Time to Take China's Official PMIs Seriously

China’s PMIs, compiled monthly by the China Federation of Logistics and Purchasing, are among China’s most useful monthly indicators,  as they are not just timely, but also detailed and plausible both for their internal consistency and because they have a track record of getting major turns in trend right.  Looked at in detail, May’s Manufacturing PMI paint a coherent picture of China’s manufacturers beginning to gear up in response to an improvement in the external trading environment which is nowhere to be found, yet, in other official data. This otherwise hidden upturn shows up dimly but consistently across  export orders, imports, buying of inputs, inventory policies, work backlogs and pricing. 

PMIs are too a good an idea to be left to fulfil their potential. The idea of surveying managers who have to run their businesses responding to perceived short-term changes in the market environment is obviously attractive. If anyone feels the cross-currents of an economy, it must surely be them. They also hold out the promise of producing a speedier verdict on current and near-future market conditions than is possible for the fuller surveys demanded by the production of conventional industrial indicators (eg, industrial output, exports etc).

So when done properly, they are extremely valuable. The best examples come from the US, where the timely ISM manufacturing index and to a lesser extent the extremely timely various regional industrial surveys have earned the right to be trusted.

But problems surface in Europe. There is certainly room for good PMIs in Europe, since official data tends to surface slower than in either the US or Asia, and in certain countries - the UK for example - the official statistics organizations currently seem incapable of generating stable series, even granted the extra time they take to produce them.  A commercial organization, Markit, has encamped on the space vacated by Europe’s official statisticians, and the beginning of every month litters Europe with a confetti of PMIs. To put it mildly, I am sceptical about their worth. I will confine myself to two observations. First, the minute sensitivities suggested by the results (the Eurozone manufacturing PMI, for example, has a standard deviation of only 0.6pts out of 100 during the last 12 months) is undermined by a lack of transparency about they are arrived at. Second, there is no significant statistical relationship between movements in the manufacturing PMI and movements in Eurozone industrial output.

The problems of Markit’s European PMIs tend also to cast a shadow over the credibility of the surveys it constructs in Asia. This is a shame, because in several countries, including India and Indonesia, credible manufacturing PMIs could be very useful.

Some Asian countries produce their own, and of these, there’s no doubt that China’s is potentially the most important. I believe China’s official manufacturing PMI is becoming a genuinely useful tool which provides timely, detailed and plausible information about the state of China’s economy.

The reason why I think China’s official manufacturing PMI should be taken seriously is that the headline figure is accompanied by 12 subindexes covering different aspects of the production phase, and that in the five cases where those subindexes can be checked against subsequently-released industrial data, they tend to tell similar stories. Moreover, those aspects which check out are central to our understanding of China’s industrial cycle: output, exports, imports, inventories and pricing.

First, we can compare the PMI subindex for output with year-on-year movements in industrial output. Since 2012, the changes in the PMI output subindex have generally moved in line with changes in the yoy changes in industrial output. Most recently, since the middle of 2015, the output PMI has signalled growth in output stabilizing at historically low levels. May’s subindex extends this trend, but signals no new deterioration.

The convergence between the export orders subindex of the PMI and actual US$ export growth is less clear, but captures well the deterioration in trading conditions endured since the middle of 2014. Currently, there is a recovery in the export orders PMI emerging that has yet to be seen in China’s raw trade data. 

Much the same can be said of the relationship between the imports PMI subindex and the imports reported in the trade data: there appears to be a general overlap of changes in trend, and currently there is a rise in imports recorded in the PMI subindex which is not yet coming through in the trade data.

When it comes to pricing, the relationship between the input prices PMI subindex and the monthly PPI yoy is much closer: both record the intensification of price deflation seen since the middle of 2014, and both are now signalling a recovery in price pressures since the end of 2015. 

Finally, we can compare the finished goods inventories PMI subindex with changes in inventories of finished goods contained as a line item in the monthly industrial profits data release. Again, the stories they tell mostly complement each other, although over the past few months, the PMI subindex has signalled a modest recovery in inventory-holdings which is not yet showing up in the industrial profits series.  

In none of these cases is the relationship between the PMI subindex and the reported data exact, but in each case it seems that the same trends and changes in trend are captured in both.  Because of that, we should be paying close attention to the official monthly PMIs: they seem genuinely to provide both an early lead on forthcoming data, and another source from which to triangulate other Chinese data.  Moreover, given the difficulties and uncertainties surrounding China’s official data, triangulating for internal consistency is always central to any interpretation of the data. 

In addition, the fact that these subindexes seem reasonably plausible lends credibility to other of the subindexes. This is particularly important because the employment PMI subindexes reported both in the Manufacturing PMI and the Non-Manufacturing PMIs provide practically the only timely and regular pointer to changes in China’s labour market that we have access to. The health of the labour markets is one of the top two economic priorities of China’s policymakers (the other is inflation). As the chart shows, currently these subindexes suggest the declines in the manufacturing sector during 2015 have been moderating since the beginning of the year, whilst employment in the services sector is largely unchanged. The net result suggests that the deterioration in China’s labour markets is moderating, though conditions are not yet improving. 

So what do these official PMIs tell us about the state of China’s economy? May’s Manufacturing PMI was unchanged at 50.1, suggesting nothing better than stagnation - although this is an improvement from the deterioration signalled between August 2015 and February 2016. The non-manufacturing PMI retreated 0.4pts to 53.1, suggesting expansion has slowed towards the lower end of a trend growth seen over the last year.  

The Manufacturing PMI subindexes, however, contain clear positive signals for both exports and imports, and slightly improved signals for both output and inventory policies. This slight improvement also shows up in quite strong upturn in trend for buying of inputs, and a noticeably slower erosion of work backlogs. In addition, there is a clear retreat in deflationary pressures reported since 2H2014.  

China's Frantic Policy Pulse and the Inflation Threat

The recent stop-start yo-yo of China’s monetary policy reflects not just the attempt to keep policy loose enough to stabilize the economy without fundamentally de-railing the strategic necessity of fundamental reform. It also reflects the fact that China’s inflationary potential is far greater, and is looming far sooner, than is recognized. So far, in a world concentrated on deflationary threats, an inflationary outbreak is on virtually  no-one’s horizon. Except, perhaps, in the People’s Bank of China.

Financing slowed very sharply in April: the addition to aggregate financing was a mere Rmb751bn, which was the lowest monthly gain since October 2015; bank lending slowed to Rmb 556 bn, on a monthly movt which was 0.6SDs below consensus.  Over the last four months, the monthly aggregate financing total has been  unprecedentedly volatile: January’s Rmb 3,425bn feast was followed by February’s Rmb 825bn famine; in turn that was followed in March by surprise gains of Rmb 2,336bn, whose largesse was revoked by April’s shockingly feeble Rmb 556bn.

This yo-yo accurately reflects the unprecedented volatility of PBOC’s open market operations. The chart below shows PBOC’s weekly interventions, and it resembles nothing so much as a cardiac arrest followed by defibrillation. It is a mistake simply to view this volatility primarily as a seasonal phenomenon, although the need to finance the end of the tax year, and then Lunar New Year holidays does drive some of the volatility. But even accounting for these flows, the volatility of the last few months is unprecedented. Twice PBOC has flooded the market with liquidity (end-January, middle of April), only subsequently to claw back the money over the succeeding weeks.

There are two main reasons why the central bank is unwilling to commit to the sort of grandiose monetary relaxation we’ve become used to elsewhere in the world, and indeed, in China during the slowdown of 208/09. First, there are the well-rehearsed set of strategic reasons why no repeat of the credit splurge of 2009/10 is to be expected. An excessively generous monetary policy do nothing to foster the transformation of the economy from an excessive investment/low return on capital model, to a model based on improving returns on capital and sustained growth in consumption. And in practical terms, it probably wouldn’t deliver the goods: in the 12m to December, the efficiency of finance had deteriorated sufficiently so that Rmb 100 of new aggregate financing was associated with only Rmb 25 of extra GDP growth. So not only would a 2009-style credit splurge subvert core strategic policy goals,  it wouldn’t even work particularly well. 

At the same time, however, China’s authorities have long blamed the collapse of the USSR on the disruption caused by the ill-considered and clumsy haste of structural economic reforms, and the need to avoid anything similar is axiomatic. As a result, in order to advance the long-term strategic goals, sufficient support must be given by monetary and fiscal authorities in the short term to sustain the economy in reasonable health. Whilst in the West there is a tendency to see the policy choice as binary (either tough reforms or monetary accommodation to flunk them), the Chinese authorities say they see things very differently: accommodation now in order to underpin the viability of reforms in the medium term.

There is, however, an additional factor which circumscribes how generous PBOC can be: inflationary pressures have to be contained, and they are stronger than consensus wishes to acknowledge. A previous post explained how the absence of viable savings products and vehicles was driving surplus savings into real assets, notably real estate and commodities, in a way which was already producing speculative bubbles. This highlights the need to accelerate financial reforms, including effective regulation. But these speculative bubble are also hinting at the likely emergence of wider inflationary pressures. 

This is only just beginning to surface in the data. April’s CPI stayed steady at 2.3% yoy, and the current deflections against trend suggest that it will stay above 2% throughout the year. This will be a surprise to a consensus which still expects it to fall to around 1.8% by 3Q.  A more worrying straw in the wind was China’s PPI, which  fell only 3.4% yoy in April, with consumer goods down only 0.2% yoy.  Not only was this less deflationary than expected, but looked at more closely, the index rose 0.7% mom, which was the steepest rise since Feb 2011, and was 2.9SDs above historic seasonal trends. 

But this may be only the tip of the iceberg. Historically, the relationship between China’s CPI and monetary policy has centred on growth in M1, with inflections in M1 growth coming usually around six months before inflections in CPI. In momentum terms, M1 growth bottomed out in the middle of 2015, and has been accelerating moderately at first, but quite vigorously since the latter part of 2015. By April, M1 growth was running at 22.9% yoy and the underlying momentum was still accelerating sharply, with April’s monthly gain 0.9SDs above seasonalized historic trends.  Unless the relationship between M1 And CPI breaks down, we should now be expecting inflation to pick up by 4Q to nearer 4% than 2%.  

Will it be different this time? Currently, the consensus apparently thinks so. That’s where the risk lies. 

What would an unexpected outbreak of accelerating inflation do to China’s policy choices? It would produce the worst of all possible world for China. To be very blunt, it would compel exactly the combination of necessary credit crunch and subsequent hard landing, followed by far-reaching structural reform, which China’s leaders are so keen to avoid. Perhaps it is this realization which is behind the dramatic gyrations of monetary policy. 

China's Balance of Payments - The Gaps Telling the Story

China has published its 1Q balance of payments data, and it’s fairly obvious that the most interesting element of them is the billions of dollars missing. In fact, the gap between what’s claimed in the balance of payments and what’s revealed in the movement of China’s foreign reserves would itself be the biggest single line-item in the presentation.  And there is an even bigger gap between the cashflows implied by the private sector savings surplus - which is partly calculated via the current account - and the cashflows reported by China’s banks.

In fact, movements in these gaps during 1Q tell us a great deal about China’s current position and policy choices. They are suggesting that:

• China has had a degree of success in stemming the outflow of cash which peaked in 3Q15 and 4Q15, but also
• With most domestic savings avenues currently closed or discredited (equities, deposits, wealth management products, P2P vehicles), the flow of excess private savings are necessarily being pushed out of financial assets and into real assets, including real estate (again) and commodities (again).

If so, the conclusion is clear: the need for financial sector reform in order to deal with the savings surplus remains urgent, because the lack of viable savings vehicles not only generates bubbles in non-financial assets, but simultaneously puts pressure on PBOC to supply the liquidity private savers no longer wish to entrust to the vehicles available.

Last week brought two pieces of news from which to judge whether the flow of cash out of China seen since the middle of 2014 has been successfully checked. First, foreign reserves rose by US$6.4bn in April to US$6.4bn to US$3.219tr, the second consecutive monthly rise following  18 months of nearly-uninterrupted decline. Second, China’s 1Q current account balance was announced to have been a US$48.1bn surplus, which was roughly in line with what was expected in the light of 1Q’s US$125.7bn trade surplus, although down by US$37.2bn yoy.

The balance of payment data ought, in theory, be the place to start to assess whether the rush of cash out of China has been checked.  And on the face of it, the situation is encouraging: China reported a current account surplus of US$48.1bn in 1Q, with a goods trade surplus of US$104.9bn partly offset by a services deficit of US$57bn, and with net international income receipts of US$1.9bn almost fully offset by the US$1.7bn recorded in net transfers out of China. On this accounting, the current account surplus was equivalent to 2% of GDP in 1Q, with 12m surplus retreating go 2.7% in 1Q from the 3% recorded in 4Q15.

But the preliminary estimates also reported that the capital and financial accounts ran a US$48.1bn, completely offsetting the current account surplus. As a result, we should have expected no change in China’s foreign reserves during 1Q. But the reserves data shows China’s reserves fell US$117.8bn in the 3m to March.

The gap between the balance of payments data and the movement in reserves can be seen as one measure of the size and direction of movements of cash and capital into and out of China without attracting the attention of China’s central authorities. When China’s economy is under stress, this gets glossed as ‘capital flight’; when times are good, it tends to just get called ‘hot money’.  In most countries, these differences tend to get logged under ‘errors and omissions.’ In China, however, the amounts involved are now so large that such ‘errors and omissions’ would be the biggest line item in the balance of payments.

Between 2005 and the middle of 2014, this difference was almost always sharply positive; since the middle of 2014, when the dollar surged, the difference has always been sharply negative. This reached a peak in 3Q15 and 4Q15, with deficits ot US$243.1bn and US$225.1bn respectively. In that context, the US$117.8bn missing from the accounts in 1Q16 is an improvement. But the unacknowledged outflow is only moderated, not yet checked or reversed. 

The mild rises in foreign reserves during March and April suggest that the situation continues to improve.  

With all its faults, if one takes China’s current account data at face value we can do a second check, by comparing movements in China’s private sector savings surplus to the net flow of cash into (or out of) China’s banking system. The theory here is that if the private sector is generating a net flow of savings after having done all the consumption and investment it intends, the result is must be a flow of cash into the financial system. By definition, the financial system can use that cashflow only to buy public sector or foreign assets. 

During 1Q, the current account showed a surplus of 2% of GDP, whilst the government was also running a fiscal surplus equivalent to 0.6% of GDP (down from 2.4% in 1Q15). As a result, China’s private sector surplus can in a 1.4% of GDP, up from 1.1% in 1Q15, and stabilizing the 12m PSSS at 6.4% of GDP.   

• In Rmb terms, the 1Q PSSS surplus amounted to Rmb 220.8bn, and the 12m surplus came to Rmb4,400bn.. 
• In 1Q, banks saw a net inflow of deposits of Rmb 813bn, but during the 12m, there was a net outflow of Rmb4,731bn. 

In the 12m to March, the gap between the surplus savings generated (Rmb 4,400bn) and the net outflow of cash from the banking system (Rmb4,731bn) came to Rmb9,131bn. Taking an average Rmb rate of 6.32 for the period, that is an amount equivalent to US$1.445tr. Meanwhile, the amount ‘missing’ from difference between the balance of payments and movements in reserves comes to US$653bn. In other words, the balance of payments and reserves data may yet be understating the extent of capital outflow, quite considerably.

This is not the only explanation, however: deposits can rise in the absence of bank lending if the private sector becomes a net seller of non-financial assets (such as property) and banks the proceeds. Conversely, deposits can grow more slowly than lending if the private sector becomes a net buyer of non-financial assets, such as property or commodities. During 1Q, the turnaround in real estate markets in first and second tier cities has been marked, and the recovery in China’s commodity markets has been strong enough to prompt concern among regulators of China’s commodity futures’ market. 

At this point, it is surely clear that it is dangerous to reach firm conclusions. However, the balance of evidence suggests that the peak of capital outflow from China has probably been reached, but that China’s savers have yet to be persuaded that the products and services available to savers (deposits, equities, bonds, wealth management products) offer acceptable rates of return. Consequently, the hunt is redoubled for real domestic assets in which to invest the surplus savings the economy continues to generate. 

The case for continued financial reform could hardly be more obvious. 

Britain's Long Upward Grind is in Trouble

The recent weakening of Britain's employment and retail sales data isn't a coincidence, but rather a sign of sliding productivity. With little in the way of credit expansion, the growth of payroll income has been the mainstay of the long expansion, supplemented recently by the private sector running down its savings surplus to a modest deficit. So in the absence of any other props, the long grinding expansion is entering a soft patch.

The UK and the US exited the Great Recession at about the same time, in the second half of 2009, but in both cases the recovery has been feeble compared to the recession, and has lacked in the usual cyclical accelerators. Rather, it has been a long upward grind, frequently threatening to ebb away out of inanition, rather than excess. In both cases, what has driven the expansion has been a slow and steady rise in employment, which in turn has been based on harder work - modest gains in output per worker achieved even in the absence of increases in capital per worker.

The hope was that eventually this grinding expansion would be sufficient to draw forth the sort of investment spending and/or credit expansion which usually act as accelerators on the upswing of the business cycle. In Britain, that hope has not yet been realized. By February 2016, bank lending in sterling to the private sector was growing only 3% yoy, but this was the highest since at least 2010, and the total loans outstanding were still 3.9%, or £60.6bn,  below their total five years earlier.  As far as investment is concerned, in nominal terms investment rose 4.4% yoy in 4Q15, and, depreciating all investment over 10yrs, capital stock was growing only 3.8% yoy in nominal terms, compared with a real GDP growth rate of 2.4%.

Without the usual contributions from these supports, the expansion continues to rely on gain in employment. However, the grounds for expecting continued employment growth are currently being undermined by falling productivity. After accounting for changes in capital stock per employee, real output per worker fell 1.3% in 2015, the biggest decline since the Great Recession, and extending a deterioration which had begun the previous year. As the chart shows, employment growth does tend to respond, albeit with a lag, to changes in this measure of labour productivity. 

This is the background to the weakening of Britain’s employment data, and consequently domestic demand indicators, which emerged in the data for February released this week. First, there was a sharp deterioration in employment gains, with only a net 20k new jobs added in the 3m to February, with 9k lost in February alone. There was no comfort in the details: the number of employees fell 23k, whilst the number self-employed rose 25k, the number of full-time jobs rose only 17k, and the number of vacancies were unchanged in the 3m to March.  In addition, average weekly wage growth slowed to 18% in the 3m to February, with wages rises concentrated in construction (up 8%) and wholesale/retail/hotels/restaurants +2.7%.  In other word, wages were rising fastest in the most pro-cyclical sectors of the economy even as the employment foundations of the expansion were being undercut. 

And in turn, that was reflected in March’s retail sales, which showed ex-petrol sales volumes falling 1.6% mom, whilst petrol sales rose 0.5%. In value terms, sales fell 1.4% mom and fell 0.1% yoy, with a monthly movement which was 1.6SDs below historic seasonal trends. This was a sharp enough fall to drag the 6m momentum vs trend to minus 0.4SDs, which is the biggest deflection against trend since the beginning of 2010. 

Not only are the employment foundations of Britain’s current expansion weakening, but so too are the financial foundations which would allow household consumption to outpace the growth of payroll earnings. First, by the end of 2015, Britain’s private sector was running a small savings deficit,  equivalent to approximately 1.1% of GDP. That deficit means that the private sector must be - and is - running down its net deposits with Britain’s banks. In fact, in the 3m to February, whilst bank lending was growing at 2.5%, sterling bank deposits rose only 1.1%. The result is that the private sector’s net deposits with Britain’s banks had fallen by an average £25bn yoy in the 3m to February. By February, those net deposits had fallen to £79bn,  

Most likely the current slowdown in retail spending signals the unwillingness to see the decline in net deposits continue or accelerate, particularly at a time when labour markets are souring. In short, whilst Britain’s long expansion may have been fundamentally acyclical, the spurs behind the current slowdown are developing their own cyclical features.

China's 6.7% yoy 1Q GDP - The Price and the Cost

China’s 1Q GDP result was good news, but was bought at a cost. If China is to maintain progress towards its stated structural goals, as I expect, then the front-loading of government investment and monetary accommodation which built this positive 1Q result will be reversed shortly after it becomes clear that the global trading environment is warming.

The 6.7% yoy GDP growth reported by China for 1Q16 neatly met the universal expectation, so sends the signal ‘nothing to see here’. So as polite guest commentator on China’s economy,  I will ignore it, and turn instead to the much more interesting nominal growth.

Nominal GDP growth accelerated to 7.1% yoy, up from 5.8% in 4Q, and with a very slight gain on underlying momentum. This was actually more impressive than it might seem, because the trade surplus is no longer a major contributor to growth. In 1Q China’s trade surplus amounted to Rmb 823bn, and rose only 8.3% yoy, adding only 43bps to the nominal GDP growth rate.  That compares with an average contribution to nominal GDP growth of 235bps during 2015. Subtract the trade surplus from China’s nominal GDP and we get some idea of what happened to domestic demand: it rose 7.1% yoy, which was the quickest nominal achieved since 2Q14.

This is the point at which to emphasize that even a modest growth in nominal GDP growth at this point is far better news than is generally acknowledged or realized. That is because the legacy of China’s extraordinary surge in investment spending during 2003-2011 has in its fifth year of retreat, allowing one to see on the horizon the long-lost possibility of profits growth.  If one depreciates capital investment over 10yrs, one finds the growth of China’s capital stock is slowing fast: .on this basis, I estimate that in 2015, China’s capital stock was growing by approximately 10% yoy in nominal terms, rather than the 15%-20% pace we’ve been used to since 2003.  My expectation is that capital stock will be growing even slower by the end of 2016. So if China’s nominal GDP sustains the very modest gain against momentum seen during 1Q, we begin to reach the time where nominal GDP is at least keeping pace with capital stock growth, and possibly overhauling it. At that point, asset turns are rising, dragging with it return on capital and profits. For many investors, this will be something they have never seen before.

So there is genuinely good news: but it was bought at a real cost, paid by fiscal policy, monetary policy, industrial policy, investment policy and overall strategic direction. Acknowledge these costs as real, but, crucially, do not be fooled into thinking that China’s authorities have abandoned their strategic goals. Rather, assume those goals will pursued with renewed intensity when the authorities think a suitable economic environment is encountered.

The first cost is a further downturn in the efficiency of finance. In the 12m to March 2016, each increase of 100 Rmb in bank credit was associated with a gain of only Rmb 33 in nominal GDP - that’s down from Rmb 44 during the same period last year, and is approaching the lows associated with the credit splurge of early 2009.  It gets worse: every Rmb 100 of new aggregate financing was associated with a gain of only Rmb 24.5 in nominal GDP in the 12m to March, down from Rmb 30.1 in the same period last year.  Improving the efficiency of financial allocation is absolutely at the heart of China’s longed-for structural reforms. It took a sharp backwards step during 1Q16.

The other obvious cost was the deterioration of the public finances. So far we have fiscal data only for Jan-Feb, which showed only a modest deterioration yoy (a surplus of Rmb 621bn in 2016 vs a surplus of Rmb 685bn in 1Q15). However, the underlying trends were worsening steeply, and if they were maintained during March, I expect the surplus one normally expects in 1Q will have all-but disappeared. If so, the published data suggests China is already running a budget deficit slightly above the 4% of GDP floated as a possibility in PBOC’s research. 

It is not difficult to see how central this fiscal spending is to the 1Q recovery. Also released today was Jan-March urban asset investment: stripping out March on its own, investment rose 11.2% yoy, but with private investment rising just 4.9% whilst public sector investment jumped 23.4%.  And it shows also in the industrial breakdown: the big gains were primary industries +25.5% yt, led by public facilities +31%, water production +26.8% and power & heat +20.9%. Meanwhile, secondary industries - that’s manufacturing - rose only 7.3% ytd. 

That’s not the sort of efficient investment pattern China needs if it is to make the epically-difficult traverse from a financial repression/capital building/surplus production model of economic growth to an efficient saving allocation/return on capital/consumer spending model. It is, in fact, a relapse. 

The danger, however, is to believe that China’s authorities have therefore forgotten or abandoned their strategic goals, or don’t appreciate how the rescue act of 1Q has put those goals in jeopardy.  It is much more likely that they view the 1Q retreat as necessary to safeguard the political environment needed to pursue those reforms in the medium to long term. If so, when the global economic temperature warms, expect the stimuli which supported 1Q to be withdrawn and reversed. 

US Wholesalers' Data Reflects Structural Change, not Cyclical Pressures

If the wholesale trade is the cyclical indicator it is traditionally held to be, then the US business cycle is in deep trouble. But fortunately (if you're not a wholesaler), what the sustained weakness of the wholesale data shows is not so much a cyclical downturn in the US economy, but rather major structural pressure on the wholesale industry as a sector.

During February, wholesalers' sales fell 0.2% mom,  the fourth monthly contraction in succession, whilst their inventories fell 0.5% mom, the fifth monthly fall in a row. In fact, things are a whole lot worse than that for wholesalers: sales have been gently sagging since towards the end of 2014, and the continued rise in the inventory/sales ratio suggests that wholesalers have been unwilling or unable to adjust their business strategies and balance sheets to reflect that fall. As a result, the inventory/shipment ratio has continued to rise practically unabated since the end of 2014, even though total holding of wholesale inventories peaked in September 2015.

To understand what's going on, it pays to contemplate the role of wholealers in an economy.  The point of wholesalers it that they absorb (buffer), and finance, the temporal frictions between suppliers and end-customers, with both ends of the bargain content to pay a fee to ensure more predictable supply, more predictable demand. Such a role cannot abolish business cycles, but will smooth frictions within the cycle. Indeed, it is precisely when wholesalers are faced with changes in business conditions which they can no longer absorb/finance, that they themselves become key indicators of a business cycle inflection point. The inventory/shipment ratio rises, and wholesalers move to cut their risk, passing on the market’s bad news to the manufacturer. This is a familiar feature of business cycles, seen both in 2000/01 recession and again, more spectacularly, in 2008/09. (It has its corollary in NE Asia when manufacturers’ inventory/shipment ratios are a regular bellwether for NE Asia’s export prices and industrial cycle.)

But as the first chart shows, wholesalers’ inventory/sales ratio has been rising almost continuously since the middle of 2014, and is now the highest it has been since early 2009, and above the peak levels seen during the 2000/01 recession. And yet there is no recession (despite the poor profits outlook), and the sustained strength of labour markets makes it very unlikely we’re about to see one now.  Moreover, unlike in 2000/01 and 2008/09, the problem is not an  unwanted build-up of inventories (they’ve been flat since the middle of 2015), but rather the sustained fall in sales.

There is a further reason to think something structural, rather than cyclical, is afoot. The second chart expresses wholesalers’ sales as a proportion of manufacturers’ and retailers’ sales combined. What is shows is that  wholesalers’ market share of total sales has been flat since mid-2011, and has been in steady decline since the middle of 2014. In January, wholesale sales’ market share fell to its lowest since December 2010.  No such extended period of market-share loss was seen either in 2000/01 or in 2008/09. No such extended decline was seen during the wild commodity gyrations of the last 15 years.

So wholesale ain’t what is used to be. Quite possibly, wholesalers’ difficulties are not this time a key cyclical indicator. Why? Once again, remember, the wholesalers’ role is to absorb and finance the frictions between supplier and end-buyer. If that role is under challenge, it is likely to be either because frictions have become easier to manage (ie, to predict and anticipate) and/or because they have become easier to finance. Or both. 

If information technologies are sufficiently distributed and trusted to cut the friction between supply and demand, and at the same time, financing conditions have improved post-crisis, the need for and role of the wholesale trade becomes smaller. If that is what is happening, today’s shocking fall in wholesale sales is poor news for the wholesale trade, but perhaps not quite so dreadful for the US economy as a whole.

Japan's Exporters Face Double Whammy - Currency & Margins

The two key factors which have allowed Japanese manufacturers to thrive despite the sharp deflation in their export prices are going into reverse. First, currencies movements against the dollar and the Rmb, are eroding Japan’s competitive position and will intensify the pressure on Yen export prices. Second, at the same time, the stabilization of commodity prices threatens to reverse the terms of trade gains which have compensated for loss of pricing power, and been the motor for margin gains over the last 18 months.

Large manufacturers have noticed: Bank of Japan’s 1Q Tankan survey of 1,087 large-scale manufacturers reported their outlook index falling 4pts to 3, which was the lowest since 1Q13. Only 11% expecting a favourable outlook, compared with 8% expecting an unfavourable outlook and the vast majority, 81%, thinking the future was ‘not so favourable’.  

This fall in optimism does not yet fully incorporate the scale of the currency whiplash now underway: today the yen is trading under 111 to the dollar, whilst the Tankan’s respondents still expect the yen to average 117.5 during FY16.

But the combination of a resurgent dollar and an Rmb determined to hang onto its coat-tails, which has handed Japan’s exporters considerable competitive advantage since 2H14, has reversed. Not only is China explicitly no longer willing to peg its currency to the dollar, but in addition, the US Fed gives every indication it does not wish the dollar to strengthen. Japan’s exporters are the principal competitive victim in these two policy reversals.

Let’s put some numbers on it:
i) between September 2012 and May 2013, the Yen lost 24.1% against the Rmb
ii) between July 2014 and June 2015, the Yen lost a further 19% against the Rmb. Between September 2012 and July 2015, the yen had depreciated by 39.2% against the Rmb.
iii) However, between June 2015 and April 2016, the yen has appreciated 17.9% back against the Rmb, and it has now lost virtually all the gains made during the 2H14 dollar rise

For Japan, this simply means both far tougher international competition from China, implying faster market-share loss and sharper downward pressure on Yen export prices. 

Which brings us directly to the second problem large manufacturers are worrying about: margins.  Looking at the detail behind the fall in the Tankan outlook index, there was no change in expected domestic demand/supply conditions, with the economy expected to remain solidly oversupplied, slightly offset by a small improvement expected in overseas conditions.  Rather, it is margins that are the worry. Currently a net 8% of large manufacturers are seeing their input prices fall, but this isn’t expected to last: only a net 1% expect input prices to keep falling. But the same moderation of deflation isn’t expected for output prices: currently a net 15% report output prices are falling, and a net 13% expect them to keep falling. Result, margins are going to fall. 

Ministry of Finance’s massive quarterly survey of private sector p&ls and balance sheets reveal just how central this is likely to be. The survey allows us to analyse how Japanese ROE has been sustained (and even raised slightly) over the last few years. The answer is simply that operating margins have risen from 3.2% in 2012 to 3.8% in 2013, 4.1% in 2014 and 4.5% in 2015. This has been enough to offset continued decline in asset turns (from 0.95x in 2012 to 0.89x in 2015) and financial leverage (from 2.82x in 2012 to 2.62x in 2015). 

Moreover, we can then disaggregate what is driving those margins. Over the last year, the story has been overwhelmingly one in which a 0.8pp decline in cost of goods sold/sales compensated for deterioration in other aspects of margins (principally SG&A expenses), which cut the margins gain to just 0.4pps. 

And that decline in the cost of goods sold/sales ratio is, in turn, a direct reflection of the rise in Japan’s terms of trade, generated by import prices falling faster than export prices. 

The final chart demonstrates how the trade-off between falling export prices and surging terms of trade has worked during the last 18 months. The very specific problem is that the combination of currency movements and commodity prices which generated this useful trade-off has gone into reverse. During the coming year, we can expect to see the red line (export prices) fall even steeper, but the grey line (terms of trade) also to fall. That in turn will begin to push up cost of goods sold/sales ratio, which in turn will drag down margins and return on equity.  The deterioration in large manufacturers’ outlook captured by the 1Q Tankan only begins to acknowledge that times are about to get a lot tougher for Japan’s exporters.