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.  

All I Want for Christmas is . . . Eu 489.2 bn

That's the demand for three-year money by 523 Eurozone banks that has just been satisfied by the ECB, lending at its average benchmark rate (currently 1%), accepting as collateral paper including Spanish and Italian bonds.

How much is Eu489.2bn?

For the ECB, it's equivalent to:

• 55.4% of the total Euro note issue;
• 73.6% of the gross amount of its previously outstanding gross lending to Eurozone credit institutions;
• It is twice the previously outstanding net lending to Eurozone credit institutions.
• It is six times the ECB's outstanding capital, and 20% of its previously total balance sheet.

For the banks, it is worth:

• 54% of the banks' total net foreign assets
• 11.8% of gross foreign liabilities
• 4.5% of the deposit base
• 21 months of new lending to the private sector at current rates
• 15 months of new deposits from the private sector at current rates.
• 2.1x the Eu230 bn of bank bonds that mature during 1Q2012.
• Probably slightly more than three quarters of the Eu600bn+ in bank bonds maturing during 2012.

For the economy of the Eurozone, it is equivalent to:

• 3.15x Ireland's annual GDP
• 2.84x Portugal's annual GDP
• 2.19x Greece's annual GDP
• 46% of Spain's annual GDP
• 31% of Italy's annual GDP

So Happy Christmas, I guess.

Banking Systems - Still All For One, I'm Afraid

Whatever 2012 may bring, no-one can claim that disasters in the Eurozone and its banking system could strike like lightening out of a clear blue sky. We have all had plenty of time to get habituated to the idea that somehow, somewhere Princip will stumble upon his Archduke. Consequently, major financial centres and their regulators, not to mention Europe's banks and their ex-Euro counterparties have had plenty of time to prepare for disaster. I have tracked how this has materially altered balance sheets of foreign banks in London and New York.

The hope therefore is that given such a lengthy warning period, if and when the Eurozone's financial system really begins to implode, other parts of the world's financial systems will prove to be more robustly insulated from the damage than they were when Lehman went down. But are they?

Every day I dutifully track the CDS market for 5yr bank bonds in the Eurozone, the US and Asia, as a reasonable proxy for perceptions of systemic risk in these financial systems. If US and Asian financial systems have been busy insulating themselves from Eurogeddon successfully, then the linkage between rising risks in the Euro banking system, and rising risks in these other banking systems should be diminishing.

We can measure whether this is true by looking at how the correlations between movements in Eurozone banking system CDS rates and those in the US and Asia have developed over the year. Here's the chart, showing the development of 30-day correlation coefficients between daily movements in the underlying CDSs.

Man, I'd have loved this chart to be different. However, like it or not, we end the year with no sign that the market believes that either US or Asian banking systems have made any significant progress in insulating themselves from Euro-risk. In fact, the correlations are at or near their all-time highs.

Sorry about that.

PS. The de-coupling between Eurozone and US systems in June this year was the consequence of developments on both sides of the Atlantic. The Eurozone saw what was then the biggest and most decisive meeting to protect the Euro – at the time these meetings had more credibility than they now enjoy. On the other side of the Atlantic, we had various developments in the stand-off in how/if to continue funding the Federal government.

Shocks and Surprises, Week Ending December 16th

Although the week's dataflow delivered more positive surprises than negative shocks, we'll start with the shocks, because potentially the most worrying almost managed to slip by undetected, a triumph of camouflage.

It's not as if China's monthly monetary data isn't widely watched, but most commentary on November's data dwelt on the relative strength of new bank lending (up 562.2bn yuan on the month) and the modesty of the slowdown in M2 (12.7% in November, vs 12.9% in October). In my opinion, they should have spent more time thinking about the 'shock' fall in growth of M1 7.8%, slowing still further from the 8.4% recorded in October. There is a ready explanation for both the weakness of M1 and the relative resilience of M2, which notices that inflation has retreated, and urges that inflation-related liquidity preference (M1/M2) has similarly retreated. The only problem with this explanation is that it's wrong (as one could also tell from the surprising strength of the previous week's retail sales numbers – up 17.3% YoY). Rather, what's happening is that China's M2 numbers since October have been newly bolstered by the inclusion of deposits from China's Housing Provident Fund – a mandatory forced savings scheme in which the size of new deposits are tied to the size of wages. M2 numbers are staying within range of expectations only because of these forced savings.

In fact, the M1 numbers almost certainly tell the right story – a story of deteriorating private liquidity and cashflows. Even with these forced savings included in the story, for the second month in a row, China's banks gave out substantially more new loans than they took in new deposits. Since the end of September, China's banks have extended 1.148tr yuan in new loans, but have taken in only 100bn yuan of new deposits (including the forced savings). To be clear, this is not just some seasonal effect showing up in the data – it's a genuine deterioration in private sector liquidity. Lucky, then, that the central bank can offset it by cutting reserve ratios.

The week's positive surprises continue to be discovered in the relative health of the world's industrial economy, which so far is almost managing to shrug off the appalling dangers European politicians seem keen to subject their citizens to in order to 'save the Euro'.

It no longer completely surprises that the more timely surveys of industrial conditions in the US show sharp improvements. This week, the Empire State Manufacturing index delivered its best reading since May, and the Philadelphia Fed Survey gave the strongest reading since April. In both cases, the improvements were driven by a sharp uptick in new orders. Nor is it beyond comprehension that Japan's machine tool orders managed a sequential jump which was 1.1 SDs above seasonal historic trends – as we've pointed out elsewhere, the minutiae of recent trade and output data has already showed the resilience of capex spending globally.

But it is a surprise that Europe's manufacturers are surviving better than expected: this week the Eurozone Composite PMI, the Eurozone Manufacturing PMI, the Eurozone Services PMI, and (separately) manufacturing and services PMIs for both Germany and France all arrived stronger than consensus had expected. True, only German and French services PMI readings managed to crawl over the expansion/contraction reading of 50 – but outside those readings, the pace of contraction was less than expected. Similarly, the 3.5% YoY fall in new car registrations in the EU25 actually hid a sequential rise of 2.4% MoM – which was 1.1SDs above seasonal historic trends.

It would, of course, be misleading to ignore the fact that the hardest of data – which also arrives systematically later than most survey data – was generally worse than expected. In the US, industrial production fell 0.4% MoM and retail sales rose only 0.2% MoM in November. In the Eurozone, industrial production grew only 1.3% YoY during October, China's Leading Index declined by 0.1% MoM – the first sequential fall since Dec 2010. This latter indicator is particularly badly-named – how can a short-term 'leading indicator' be doing its job properly if October's 'leading indicator' is delivered two weeks after the hard release of economic data for November?  

Trade Data vs 'The New Great Depression'

On the day that Christine Lagarde warns that the world may be tipped back to a new 1930s-style Great Depression, it's worth pointing out that it's not happening so far. We have almost all the data now for November, and so far not only is the slowdown nothing like what happened at the end of 2008, but it's less dramatic even than the slowdown which accompanied the near-recession of 2000-2001.

In fact, NE Asia's exports showed positive sequential momentum in November, as did G3 imports in October (both the latest data).

(True, Christine Lagarde's analysis carries all the knowledge and authority of economics and finance which you'd expect from a French socialist labour lawyer. It's a shame that when she speaks, you never know whether its the French politician, the labour lawyer, or the judgement of the IMF that's coming out. Still, if you will appoint completely unqualified people to important jobs, you can't be surprised when they discredit the institution upon which they have been foisted.) 

The hinge of world trade remains the link between Western import demand (US, Eurozone, and Japan) and NE Asia's exports (China, Japan, Korea, Taiwan). Plenty of lucrative careers have been sustained maintaining that these two will or are decoupling, but so far they haven't and you shouldn't be holding your breath. In the three months to October, for example, G3 imports grew 17.2% YoY whilst NE Asia's exports were up, er, 15.6%. Were I to plot the 6m sequential momentum of these two against each other, you'd barely be able to see daylight between them.

Now let's look at the dynamics of G3 imports a little more closely. In October, in dollar terms, G3 imports rose 14.9% YoY (US up 12.9%, Eurozone up 13.2%, Japan up 26%), and the rise of 2.1% MoM was 0.3 Sds above what one would normally expect in October. The six-month moving average of that momentum reading shows a reading 0.08 SDs from historic trends – ie, virtually no deviation whatsoever. (By the way, it is not weakness in the dollar generating these YoY movements: the dollar was down only 1.1% YoY against the SDR in October.)  

Clearly, this is a less buoyant picture of momentum than we've experienced during the last couple of years. But it remains well within the range of 'normal', and miles away from the experience of 2008/09. I put a lot of emphasis on those momentum readings, because they express fundamental changes in direction sooner and more accurately than YoY readings. Compare what's happening now with what happened in the run-up to the end of 2008: the lurch down may eventually materialize, but it hasn't yet.

Now consider what's in that trade data already. Here's what I wrote about the data-flow last week, in Shocks and Surprises, Week Ending December 9^th. “When we extract the detail from this mass of data, we confront a paradox:

• on the one hand there's a very sharp contraction in the trade in intermediate goods, which bodes ill for the short-term industrial output,
• on the other hand, the demand for capital goods is, so far, undiminished, which suggests that capex plans, and therefore expectations of how the industrial cycle will develop over the medium and longer term, are unchanged, and rather bullish.”

The point at which companies stop buying intermediate goods, is precisely when we should see the most abrupt short-term collapse in trade numbers. It should be happening right now.

So let's look at November's exports from NE Asia: we have the full data for China, Korea and Taiwan, and we have numbers for the first 20 days of the month for Japan). There's no denying the data is patchy and volatile: China's exports were up 13.8% YoY as were Korea's but Taiwan's export growth slumped to 1.3%, whilst Japan's (probably) rose 6.1%. Part of this – particularly Taiwan's problem, for example – are the result of specific sectoral weaknesses. But overall, the slowdown that's happening so far more resembles 2000/01 than 2008/09.  

The danger, of course, is that I'm being complacent – that I'm the man flying past the 31^st floor window murmuring 'well, it's all right so far.' After all, European politicians seem bent on subjecting the continent to the Euro for as long as possible, which virtually ensures the period before its failure will be one without significant European economic growth, and the period after its failure will be to some extent chaotic.

(See Mohamed El-Erian's excellent summary of the dynamics of the crisis, in Foreign Policy.) 

But there are two reasons why even this outcome is likely to result in a milder downturn for world trade than currently seems likely. First, we are still starting from a very low base: G3 imports fell 28% in 2009 (12m to October 09), and the recovery of 2010 still left them 15% lower than in 2008. In the 12 months to October 2011 G3 imports were only 1% higher than they were in the same period in 2008. Second, whilst the collapse of Lehmans really was a surprise, the travails of the Eurozone most emphatically are not. Probably the only people in the world who don't know how, ultimately, this will have to end are Europe's politicians. It seems inevitable that eventually even they may have their moment of enlightenment – at which point, the very least we can expect is that the European Central Bank may discover an appetite for preserving the financial system rather than its virtue. Meanwhile, as I have tracked many times, the world's biggest financial centres (New York, London) have quarantined Eurozone banks as best they can. That quarantining can never be perfect, but we can certainly expect it's getting better with every working day.

So what matters is timing. If the breakup of the Eurozone can somehow be fended off until 2013, the ensuing chaos may have less of an impact than if it happens next week. Moreover, the trade data that's staying within normal bounds now may continue to do so throughout 2012.

Global Capital Demographics

Yesterday I wrote about how in the Eurozone, where there is by definition little room for competitive flexibility in labour markets, and none in currency rates, one of the few remaining keys to comparative advantage is in the relative age of a country's capital stock. Thus, now that Germany has quietly been renewing and modernising its capital stock over the last couple of years whilst France and the Netherlands (as competitors) have been letting theirs quietly age, its comparative advantage within the Eurozone is only likely to widen.

But what's happening in the rest of the world: how do the demographic trends in capital stock work out in the US and NE Asia, as well as the Eurozone? Can we learn anything about the shifts of global comparative advantage from this, with all the potential for adjustments for pricing adjustments in labour and currency markets that implies? (I am, incidentally, absolutely aware that this is a long way from the last word on this issue – a complete analysis would also have to take in growth of capital stock, labour productivity, terms of trade and currency fluctuations. I am concentrating on this issue of the demography of capital because it's usually tends not to surface on economists screens.)

Let's start with NE Asia, where we can see very different trends emerging throughout the last 20 years, which we can interpret.

Starting with Japan, we can see that the implosion of the bubble economy in 1990 led to a long period where Japan hung back on re-investment and let its capital stock age. This period lasted for a full decade, so that by 2000, the average age of capital stock had risen to 4.16 year, from a low of 3.41 years in 1991. That was about as old as Japan's capital stock got, but it was not until around 2005 that corporate Japan began quietly to reinvest and renew – a modest trend which was halted in its tracks, and reversed, by the global financial crisis in 2008/09. Right now, Japan's capital stock is once again about 4.1 years old on average – the oldest in NE Asia.

The contrast with China is, of course no accident: rather, that contrast represents the impact of Japanese industry relocating and expanding out of Japan and into China. The investment cycles generated by China's financial system prior to Zhu Rongji's reforms were wild affairs, as the swings in the average age of its capital suggests. However, the last ten years has seen a combination of enormous and sustained investment, which has left China with the fastest growing, but also youngest capital stock in NE Asia. The capital demographics of South Korea and Taiwan bear the imprints of, respectively the 1997/98 financial crises for Korea, and the post-2001 political/diplomatic deterioration for Taiwan. South Korea's aggressive currency depreciation in 2008/09 bought the room for, among other things, an attempt to rejuvenate its capital stock.

Over time, as economic weight in NE Asia has shifted dramatically to China, so it is China's investment spending which has gradually come to be the swing factor in the demographics of NE Asia's capital. I have weighted these demographics by a moving three-year average nominal GDPs to generate a demographic for NE Asia as a whole. This shows that the age of the region's capital stock has remained roughly stable at around 3.6 years since 2008. Here's how it compares with what's happened in the US and the Eurozone.

This is a really dramatic demonstration of how comparative advantage is likely to have shifted over the last decade. In 2000, the US had by far the youngest capital stock, whilst NE Asia was still aged by the combination of Japan's irrecoverable bubble economy, and the 1997/98 financial crises. We can infer that Europe's capital stock was older than that of the US, but younger than NE Asia's. In 2011, the situation has reversed very dramatically: now NE Asia's capital stock is by far the youngest; the US's is by far the eldest (and older than it has ever experienced), whilst Europe's capital stock, too, is old and still aging at an unprecedented pace.

Grounds for NE Asian triumphalism? Perhaps. But take another look at the second chart. Doesn't the current US/NE Asian situation look rather like the beginning of the 1990s – the last time that America was generally considered down and out?   

Who's Got the Newest Euro-Kit?

It doesn't seem like a rash assumption that in 2012 there is more likely to be a shortage of demand than supply for most goods and services in the Eurozone. Who sort of company, and what sort of country, does that suit best?

The standard answer – and it's not wrong – is that in these circumstances, operating margins get squeezed, and consequently the winner will be the one who can maximise asset turns. Any company (or country) which has been investing heavily on the expectation of maintaining operating margins is going to be profoundly disappointed and possibly financial threatened.

But the standard argument misses one crucial point: the company/country that's been investing most heavily recently may have a larger stock of capital on which it must raise asset turns, but it will also have the newest stock of capital equipment. And if the world is one in which labour markets are sticky (wages difficult to cut, employees difficult to fire) and fx rates similarly sticky, the later the generation of equipment, the better. In cases where there are few other avenues of comparative advantage, arming your workers with the newest generation of equipment could be the difference between competitive success and failure.

The caveats that this will prove most important in countries with sticky labour markets and no room for currency fluctuations directs our attention immediately to countries within the Eurozone. Of the large Eurozone economies, neither Italy nor Spain is likely to be a position to respond to deteriorating market conditions with anything more than lunges for survival. But we need not assume that Germany, France and the Netherlands will necessarily be in survival-only mode. So which has the newest capital stock?

We can estimate the average age of capital stock by by extending my usual technique of depreciating all fixed capital spending over a ten year period. When we do, this is what we find.

This chart tells us something rather important: whilst Germany still has, on average, just about the oldest capital stock of these three countries, the difference – which is an important element of comparative advantage – has narrowed dramatically since the financial crisis. As of September, the estimated average age of Germany's capital stock was 3.89 years, now virtually indistinguishable from its Netherlands neighbour, but only very slightly older than France's average 3.83 years. During the pre-crisis years of 2005-2008, the age gap between Germany and France averaged 0.32 years, and the age gap between Germany and the Netherlands averaged 0.19 years. What's more, these are necessarily slow-moving trends, and it's very likely that when the final data for 2011 is published, we'll find Germany has newer capital stock than the Netherlands. By the middle of 2012 we should expect it to have a newer capital stock than France.

This represents a structural sea-change in comparative advantage within the Eurozone, in Germany's favour. Having deflated its way back to competitive equality, those same forces are now entrenching a new comparative advantage. It is extremely difficult to see how France and the Netherlands can be expected to recoup the ground they are losing right now, except by developing competitively flexible labour markets. Let me put this in plain language: we should expect the growth differentials between Germany and even its financially-confident neighbours to widen from here in a way simply not seen since the introduction of the Euro. German economic dominance over the Eurozone will grow inexorably.