserved' deposits commandeered by the central bank amounted to just under Rmb 17tr, equivalent to 36% of GDP.

The central bank and will release those deposits back into the monetary system as required – and they are surely enough to offset liquidity pressures stemming from any foreseeable deterioration in the loan-book (which, after all, currently totals only Rmb 55.5 trillion). Indeed, the process has already started, with reserve ratios being cut by 50bps in both December and February, in response to a sharp slowdown in monetary aggregates.

The conclusion is straightforward: despite its deteriorating internal cashflow and emerging credit-quality problems in the banking system, China's economy need not be forced into a 'hard landing' in 2011 by financial or liquidity constraints.

Structural Problems

The cyclical problems on their own are manageable. But China faces extremely difficult structural problems too, which policymakers are unwilling to ignore any longer, and which complicate economic management hugely this year.

Of course, the structural problems also intensify the cyclical problems. For example, the deterioration in China's cashflows are ultimately linked to deteriorating return on capital, and in 2011 China's private sector savings surplus had shrunk to 5% of GDP from a peak of 11.5% in 2009. On current trajectories, this surplus will contract nearly to zero over the coming two years.

The structural problem stems from the approaching exhaustion of China's existing growth model, in which huge saving levels are encouraged in order to finance correspondingly huge investment programmes, which subsequently turn out more goods than the domestic economy needs, and which therefore has to find markets for its surplus production abroad. There are two reasons this model has reached its sell-by date. First, it is increasingly difficult to either ignore or control the swathe of inefficient investment which depressed return on capital (and compromises banks loan portfolios). Secondly, China has grown so big that the rest of the world can no longer be expected to find an appetite for all the surplus production China wants to sell them: every percentage point of export market share won is gained at an ever-increasing investment cost.

If China is to switch to a growth model in which consumption rises more quickly than investment, the whole structure of savings and capital allocation (banking, bond markets, stock markets) will have to change radically. This is the most difficult policy traverse in the world, and one which the IMF has been poring over with the Chinese government in order to discover what sort of sequencing of financial reform will cause the least disruption.

And here we come to the real difficulty: there is every sign that China's government intends to press ahead with these reforms even in the face of the cyclical difficulties. What no-one knows is:

• How quickly and radically they intend to act;
• Whether they will press ahead even if cyclical pressures are more intense than expected;
• What effective resistance can be expected from the major beneficiaries of the current system of capital allocation (principally State Owned Enterprises, and the personnel of the Chinese Communist Party);
• Whether the forthcoming generational mass change in leadership will disrupt the agenda. (The change in leadership takes place throughout 2012 and 2013 and encompasses all parts of China's structures of political and administrative governance);
• What the economic impact of financial reform will be in terms of savings rates, investment rates, consumption rates.

The truth is, China is a wild-card in the global economy in 2012. A 'hard landing' will almost certainly be avoided, because China has the financial resources to generate cashflows to avoid one. And it will choose to avoid one. But at the same time, if China's policymakers believe they can safely advance structural financial reform at the cost of a growth slowdown, they'll probably choose to do it. Currently the consensus forecasts for China in 2012 and 2013 are 8.5% and 8.4% respectively – my own view is that it will be somewhat slower at around 8% in both years.

2012 Eurozone - For Now, A Normal Recession

The ECB's willingness to supply Eurozone banks with cheap long-term funding, coupled with the US Federal Reserve's willingness to supply ECB with enough dollars to plug the hole left by financial institutions' capital flight from Europe (Eu135bn in December alone!) makes it likely the Eurozone can avoid financial implosion this year.

But it is unlikely to avoid recession. All three main ratios underpinning the business cycle point towards recession: nominal GDP growth is now so slow that asset turns and return on capital are falling – which usually triggers a downturn in the investment cycle. Europe's terms of trade have deteriorated back to their 2008 lows. And the pace of bank deleveraging, which has been the most gentle of headwinds during the last five years, is picking up dramatically. Falling returns on capital, rock-bottom terms of trade, and accelerated deleveraging dictate a private sector recession. And that's before the impact of tighter public sector budget discipline is taken into account.

Nor is it easy to expect an early exit from this recession, since the underlying problems of competitiveness within the Eurozone are ignored entirely by the current attempts to 'save the Euro'. Yet these issues will eventually be addressed in one way or another. The bullish view is that eventually Germany will reconcile itself to very rapid nominal GDP growth, including a bout of inflation and a current account deficit rather than watch deflationary forces consume southern Europe. This may, in the end, be correct. But it won't be in 2012.

For more than a year now the world has worried that the Eurozone's financial problems are so extreme that they must inevitably drag the region into recession, and possibly much of the rest of the world with it.

Mainly these concerns are correct: the introduction of Euro-financing to countries who's productivity growth cannot begin to keep pace with German productivity growth has opened up huge gaps in competitiveness within the Eurozone which had been masked only by enormous build-ups of Eurozone debt. In the process, the nominal GDP of the weaker countries soared extraordinarily compared with the GDP of the core Eurozone countries, primarily Germany, and also compared to other developed economies. The chart below shows how it happened.

Now this debt financing is no longer available, and the underlying competitiveness issues widely understood, the Eurozone as currently constituted is living on borrowed time. By my calculations, even if labour productivity in the peripheral countries of the Eurozone had kept pace with Germany's, the scale of 'internal devaluations' needed in these countries to restore their intra-Eurozone competitiveness are simply impossible to achieve. Greece needs a devaluation of around 55%, Spain 50% and Ireland 45%. On the other hand, the scale of 'internal devaluation' needed by Portugal (18%) and Italy (10%) seem plausible.

Sooner or later, these devaluations will be made, either by massive and economy-shredding deflation in the peripheral countries (which surely could not be achieved without intense political disruption), serious and sustained inflation in the core countries (distinctly unwelcome to Germany), or through these countries accepting and external devaluation through exiting the Eurozone.

These choices seem obviously to most observers outside the Eurozone, but they currently elude the imaginations of Eurozone politicians and policymakers. And in the short-term, they continue to believe they are faced primarily with a liquidity problem (which can be resolved in the medium term by various 'rescue' expedients) whilst in the medium term the most visible aspect of the problem – the build-up of government debt – can be addressed by cutting public spending, closing fiscal deficits.

I expect they will continue to believe this even if Greece defaults and devalues later this year. Greece can yet be declared a 'special case', and the policy of liquefy the Eurozone banks whilst tightening the fiscal austerity screws will be maintained.

In the short term, it remains a reasonable expectation that continuing major infusions of extra liquidity can indeed prevent the underlying economic incompatibilities of the Eurozone from degenerating into uncontrollable financial crisis. For the ECB, even after taking into account the huge new lending of long-term money to Europe's banks at cheap rates (Eu489bn in three-year money in late December, with more to come later this year), still remains only modestly leveraged by central bank standards, with a total assets/equity leverage ratio of around 33x. That ratio could rise to around 45x before it would stand comparison with either the US Federal Reserve or the Bank of Japan.

But postponing financial catastrophe is not the same thing as fending off recession, and my three main cyclical indicators – return on capital, terms of trade, and leveraging trends - all point to recession in the Eurozone this year. There are three main indicators: return on capital is already falling; terms of trade have fallen back to 2008 levels and area likely to fall further if commodity prices continue rising; and bank deleveraging still has a long way to go. Beyond that, the ECB's new largesse is perversely also having the effect of accelerating the deleveraging process by making buying Eurozone sovereign bonds a much more attractive business for banks than the risky business of lending to the private sector.

By my estimate, the Eurozone had recovered about half the return on capital it lost during the financial crisis in 2008, unlike the US where the recovery was far quicker, and where ROCs are now at their highest level since 2000. Worse, it seems that ROC peaked in 3Q11 and almost certainly fell marginally again in 4Q11. When asset turns (sales/total assets) begin to fall one can expect investment spending to fall in sympathy – although this may be delayed by other factors which disguise or delay the underlying deterioration.

But there are only two disguises available in the medium term: either operating margins (indicated by international terms of trade) can rise, or financial leverage (indicated by bank loan/deposit ratios) can rise. Right now, neither of those tactics are available: whilst the Eurozone's terms of trade were steady throughout most of 2011, they are just about as bad as they were in 2008 at the height of the commodities boom. And whilst bank loan/deposit ratios have fallen consistently throughout the last five years, the fall has been so gentle it has merely allowed the ratio to drift down from a peak of 117% in 2007 to 104.4% now. Compare that to ratios elsewhere: 82% in the US; 96% in the UK; 68% in China and 70.6% in Japan and it is clear that the European banks still have a lot of deleveraging to do, and probably at a rather more rapid pace than during the past five years.

Indeed, one can see this more rapid pace emerging since December. Ironically, it is also hastened by ECB's determination to prop up Eurozone sovereign bond markets by making huge amounts of liquidity available to Europe's banks. The banks face a practical question: why take the risk of lending to the private sector when you have the choice both of taking the ECB's money and buying sovereign bonds, or alternatively, of simply putting the money back on deposit with ECB?

And that's what's happening: when ECB auctioned Eu 489bn of cheap three-year money in mid -December, the banks used that funding partly to lengthen their debt maturities, so the absolute rise in ECB lending came to only Eu214 billion. As more short-term debt has matured and not been replaced, the gross new lending has fallen to only Eu 122.25bn. Meanwhile, what have the banks done with the money? Overwhelmingly, they have re-deposited it back to the ECB: since mid-December, financial institutions' deposits with ECB have jumped by Eu307bn. In other words, the impact of the ECB's supply of cheap money to the Eurozone banking system has been, very perversely, to leave the ECB's net supply of credit to financial systems down by Eu 184.8 bn. In fact, the ECB's net supply of credit to financial institutions is now at its lowest point since the crisis began.

It is quite possible that in the next few months the ECB will become a net holder of deposits from Europe's banks. And, not surprisingly, at the same time, European bank lending, and European monetary aggregates are slowing very sharply.

In conclusion: the upside potential in Europe this year is limited to avoiding full-scale financial crisis. Even so, we should expect a year of unrelieved recession for the Eurozone as a whole, and on current policies there is no real reason not to expect this financial/economic stalemate to drag on throughout 2013 as well. Bond yields, naturally enough, are unlikely to rise. However, as precautionary savings ratios rise, we should expect the private sector savings surplus also to rise, which – if the Japanese example is anything to go by – also suggests we should not expect any collapse in the Euro (whatever this currency turns out to be).

2012 US - Strong Cyclical Upturn with Matching Upside/Downside Risks

The central expectation is for the US recovery to continue to accelerate throughout 2012, and we expect both the current consensus forecast of 2.2% in 2012 (up from 1.7% in 2011), and the US Federal Reserve's band of 2.2% to 2.7% will prove to be excessively conservative.

The basis for that judgement is that by our estimate returns on capital are around their highest since 2000 and are still rising, which will continue to foster investment spending; labour productivity continues to grow (adjusted for changes in capital stock), which will underpin the slowly- accelerating addition of jobs; and, most importantly, we believe that the net develeraging of the economy which started in 2008 is now complete. We do not expect significant re-leveraging to take place this year, but the mere fact that deleveraging is no longer the key dynamic will shift the economy out of its modest 2.4% annualized growth trend which it has sustained since the end of the recession in 2009 and towards a 3%+ rate.

As this faster growth path becomes acknowledged we expect to see bond yields lift from their current excessively-low level (roughly 180bps below 'fair value' in our models). It is the recognition of faster-than-expected growth rather than a resurgence in inflation which we expect will undermine the bond market.

This scenario has threats both to the upside and the downside. On the upside, if monetary velocity (GDP/M2) even stabilizes at its current precedent low levels, then somehow we have to expect double digit nominal GDP growth. On the downside, the cycle could be choked off by a sustained rise in commodity prices sufficiently strong to erode the US terms of trade sharply. What would it take? Oil at US$140 a barrel would be threatening but not conclusive; oil at US$165 a barrel would trigger a 'soft patch' to disrupt the recovery.

The fundamentals supporting the business cycle remain unusually positive. Return on capital is the most positive since 2000 and still rising, despite the 'soft patch' of mid-2011. Since aggregate capital stock is unlikely to rise more than 1.5-2% this year in nominal terms, that return on capital will keep rising. As a result, the capital spending cycle in the US will continue to accelerate throughout 2012.

The allegedly 'jobless' recovery will keep expanding payrolls at an accelerating rate. Real labour productivity levels, adjusted for levels of capital per worker, have recovered to levels last seen in 2001, and continue to rise – albeit at a slightly slower pace. This real productivity growth will continue to underpin growth in labour markets. In 2011, employment rose by only 1% on average – in 2012 this can be expected to rise to between 1.6% and 2.2%.

Most importantly, there are signs that the household sector deleveraging which has been the main driver of the US's sub-par recovery has burnt itself out. There are both indirect and direct indications of this. The most indirect are the way in which various debt to income, and net household financial assets to GDP ratios have been returned to normal historic levels. 

The most direct are the readings of monthly additions to consumer credit, which in recent months have risen from previously steady readings of around US$7bn a month to more than US$20-bn a month. But the most powerful confirmation is the way in which the banking sector's loan to deposit ratio first stabilized at around 81% in September (down from an early 2008 high of 102%), and have since very modestly begun once again to expand.

We do not have to assume that a structural deleveraging will immediately be followed by a cyclical re-leveraging. But simply removing the deleveraging dynamic will release one of the main breaks on the US cyclical upswing. And this is consistent with what we see elsewhere in the economy.

It is also consistent with a continued fall in the US private sector savings surplus, which fell to 3.8% in 2011 from 7% in 2010, and has generally been falling at a rate of around 2.4percentage points a year. This will continue, partly because bond yields have fallen so low as to represent extremely poor value, with 10 year bonds yielding around 180 basis points below what one would expect given policy rates, and prospects for growth and inflation.

The Federal Reserve has played a significant role in depressing bond yields, both directly (through quantitative easing) and indirectly (through the threat/promise of more quantitative easing to come, backed by the release of extremely pessimistic growth and inflation forecasts). Historically, one of the results of bond yields falling sharply below 'fair value' has been to dissuade saving; and conversely, when bonds are 'cheap' relative to fair value, saving surpluses have tended to rise.

From this we can reach two conclusion.

• First, we should expect private sector savings surplus to continue to decline during 2012 – probably to around 1.5% of GDP.
• Second, the current over-valuation of US 10 year treasuries relative to 'fair value' make them extremely vulnerable to signs of the sort of accelerating US cyclical upturn we fully expect in 2012. What makes those bonds vulnerable is not necessarily 'the return of inflation', but rather a reassessment upwards of likely GDP growth, and reassessment downwards of the likelihood of third round of quantitative easing by the Federal Reserve.

Our central expectation for the US, therefore, is for the cyclical upswing to gather momentum throughout 2012. Moreover, this is now emerging in the monthly data-runs, particularly in labour markets and surveys of business conditions and consumer confidence, but also more cautiously in the housing market and banking markets.

However, there remain two main ways in which this central expectation can be blown off course – one threat to the upside, and one to the downside.

Upside Risk: Monetary Velocity and Nominal GDP

The threat to the upside is simply stated: monetary velocity (GDP/M2) in 2011 sank to lows unseen in the US since the end of the Second World War, yet at the same time, M2 is growing around 10% a year with strongly positive underlying sequential momentum. It therefore requires only that monetary velocity falls no further for nominal GDP growth to start accelerating into double-digit growth.

Two of the (linked) factors which have depressed US monetary velocity are

1. the deleveraging of the banking sector, as shown in the fall in loan/deposit ratios; and
2. a sharp aversion by the household sector to financial risk since the onset of the financial crisis in 2007/08.

But we already can observe that the fall in loan/deposit ratios is bottoming out. And we also know that 2011's combination of extraordinary shocks (principally from Japan and the Eurozone) is unlikely to have quite the same power to surprise in 2012. In these circumstances, a continuation of the sharp decline in monetary velocity is no certainty.

Downside Risk: Commodity Prices and Terms of Trade

The threat to the downside is similarly easily stated: the US cycle remains vulnerable to sharp and sustained rises in commodity prices. This vulnerability shows up when we look at how both recessions and 'sort patches' in recent US economic history have been preceded by a fall in the terms of trade (caused by rising prices of imported commodities -mainly oil).

Recessions

• 3Q00 to 3Q 01 – preceded by a 9% fall in terms of trade 1999- 3Q00.
• 1Q08 to 2Q09 – preceded by and intensified by a 13% collapse in terms of trade between 1Q07 to 2Q08.

Soft patches

• 2Q-3Q06 – preceded by a 7% fall in terms of trade between 1Q05 and 3Q05,
• 1Q-2Q11 – preceded by a 5% fall in terms of trade between 3Q10 and 2Q11.

Since the beginning of 4Q11 the rise in commodity prices has depressed US terms by nearly 3%, and the current rally in oil prices will extend that fall. As that fall increases, so does the likelihood of a further 'soft patch' emerging in the second half of 2012. In the absence of unexpected severe supply-side shocks to rival the auto-industry shock delivered by last March's Japanese earthquake/tsunami disaster, and given the robust improvement in all other cyclical indicators, I would expect the cyclical sensitivity to terms of trade falls to start to have an effect nearer a 7% fall than last year's 5%.

The current spike in oil prices (Brent at US$122 a barrel) won't do it. For reference, it would take an oil price of US$165 a barrel to engineer a 7% fall from the September terms of trade peak. Oil at US$140 a barrel would take be consistent with a a 5% fall in terms of trade from the recent peak.

2012: A Year When Cycles Diverge

(I have just returned from a short period in Bahrain (about which more at a later date), where, among other things I was asked to write an overview of the global economy highlighting the likely trajectories for 2012.   The result was a series of five pieces, of which the following is the introduction. I hope you find the series meets your standards.) 

This will be another year in which the best thing an investor can do is forget the lessons that have been drilled or beaten into him during the last few years. Two of the most popular lessons are that deleveraging once started is pernicious and long-lasting. The second is that we live in a risk-on, risk-off world in which the global economy and global financial markets are so inter-related and inter-dependent that trouble anywhere means trouble everywhere. In the globalized economy, there is simply no place to hide, since business cycles of separate countries cannot escape being heavily synchronised.

Yet in 2012, we can and should expect the major economies of the world to diverge in their business cycles, as cycles become less synchronized than probably any time over the last ten years. More than at any time in a decade the fate of the world's major economic power-houses will rest on the underlying fundamentals of return on capital, financial leverage, terms of trade and policy-development.

We will gradually discover that we're exiting the 'risk-on, risk-off' world, and backing blindly into a world where asset discrimination once again begins to matter, a lot.

This divergence between economic cycles is already apparent even at the beginning of 2012, with the US accelerating more than expected, China (probably) beginning to slow more painfully than seemed likely at the end of last year, even whilst avoiding a 'hard landing', and the Eurozone straightforwardly heading into recession and, on the periphery, into something far worse.

Separate economies, rather than being harnessed together, are now responding to their different underlying cyclical stimuli, as well as policy settings which are now quite different in, say, China than, say the US.

This divergence is not yet widely recognized or understood. It is possible because the imbalances between savings and investment, reflected in current account balances, have fallen in virtually all economies to unusually low levels. Think of the global economy as a giant jigsaw puzzle, in which the giant regions fit together: in that analogy, current account surpluses and deficits are the cut-outs and bulges that lock the pieces together. The bigger the current account imbalances, the tighter the fit. Looking at the four major economies of the world (US, Eurozone, Japan, China), one can see reasonably clearly that the current account surpluses in China and Japan have peaked, whilst the US current account deficit has improved somewhat.

But if one simply counts up the total imbalances (negative or positive) as a % of GDP for these countries, the radical fall in the total current account imbalance shows up much more clearly.

 In 2008, the combined current account imbalances of these countries amounted to 24% of GDP: by 2011 this had shrunk to 11.1% - which was the lowest total since 2001. On current trends, that ratio will shrink further in 2012.

There are two profound consequences for the world economy. First, this chart tracks the degree of inter-dependence of these major economies, the degree to which, for example, China's growth is potentially exposed to a slowdown in the US. The lower the total, the more the fate of these separate economies lie in their own domestic circumstances. When China's growth was predicated on running at current account surplus of 10% of GDP (2007), what happened to US demand mattered a whole load more to it than it does now, when its current account surplus has shrunk to 3.9%. Ditto all the other bilateral economic relations possible among these four leading economic blocks.

So the first consequence is a lesser degree of inter-dependence, and therefore a greater ability for cycles to diverge according to individual economic circumstances. And we expect those circumstances do diverge considerably now.

The second consequence is that economic cycles are less hostage now to capital flows than at any time since 2001. Again, this is simply a consequence of the shrinking of current account imbalances, since every current account deficit must and will, by definition, be met by a capital flow. The lower the underlying imbalances, the less important the outcome of international capital flows.

So, we propose that in 2012, we to cast aside the assumption that the world and its financial markets are inextricably entwined and that what afflicts one will necessarily infect the other. It's not that its not true exactly – it's just that that truth is less effective, less important, in 2012 than it has been at any time since the beginning of the Euro in 1999. 

Shocks and Surprises, Week Ending January 7th

• Growth surprise emerging in US
• Echoed, against all the odds, in UK
• Germany shocks with weak retail and factory orders data. Eurozone too.
• China contradictory – weakness remains sectoral rather than systemic, whilst HK retail sales keep booming.

The first week's data of the year underlined the possibility that 2012 would be ambushed by a growth-shock from the US, for which bond and currency markets remain completely unprepared. There were no negative shocks from the US, but such big positive surprises from labour market that economists and statisticians were left interrogating the seasonal adjustment process for explanations. First the ADP count of changes in employment during December came in at +325k, which was the strongest monthly reading since at least 2002, and which was 123k higher than the 1SD upper range of expectations. This reading was completely unexpected, but the implications could be ignored because the week also brought the Department of Labor's count in change in non-farm payroll. Though less spectacular (+200k for non-farm, +212k for private payrolls), these were still stronger than the range of economists' expectations. This had a knock-on impact on the unemployment ratio, which fell unexpectedly to 8.5%.

I've previously written about how the fundamental ratios of household leverage had already been largely normalized by the end of 2011, so continued spending was now primarily hostage to confidence, which in turn meant the labour market. With the powerful improvement in the US labour market, then, one can expect a surge in both confidence and spending. This week we got some evidence of surprises opening up on these fronts. First, the RBC Consumer Outlook index reported the biggest monthly jump since September 08 (rather worrying, that), and the best reading in the Bloomberg Consumer Comfort index since July. And then there was a completely unexpected 1.2% MoM rise in construction spending, with residential spending up 1.8% MoM and non-residential up 0.9% MoM.

So far, economists, commentators and policymakers have not factored in these positive surprises from the US, nor their likely impact on fiscal sums. If one looks at consensus forecasts for 2012, we're still stuck at GDP growth of around 2.2% - unchanged since November, and actually still slightly down from the 2.3% consensus expected for 2012 in October.

More surprising than the emerging strength of the US, perhaps, is the strength of recent data from the UK – the country which, let it not be forgotten, in November chalked up consumer confidence worse even than the darkest days of 2009! Confidence continues to be wretched - this week saw the Lloyds Business Barometer reading plunge to its worst since 2009 – but indexes of economic activity bely this depression. On Monday the Manufacturing PMI came in sharply better than expected (49.6), on the back of the first rise in export orders for five months (Germany, Eastern Europe, and China to thank for that). The next day, the Construction PMI outstripped expectations, with civil engineering, residential and commercial construction all expanding for the first time in nine months. Finally on Thursday, the Services PMI, at 54, gave the strongest reading for five months, based on strong readings for activity and new business.

Britain certainly believes its economy is well within the impact-zone of any Eurozone implosion, but for now its trajectory is rather different, and better, than it perceives.

Meanwhile, the Eurozone delivered three sets of data showing end-demand beginning to buckle worse than consensus was prepared to envisage. The first, and probably more important, was the 0.9% MoM fall in German retail sales in November. Since Germany is, by almost all counts, the one industrial economy in the Eurozone which continues to grow, and where unemployment ratios continue to fall, it is to Germany that we must look for retail demand to be maintained. Well, it isn't: sales excluding autos fell 0.9% MoM and rose only 0.8% YoY, whilst car sales fell 3.9% MoM. With Germany's numbers shocking like this, it was inevitable that retail sales figures for the Eurozone would shock similarly. And they duly did, falling 0.8% MoM and 2.5% YoY. The only positive outliers were Ireland (up 2% MoM) and Austria (up 0.5%). End-demand in the Eurozone will not be rescued by Ireland and Austria!

The third serious Eurozone disappointment of the week again came from Germany, where factory orders fell 4.98% MoM in November, giving back all the unexpected strength experienced in October. The most alarming aspect of these numbers was their composition: capital goods orders fell 6.5% MoM, whilst intermediates fell 2.9% and consumer goods fell 2%. Even worse, the sharpest fall of all was for capital goods orders from outside the Eurozone, which fell 13.1% MoM.

Directly contradictory stuff from China, with the HSBC Services PMI for December unchanged on the month, and modestly positive (52.5), whilst the official PMI for the non-manufacturing sector recorded a sharp rebound (56) from November's contractionary 49.7. Meanwhile, quarterly surveys of the business climate and entrepreneur's confidence showed, respectively, the worst readings sinc 1Q09 and 3Q09. In both cases, the most depressed sectors were real estate (no surprise there) and transport/communications – which I take to be a comment not only on depressed shipping markets, but also the nationwide shortage of diesel fuel. On the other hand, distributive trades (wholesale & retail) and infocomm recorded virtually no downturn on either business climate or confidence. More surprisingly, the construction sector seems to be surviving far better than the real estate sector, both in current business climate terms, and in confidence, too.

This granularity is interesting, since it suggests so far that the real estate travails induced by China's credit squeeze has not yet soured the entire economy. Rather, it seems those woes have remained sectoral rather than systemic at this point. If this can be maintained, China's chances of avoiding a hard landing look good. Meanwhile, one can look over to Hong Kong and find its retail sales still surprising on the upside, rising 16.9% YoY in volume terms and 23.5% YoY in value terms – both still more resilient than consensus expected.