Shocks & Surprises - Week Ending July 13th

·        The 8.6% mom contraction in China's June imports which shocked at the start of the week was the key to unlock most of what happened next. The crucial thing was the sharp fall in China's commodity imports – crude oil, refined products, copper, iron ore – and the impact this has on commodity prices.

·        All regions reported on producers’ prices, wholesale prices and trade prices. Except for US PPI, these indexes fell more sharply than expected. These are generally positive surprises, because prices of raw materials and intermediate goods fell more sharply than final goods, and import prices fell more than export prices. Relative price movements thus improved both industrial margins, and terms of trade for all but commodity-producers. The result is that trade balances are generally improving even though trade volumes remain uninspiring.

·        Just as expectations about monthly data have deteriorated enough to make it far easier to surprise than to shock, economists have finally downgraded forecast growth and inflation for the US and Europe. A month ago, the US expected 2H growth of 2.4% - now this is down to 2.2%.  A month ago, Europe’s recession was expected to be done by year-end – now that has been pushed out to 2Q13. Bucking the trend, Japanese forecasters, have raised their forecast for the next six months to around 2% from the previous 1.5% in capitulation to a run of  surprisingly positive monthly data.

This is an extract from a weekly four-page publication "Global Shocks & Surprises" which summarises developments in US, Asia and Europe, and draws out the key messages from the data in a concise form. If you wish to take a look at this please email me at michael.taylor18@btconnect.com

The Good News Is . . . China's Slowing

“And now China's slowing, I don't see any spark for growth anywhere in the world,” lamented a friend last night. My friend is right to be worried, because he runs a string of listed mining companies. Which puts him in the same situation as Australians, Middle Eastern oil-producers and . . . virtually nobody else. For the rest of us, the fact that China is slowing is almost unreservedly good news. Unfortunately, our imaginations are so locked-in to the model that emerging markets growth is the only hope for the world, we cannot see what is plainly obvious.

China is the marginal buyer – the price setter – for every major commodity in the world. When China slows, commodity prices fall. When commodity prices fall:

• households everywhere in the world (with the exceptions noted above) get an immediate boost to real incomes,
• non-commodity producing countries get a lift in their terms of trade, and
• corporates in those countries get some immediate relief from margin pressure.

All this is obvious, and is already showing up in the data.

In a global economy suffering from stagnant demand in over-leveraged developed economies, there could be no better news. Falling commodity prices are identical to an unexpected one-off bonus, or an income tax refund. Nominal incomes may be rising very slowly, if at all, but as gasoline prices fall, real incomes are boosted. That means either non-gasoline consumption can rise, or household balance sheets can be fixed faster without cutting into non-gasoline consumption.

But there's more. Don't imagine this works only for the West: these dynamics work as well inside China as elsewhere. Falling commodity prices, if passed on to the consumer, boost real household incomes there too. When China slows, the headline numbers tell us that China's imports growth slows sharply. And if China's import growth slows, doesn't that mean that Western hopes of exporting to China slow with it? Not at all: it means commodity-producers' hopes of exporting to China slow. If you are exporting goods or services to China's household sector, it's probably either a wash, or a modest positive (as Chinese household incomes, and corporate margins improve).

Now let's see how this is playing out in the data. The big shock of the week, and the one which unlocks the key to most of the rest of the week's data, was China's imports for June: they fell 8.6% mom – a fall 1.3SDs below seasonal historic trends which was sufficiently bad fully to reverse May's gains. China's imports fell because of collapsing commodities buying: in volume terms crude oil fell 14.8% mom (lowest volume since Dec); refined products fell 15.6% mom (lowest since Sept); iron ore fell 8.7% (lowest since April); copper fell 17.5% mom (lowest since Aug). By country, the biggest loser was Australia, down 17.5% mom.

(Withdrawal on this scale by the marginal buyer, if sustained, is most unlikely to be properly reflected in prices yet. We have yet to discover just how much untracked and undisclosed commodity inventories are meandering aimlessly around the world's oceans, sitting it out and waiting for an upturn before docking.)

But now let's look at the data outside China. First of all, let's look at terms of trade, where the story is unambiguous: 

• US import prices fell 2.7% mom in June, whilst export prices fell 1.7% mom, so terms of trade rose 1% mom. Over the last three months US terms of trade have gained 2.2%.
• Korean import prices fell 3.6% mom in June, whilst export prices fell 3.6%, so terms of trade rose 2% during June. In the three months to June they improved by 5.3%.
• Taiwan import prices fell 2.2% mom in June, whilst export prices fell 0.7%, so Taiwan's terms of trade improved 1.6% mom. That takes the improvement over the last three months to 3.6%.
• In Europe, the latest data we have is Germany's data for May: they show import prices down 0.7%, whilst export prices fell only 0.1%, so terms of trade rose 0.6%. Since March, however, they have now risen 1.3%, and we should expect a similar trajectory in June.

Improvement in the terms of trade in the short term (ie, before the change in relative prices affects other economic choices) a boost to trade balances, which in turn implies greater liquidity in the economy, and improved cashflows into the banking system (which turned up, for example, in China's June money data).

The same transfer in relative pricing power is also showing up in the change in producers and wholesalers prices, in a way which demonstrates the potential relief to operating margins:

• In Japan, the Domestic Corporate Goods Price Index showed raw materials down 3.7% mom, but intermediates by 0.8%, and final goods down only 0.5%.
• In S Korea, the PPI fell 1.4% mom, led by agricultural products. Outside those, however, chemical, petroluem and petrochemicals and basic metals fell most steeply, whilst electronics rose 0.5% mom and vehicles 0.4%.
• In Taiwan, the WPI fell 1.2% mom, but with raw materials down 6.2%, intermediates up 0.1% and finished goods up 0.6%.
• In Germany, the WPI fell 1.1% mom in June, and although the full data-set is not available, it is clear from what data is available that the fall was led by fuel costs.
• In France, May's PPI fell 1.1%, mainly because of a 5.3% fall in coke and refined products, but prices of manufacturing products fell only 0.7%.
• Even in inflation-prone Turkey, the PPI fell 1.5% mom in June, as crude petroleum /gas fell 8.6% mom and agriculturals fell 6.1%, whilst manufacturing goods prices fell only 0.75%.
• In the US, the story is slightly different, in that most unexpectedly, the PPI did not deflate in June, but rather rose 0.1% mom. But even here the margins story is the same: crude goods fell 3.6% mom, intermediates fell 0.5%, and finished goods rose 0.1%.

So margins, cashflows and financial systems are getting relief from the falling commodity prices which the Chinese slowdown is precipitating.

But will this boost to the corporate and financial sectors also, crucially, be passed on to the household sector? By the end of 2011, gasoline and energy spending accounted for 4% of US household consumption, and almost certainly more in a Europe where – inexplicably, irresponsibly and regressively - government policies assume and usually encourage ever-rising real fuel prices. Rather than worry about the slowdown in China, Western economists should worry about Western governments not allowing the pricing benefits of that slowdown to pass to their household sectors. 

On current showing, such stupidity must class as the default setting.

The Strange Insouciance of Global Finance: Part 2

About a month ago, I pointed out the strange insouciance of global finance, demonstrated by the retreat of risk pricing.

Well, nothing's changed on the pricing front. But over the few days two experienced and usually level-headed investors have played it back to me, forcefully. One points out that although the US is reportedly flying teams of underwater fighters into the Straits of Hormuz,  and  Britain's secret services is warning Iran will be nuclear-tipped by 2014 unless stopped, there's virtually no risk premium built into oil prices (or Saudi sovereign CDS rates, for that matter). Meanwhile, Syria shoots down Turkish jets whilst at least one Syrian general defects to rebels lining up near the Turkish border and Russia reflags the cargo-ships carrying gunships to Syria, in order to evade P&I insurance problems. "Do people think nothing will happen," he asks?

The other - a bearded prophet visiting from the East - wags his finger at me as we mull over the political impact of the Libor scandals: "Don't people realize - when the Conservative Party publicly abandons finance, something's changing fundamentally. How can people not know?"

I could go on: the US is still facing its fiscal cliff, with a  bought-and-sold political system that seems  unable to act. The Euro continues to beggar generations of Southern Europeans, but every time you hear a Euro-pol speak, it's to assure us that they'll do whatever needs to be done to 'save the Euro'. (At this point, I mentally retune to  Highway 61 Revisited: "God says to Abraham, kill me a son / Abe says man, you must be puttin me on . . . ").

All these are problems, any one of which could collapse financial markets later this year. And it's not as if we haven't been told: there's a whole industry out there dedicated to shrieking panic at you (seen InvestmentWatch recently?)

Now, take a moment out of your day, and play some war-games in your head - what happens after the first missile is launched across the Straits?  What's the end-result? What's the end-game? Tough to figure, I think.

Yet pricing of financial assets, and commodities, seems to assume that none of this matters. Why?

These are the sort of risks, and the sort of questions, which finance gets wrong all the time. It's not Donald Rumsfeld's "unknown unknowns" that destroy value,  it's the "known unknowns" where the danger lurks. We get them wrong, time after time. We get them wrong systematically.

And this is where we should turn to Kahneman's 'Thinking Fast & Slow'. (If you haven't yet read this book, do so today.)  Risk pricing gets this wrong because, in Kahneman's terms, it's the result of Type I thinking - the fast, instinctive, automatic, usually unconscious adaptation to immediate events which characterises good traders. The great thing about Type 1 thinking is that it is cheap, fast, and almost all the time gets to the right solution.  It finds the immediate equilibrium price fast.

The problem with Type I thinking is that, for all its virtues, it invariabley makes predictable mistakes. In theory, those mistakes can be avoided by Type II thinking - the slow, effortful, expensive type of analytical thought we instinctively avoid, and which hides in the research office. But usually it's too slow, too expensive, too much effort, and anyway, the traders usually get it right, don't they?  (Did you really think through what happens after the first missile is launched across the Straits? Of course not - it's too much bother. I didn't either.)

Financial markets operate almost exclusively on Type I thinking, and risk is priced on that model. This is what is Type I is likely to be acting on right now:  "I've been hearing about Iran/Syria/Financial Crisis/Fiscal Nightmare/the wretched Euro for months now, and nothing's happened. Nothing's likely to happen. . . "

Let's hope that's right.  But recognize that it's the same  kind of reasoning that LTRM did on Russian politics . . . .

China's June Money Data - Three Observations

• M1 Growth Surprised, But Liquidity Preference is Still Stuck
• China's Banks Net Cash Inflow Is Recovering
• Quarter-end Social Financing is Nearly Double New Bank Loans

First, from a purely shocks & surprises point of view, the 4.7% yoy rise in M1 was a positive surprise, outstripping consensus expectations, even though its sequential rise of 3.2% was only 0.17SDs above historic patterns. Although M1 also rose faster during June than M2 (2.8% mom and 13.6% yoy), this does not mean that the historic fall in liquidity preference has been reversed: rather it conformed precisely to usual seasonal patterns. The best one can say is that the fall in liquidity preference did not accelerate in June, and may, possibly be stabilizing. If so, this lifts some depressing pressure off domestic demand.

Second, as expected, the surge in China's trade surplus during the second quarter is restoring the net positive cashflow which China's banks have been increasingly sorely missing. June's monetary data confirms this : bank loans rose by 920bn yuan during June (and by 16% yoy) whilst bank deposits rose by 2,860bn yuan (and by 12.3% yoy), resulting in a net deposit inflow for the month of 1,940bn yuan. Now there are pronounced seasonal patterns at work in China's banking system, but it is not that that's driving this cashflow, but rather a genuine rise in the private sector savings surplus.

This month the 3.3% mom rise in deposits was 0.64SDs above seasonal patterns, whilst the 1.6% mom rise in loans was 0.82 SDs below those patterns. In other words, the improvement in cashflow is greater than one would expect: and in fact it was

• 52% bigger than the cash inflow of June 2011, and
• sufficiently large to inflect the 12m trend.

China's banks are reliquifying even before we take into account the impact of lower reserve ratios.

Third: there's plenty of financing going on outside the banking system. Whilst new yuan bank lending amounted to 920bn yuan, total 'Social Financing' (which includes a wider set of financial instruments) came to 1,780bn yuan. We do not yet know the components of this figure, but back in March it was similarly swollen by a sharp quarter-end issuance of bankers acceptances which helped unfreeze emerging corporate 'triangular debt' problems. Probably the same thing happened again in June, and for the same purposes. Notice, however, that during these spikes, what's happening in the banking system (and the monetary aggregates) now tells only about half the story.

What China's Surging Trade Surplus Means

• China's Private Sector Savings Surplus is On the Rise Again
• This Will Slow Domestic Demand, Probably by Around 1.5% of GDP This Year
• Bad News for Commodity-Producers
• But Rising PSSS Means Recovering Cashflows into Banks and Financial System
• Even as NPLs Rise, Financial Crisis Mysteriously Retreats
• Problem: Transition to Domestic Demand-led Growth Recedes From View  

China's US$31.7bn June trade surplus confirms what we had already suspected – that China's private sector savings surplus (PSSS) is no longer falling. The surplus, which was 42% bigger than in June 11, and was the largest since July 11, was the product of a a 8.6% mom 1.3 SD sequential collapse of imports, rather than any surge in exports (they fell 0.5% mom). Whilst 1Q12's trade surplus of US$1.15bn was only fractionally better than the US$706mn deficit in 1Q11, the US$68.85bn surplus of 2Q12 is 47.3% bigger than that recorded in 2Q11.

The trade balance is not the only component needed to calculate the private sector savings surplus: we need also the current account and the fiscal position (ie, public sector saving/dissaving). But since we have government revenues and spending data up until May, and the trade balance is by far the biggest component of the current account, we can be fairly certain of the trend.

I estimate that the 2Q12 current account will show a surplus of about US$82.9bn, which is likely to be around 4.4% of a nominal GDP which itself is likely to grow by around 10.7% yoy. China's balance of payments is intensely seasonal, and that 4.4% compares with 3.5% in the same period last year, and lifts the 12ma to 2.8% from the 2.6% up to 1Q12.

At the same time, the fiscal numbers up to May suggest government revenues will rise around 13.1% yoy in 2Q (vs 14.7% in 1Q), whilst expenditure is likely to grow 11.4% yoy (vs 17% in 1Q). If so, China's government will show a surplus of Rmb 538bn in 2Q12, compared with Rmb 437bn in 2Q11.

A larger government surplus, of course, will mean that private savings surpluses account for a smaller portion of the overall current account surplus. This is particularly clear in this case – in fact expected budget surplus in 2Q is just about the same size as the expected current account surplus. As a result, the private sector remained very slightly in deficit during 2Q12, albeit at only a quarter of the deficit of 2Q11. But this is highly seasonal data, and on current trends, we shall see the savings surplus burgeon in the second half.

 The decline in the PSSS of the last two years has already been halted, and 2H will see it sharply reversed.

This has consequences for China's economy and for its banking system. For the economy, it is fairly simple: any retreat in the surplus savings made by China's private sector represents a rise in the proportion of income consumed or invested in the domestic economy. During 2009 that added an amount equivalent to 1.3% of GDP to Chinese domestic demand; in 2010 it added an amount equivalent to 1.9%, and last year it added 3%. This year, if the trends of the first half persist, the rising PSSS will probably subtract an amount equivalent to around 1.5% of GDP from domestic demand.

That doesn't mean that GDP will shrink by a similar amount, since the loss to domestic demand will be partly recouped by net exports (as we see). But it does mean a slower rate of demand growth for those commodities and services fuelling China's domestic economy. We also saw this in June's trade numbers, which conspicuously featured some of the weakest imports of industrial commodities seen since variously December (crude oil) to last August (copper).

In the short term, it will also underline the extraordinary difficulty of weaning an economy off an exogenous growth model (financial repression, massive investment, exporting of the resulting surplus production) and onto one more powered by domestic demand.

But for China's banking  and financial systems there is a silver lining: a rising PSSS will help re-liquefy a financial system which has begun to recognized that the net inflows of deposit cash on which it relied has been drying up. This matters hugely: when the banks enjoy net positive cashflow, they are not forced by sheer commercial necessity to come to terms with any assets on their books which are wrongly-priced. (On a related issue, non-performing loans are easier to rollover or extend). It is only when banks are forced to sell assets in order to generate a positive cashflow to substitute for the suddenly insufficient inflow of deposits that they discover the real value of those assets. It is no coincidence that Chinese bank npls are rising just as banks'  net cash inflow has begun to dry.  Conversely, as the PSSS once again begins to rise, we can expect issues such as those local government financing vehicle loans mysteriously to fade into the background.

In other words, the chances of a slowdown in the domestic economy rise (bad luck, commodity producers), but the 'crash landing' scenario retreats.  

Shocks & Surprises - Week Ending July 6th

·        Central banks in Eurozone, Britain and China acted, but financial markets have already absorbed the run of shocking data since mid-April. As a result, ‘surprises’ outnumbered ‘shocks’ for the second week running.

·        The US generates enough surprise, particularly from labour markets, to sketch a closing bracket to the soft patch. In Europe, expectations are so black now that even ‘dark grey data’ registers as sunny. In Asia, corporate Japan’s bullishness is genuinely surprising, and turns up in various Asian data-points.

·        Commodities deflation so far is sustaining rather than eroding industrial operating margins. In the US, input prices fell the most since April 09; in Taiwan WPI and Import Price Indexes showed rises in margins and terms of trade respectively.

·        The outlier is China’s domestic economy, where service sector prices fell the sharpest for 38 months.      

This is an extract from a weekly four-page publication "Global Shocks & Surprises" which summarises developments in US, Asia and Europe, and draws out the key messages from the data in a concise form. If you wish to take a look at this please email me at michael.taylor18@btconnect.com

Why Japan Is Investing Again

The most overlooked surprise of the week so far was 6.2% rise in Japanese capex planned by large companies for this fiscal year. That's the first anticipated capex rise since at least FY08, and the details get even more aggressive: large manufacturers plan to raise spending by 12.4%. Why is it happening?

It's not as if Japan's immediate cyclical or structural signals or the global environment especially inviting.

Japan's industrial sector modestly lost momentum during April and May, although the 6m momentum trendline remains positive. In May, industrial production rose 6.2% yoy, with exports up 10% yoy in yen terms and 13.8% yoy in volume terms. However, the inventory/shipment ratio jumped in April and retreated only mildly in May, leaving it still a full standard deviation above the long-term average, and capacity utilization remains about 0.2 standard deviations below the long-term average. This is not disastrous - there is no comparison with what happened in 2009 – but it is an unlikely foundation for the start of a new capital spending cycle.

The structural situation for Japanese industry is not particularly compelling either. The Ministry of Finance's quarterly survey of private sector balance sheets show not only that ROE remains at extremely low historic levels, but also that there's been only the mildest upturn in the crucial asset-turns ratio (sales/total assets). Although obviously there is some recovery from the disasters of 2Q and 3Q, for Japan's private sector as a whole, 1Q asset turns were just 1.01, which is unchanged from 1Q11.

The rest of the Dupont ratios aren't going anywhere good quickly, either:

• operating margins have recovered from the catastrophes of mid-2011, but at 3.04% for 1Q and 3.12% on a 12m basis, are still below pre-2009 levels. More, the ratio of cost-of-goods sold seems to have bottomed out in late 2010, and is modestly rising;
• financial leverage (total assets/equity) appears to have bottomed out at about 2.71x, after falling for the last 21 years. But net debt/equity has been steady at around 60% since around 2007. It seems unlikely that Japan's ROE will be rescued by higher leverage ratios any time soon.

So what is motivating Japan's sudden resurgence of investment spending? The intuitive answer is that last year Japanese industry discovered unexpected vulnerabilities, both at home (earthquake, tsunami etc) and abroad (Thai floods). The surge in capital spending is what it takes both to fix and diversify those supply-lines.

This may be part of the motivation, but if so, it has arrived at a very opportune moment. For there are two factors operating within the companies themselves, which are also mandating the rise in capital spending.

First, depreciation has accelerated sharply, rising by 6.6% in the 12m to end-March. This is the most rapid rise in depreciation since at least 2000 (where my data stops). Without a corresponding rise in capital spending, the capital stock of industrial Japan will shrink, and fast. In fact, even with capital spending rising 3.3% yoy in 1Q, those additions to capital only barely cover the depreciation write-offs. In other words, regardless of the health of the world's business cycle, if corporate Japan is going to attempt to maintain its position, it has no choice but to start investing.

At the same time, corporate Japan is awash with cash. In fact, the amount of cash on corporate Japan's balance sheet, expressed as a number of months' sales, is the highest it has been since the immediate aftermath of the bubble bursting (1991). Cash now accounts for 11% of corporate Japan's total assets – again, one of the highest proportions in Japan's post-bubble history. Japan's return on assets may be fairly paltry at around 3.4% (annualized 1Q11), but the return available on new equipment is unlikely to be worse than that on cash.  

What's more, the drag of cash on the balance sheet is going to get worse. Cashflows were up 72% yoy in 1Q and up 40% on a 12ma. In fact, corporate cashflows seem to have been in recovery since the nadir of early 2009, and that recovery does not seem to have been particularly compromised even by the disasters of 2011.

I think these twin considerations are important prompts behind Japan's reinvestment.

There is, of course, a radical alternative view, of corporate Japan's available choices. The 'hospice option' holds that the proper corporate response to an aging and shrinking population is precisely for companies to shrink their balance sheets and capital stock, whilst spinning off sufficient cash to allow for a peaceful demographic decline. By the look of things that's not where corporate Japan wants to go.