ECB's QE: More Magic Than Mechanics

So, will it work? 

It would be easier to answer that question if we could form a clear idea of what Mr Draghi thinks this quantitative easing will achieve and how it will achieve it. That is not easy.

It seems to me that throughout this financial crisis there have been four models about what QE might achieve:

• The first is relatively straightforward: quantitative easing has been (in the US and UK particularly) a way of publicly guaranteeing the solvency of potentially distressed financial systems. 
• In the second model the central bank hopes to master the longer-end of the bond market, driving investors are driven into riskier instruments, and thus driving down risk premia. In terms of the economy, by depressing bond yields below 'fair value' rates, central banks and economists entertain the hope that savings rates would be cut, and investment spending encouraged. In both the US and UK this has happened very slowly, very late in a business cycle, and to the extent that it has happened at all there is no certainty (and limited probability) that QE played a key role in changing savings/investment choices. 
• The third model involves using QE to announce a public 'regime change' of monetary policy which, by itself, manages to raise inflationary expectations. 
• The fourth model is quite different and the polite financial community pretends it hasn't noticed it: in Japan, QE is being used as a way in which the central bank can achieve hegemony over/functionally replace a banking system which seemingly cannot be revived from its decades-long coma. 

Which of these engines does the ECB think it has set in motion?

The first move is to listen to what Mr Draghi had to say. The key passage, it seems to me was this: “while the monetary policy measures adopted between June and September last year resulted in a material improvement in terms of financial market prices, this was not the case for the quantitative results.” What does he mean by quantitative results? He could mean either there was insufficient positive results in terms of credit (and he's right, bank lending to the private sector fell 1.4%, or by Eu151 bn over the 12m to Nov), or alternatively, the 'quantitative result' he may be referring to could be economic output and economic growth.

Nor did Mr Draghi get significantly more coherent as he outlined what he thought might be achieved: QE would

1. decisively underpin inflationary expectations 
2. ease financing conditions for firms and households 
3. 'reinforce the fact that there are significant and increasing differences in the monetary policy cycle between major advanced economies.' 

That last is simply obscure: the obvious explanation is that he is simply talking down the Euro – is this really what he intended?

If from all this you can construct a clear set of aims, and a picture of the mechanisms by which the Eu60bn per month buying of assets will achieve those aims, you are one step ahead of me. But if pushed, I would say he is relying on a 'regime change' to push up inflationary expectations, whilst hoping that ECB's bond-buying will somehow be passed on to firms and households.

There are two problems getting in the way of that second hope. The first, of course, is that the longstanding expectation that ECB would eventually be driven to something like QE has already depressed both sovereign Eurozone bond yields, and risk premia. Ten-year Eurozone sovereign bond yields are only around 50bps, with the risk premium of 10yr BBB bonds approximately 100bps, and, for troubled sovereigns such as Spain, around 140bps. The marginal impact of squeezing these premia down further can surely be only slight.

The second problem is that even as national central banks buy bonds from their own financial system, the receipts are likely to pool in the most credit-worthy systems. Within the Eurozone, that means the German banking system, where we will be able to track the process by the Bundesbank's Target 2 balance with the ECB. Outside the system, the Swiss National Bank is making a radical assumption that plenty of the ECB's QE is coming its way. For evidence, consider changes in the ECB's balance sheet:  

and the way the fluctuations of 2011 to 2014 have been mirrored in the Bundesbank's Target 2 balances with ECB: 

and the short term liabilities and foreign investments build-up in the Swiss National Bank:

Why should we expect it to be different this time?

China in 4Q: Tactical Reverse Delivers Modest Victory

China's release today of December's monthly data and 4Q GDP results contain enough information to give us answers to two distinct questions:

• To what extent have China's authorities succeeded in halting the slide of the first three quarters?
• How much progress has been made in 2014 towards steering China towards a less resource-inefficient model of growth?

The answer is that it's reasonable to believe the slowdown in China's economy was indeed brought under control and in some respects reversed. But there is a price: virtually all measurements suggest China made no progress at all in 2014 in discovering a more efficient growth-model.

December Data and 4Q Growth

There was just enough in December's industrial and domestic demand data to suggest the underlying loss of momentum continued to moderate. For the industrial sector, the 7.9% yoy rise in output was a surprise exactly big enough to offset the fall to 7.2% recorded in November.  It included a 2.6% yoy rise in electricity generation which also just about kept that indicator conforming to trend.  Similarly, the 9.5% yoy growth in US dollar exports (9.8% yoy in Rmb terms, and 9.4% in volume terms) was very modestly greater than historic seasonal trends would expect. So the industrial sector ended 2014 in much the same state as it has been since 2012 - oscillating in a narrow range around, and usually just under, trend momentum.

Domestic demand has been the greater challenge as, broadly speaking, it tracked fluctuations in monetary conditions.  And December's data was collectively strong enough to show positive momentum for the first time in a year, which pulled up the 6m trendline slightly, although it is still solidly negative. The strongest signal was from car sales, which rose 16% yoy and were 1.5SDs above trend. In addition, retail sales growth of 11.9% yoy was 0.4SDs above trend for a second successive month. But these gains were offset by still-slowing urban investment (15.7% yoy ytd), and the continuing deterioration in employment conditions as tracked by the official manufacturing PMI.

My momentum indicators suggest that the deterioration of 1H has been mildly but successfully reversed in 2H, and particularly in the last quarter. And,  perhaps surprisingly, the quarterly nominal GDP results suggest the same thing.  This is not immediately obvious: nominal GDP growth slowed to 7.8% yoy in 4Q from 8.5% yoy in 3Q.  When one strips out the impact of the trade surplus (Rmb 917.3bn in 4Q14 vs Rmb554.3bn) in 4Q13 in order to get an idea of domestic demand, nominal GDP growth actually accelerated very mildly, to 6.1% yoy in 4Q from 5.7% in 3Q14.  Going further, one can also strip out the fiscal position, to get closer to movements in private domestic demand: we have the fiscal data only for October and November, but  judging from those two months, it seems clear that, despite the public commitment to supporting economic growth, the fiscal position actually tightened slightly during the quarter. (In the 3m to Nov, revenues rose 8.4% yoy and spending rose only 1.9%, and the Rmb 350.8bn deficit compared to a deficit of Rmb 540bn in the same period 2013).  As a result, when you exclude the impact both of the net trade position and the fiscal position,  I estimate the remaining private sector domestic demand grew 8.2% yoy in 4Q, up from 5.2% in 3Q and 5.8% in 2Q. In short, the deterioration was checked in 4Q.

That conclusion is also supported by my proxy for  the private sector savings surplus, comprising the trade surplus minus the fiscal position.  As the chart shows, the huge build-up of private savings surpluses which accompanied the slowdown throughout most of 2014, stabilized during the last few months of 2014, as confidence stabilized enough to cap the rise in precautionary saving. We do not yet have current account data for 4Q, but during the 12m to September, the PSSS rose to 4.6% of GDP from 3.5% in 3Q13.  For the time being, it seems likely that the ratio did not rise more in 4Q14.

Structural Issues - The Challenge Ducked

The evidence suggests that the government's attempts to avert a spiralling slowdown met with modest success during the latter part of 2014. But there has been a price: there has been no obvious sign that China is edging towards a more resource-efficient growth model. Rather, the longer-term deterioration has continued,  with the marginal improvements since the middle of 2013 scuppered in 4Q14.

My return on capital directional indicator expresses nominal GDP as a flow of income from a nominal stock of fixed capital, and I calculate movements in that capital stock by depreciating nominal gross fixed capital formation over a 10yr period. We do not yet have the formal by-expenditure breakdown of GDP for 2014, so 2014's 7.7% yoy investment spending is modelled from the 15.7% yoy rise in urban fixed asset investment.  This may prove a conservative estimate of investment spending in the national accounts, but even so, it implies China's capital stock is growing around 13.3% yoy - far faster than the c8.2% growth in nominal GDP. As a result, there is absolutely no sign that the fall in the directional indicator is easing up.

Perhaps it might be argued that after the huge investment frenzy of the last 20 years, it is quite unreasonable to expect a rapid turnaround in this indicator. However, it is difficult to see any improvement in other indicators, such as monetary velocity (GDP/M2): although the pace of deterioration has clearly moderated, it has probably not yet improved. (Monetary velocity may be interpreted as indicating changes in marginal output/capital ratios once the effect of changes in the credit cycle are accounted for.)

More directly, one can look at the economic efficiency of finance, tracking how nominal GDP has reacted to the addition of 1 yuan of bank lending, or more broadly 1 yuan of neg aggregate financing. At the beginning of 2014 there were signs that this was finally beginning to recover from the falls of 2008-2009 and 2012. However, developments in 4Q appear to have snuffed out that recovery: in 2014 one yuan of bank lending was associated with just 0.53 yuan of GDP growth, down from 0.77 yuan in 4Q13, and dipping back to the lows of early 2013.  Calculating the similar ratio for aggregate financing, one yuan of aggregate financing was associated with marginal GDP growth of just 0.30 yuan in 2014, down from 0.40 yuan in 2013.

None of this is to write the obituary on China's efforts to re-cast its growth model. But such a traverse is tremendously difficult at the best of times, and in 2014 China's authorities evidently discovered this was not the best of times. The economic strategy no doubt remains, but 2014 was a year in which economic tactics took precedence.

If ECB Goes QE, Remember Bundesbank's T2

Even if Mario Draghi can retain unanimous monetary policy board consent to a really sizeable programme of quantitative easing, the underlying untreated fractures in the Eurozone’s financial system make it difficult to believe it could significantly deflect the Eurozone’s economy much from its current trajectory. Put baldly, the mechanism by which the central bank can hope to transmit monetary policy initiatives throughout the economy are broken. And they are most broken where they are most needed.

Regardless of the ECB’s public policy pronouncements, movements in its balance sheet reveals what policy has actually been. And that policy has been to claw back the support to the Eurozone financial system it provided during the first phases of the Eurozone crisis in 2012. Between 3Q12 and the end of 2014, the ECB’s total balance sheet contracted by just over Eu1tr.  In calendar 2014, the ECB’s balance sheet shrank by Eu251bn, a contraction equivalent to approximately 3% of Eurozone GDP.

In terms of net lending to the Eurozone’s financial institutions, the total has fallen from roughly Eu650bn in 2H2012 to around Eu480bn in 2H14.  Evidently, the desire to shrink the ECB's balance sheet was a higher priority than steering the Eurozone away from deflation, fostering growth or eroding the unemployment totals of Southern Europe.

This will at least please the Bundesbank, since the fractures in the Eurozone banking system have forced it to become a massive lender to the ECB.   The problem is that Germany’s role as the Eurozone’s principal banking system safe haven results in large chunks of Eurozone liquidity pooling into Germany's banking system, which in turn results in the Bundesbank being the chief re-cycler of those funds back to the ECB. The chief tracker of Germany’s save haven/capital recycler role within the Eurozone is the fluctuations of the Bundesbank’s Target 2 net position with the ECB.  When Euro liquidity was fleeing Southern Europe financial systems and washing up in Germany’s commercial banks, the Target 2 net position of the Bundesbank with the ECB rose to a peak of Eu751bn in August 2012.  This was an amount equivalent to just under 25% of the ECB’s total balance sheet. Subsequently, this flow modestly reversed, with the Target 2 total falling to Eu470bn by March 2014, but since ECB also shrank its total balance sheet during the same period, the Bundesbank’s net position is still equivalent to 22% of the ECB’s total assets.  

Since March, however, the position has been largely unchanged, though over the past few months it has expanded very slightly. But this stability is not a return to 'normality': between 2000 and 2007, and prior to the Eurozone debt crisis, the Bundesbank's Target 2 balance averaged under Eu10bn. 

Now consider the implications of the relationship between movements in the size of the ECB’s overall balance sheet and the Bundesbank’s Target 2 balances with the ECB: they rise together than more recently have fallen together, but whilst the ECB’s balance sheet has returned to 2010 levels, the Bundesbank’s Target 2 balances are approximately two and half times what they were in 2010.  

What this tells us is that, despite what the fall in sovereign risk premia may assert, the perceived imbalance of risk in banking systems between Germany and the rest of the Eurozone has not been eradicated.  ECB’s guarantees of liquidity have suppressed risk premia, so that at present, Spanish 10yr sovereigns carry a bare 88bp risk premium, but if that premia has been ‘artificially’ suppressed by central bank actions and/or promises of action, it merely means that investors are no longer paid enough to offset the residual financial system risk. Hence liquidity continues to flow out of the Eurozone’s riskier banking systems and back into Germany’s banking system. 

The underlying fracture in the Eurozone between Germany and the rest of the Eurozone has not mended. The analogy of the ECB using a sticking plaster to treat a fracture is compelling: the smooth surface masks terrible and possibly irreparable damage beneath the skin. 

In particular, it illustrates just how limited any ECB ‘quantitative easing’ must be in effect, even if Germany’s representatives should allowed a concerted effort in that direction. For the evidence suggests that if ECB poured liquidity en masse into the Eurozone’s banking system, the economic and financial fractures in the Eurozone would result in liquidity quickly circling back once again,  quite uselessly, into Germany’s banking system.  Whilst this might – only might – help inflate German asset prices, it can hardly be expected to do the same for, say, Spain CPI, or Italian unemployment, or ex-German Eurozone growth. The underlying divergence directly sabotages the mechanism by which any conceivable (ie, nationally non-specific) monetary policy can take effect. 

It has been claimed that central bank quantitative easing can or has achieved different things at different times, using different mechanisms. The two most common beliefs are that sufficiently aggressive central bank intervention can effect ‘regime change’ which effectively encourages nervous financial systems with depleted risk capital, to reassess likely future returns and expand balance sheets which would otherwise be frozen.   Secondly, it has been asserted that if central banks can crush the risk premium across the range of financial assets, it can drive investors back into those ‘riskier’ assets from which they had recently fled.  

Both make the assumption that although balance sheets may be compromised and risk capital in short supply, the fundamental banking mechanism through which a central bank can act remains sufficiently intact to be rescued.  But in the Eurozone’s case, the enduring size of the Bundesbank’s Target 2 balance tell us that is not the case: Europe has many distinct national banking systems  with different risk characteristics masquerading as a single system.  But it's the still-giant Bundesbank Target 2 balances which reveal the truth. 

Corporate Japan Unfazed, Unmoved in 3Q

Japan's quarterly survey of private sector p&ls and balance sheets is usually more revealing than the GDP estimates.  After all, these allow us to pick apart just how corporate Japan is making money, and what it's then doing with the money it's making. The short answer is that despite the pressure on topline revenues during the last six months, operating margins continued to rise, thanks to gains in employee sales easily employee costs. Those sustained margins mean cashflow remains strong, up 56% yoy in 3Q and up 64.1% on a 12m basis. But there's still no significant appetite to re-invest that cash: investment in plant and equipment rose only 5.5% yoy, equivalent to only 77% of cashflow during the last 12 months. Moreover, that investment once again only just covered the depreciation expenses claimed.

Good News First: Margins Survive Sales rose 2.9% yoy against a fairly easy base of comparison, with the quarterly result just as disappointing in 3Q as in 2Q: in other words, the topline continued to suffer from the after effects of the sales tax rise.  Still, operating profits rose 3.8% yoy, which pushed up the 12m OPM to 4.07%, the highest since the immediate aftermath of the Bubble in 1991.  

How has that rise in 12m margins been achieved, and is it sustainable? For the quarter, the cost of goods ratio rose 0.8pps to 78% in 3Q, and rose 0.3pps to 77.7% in the 12m to Sept. For the quarter, this was only partly offset by a 0.4pp fall in SG&A/Sales to 18.3%, but on a 12m basis, SG&A fell 0.8pps to 18.3%. The main driver behind that improvement was personnel expenses, which rose only 1.7% yoy in 3Q (compared to the sales rise of 2.9%). For the quarter, personnel expenses/sales fell 0.4ps to 12.6% of sales, and on a 12m basis, they fell 0.6pps to 12.5%. More directly, sales per employee rose 7.1% yoy and 9.6% on a 12ma, whilst expenses per employee rose only 2.2% yoy and 4.3% on a 12ma. The sales/expenses multiple per employee rose to 7.98x in 3Q14, which was the highest since 4Q10, and on a 12m basis it rose to 7.91x, the highest since 2Q11.

There is no reason to think that corporate Japan will be content to allow this multiple to slip – certainly not before it reaches the levels around 8.3x that was achieved immediately prior to the financial crisis.

And Now The Less-Good News  But despite the ability to maintain margins, corporate Japan has not entirely managed to escape the tax-generated headwinds which slowed the economy. After all, it is easier to patrol margins in these circumstances than to restructure the balance sheet in the face of a probably transient shock to the top line. Corporate Japan's asset turns (sales/total assets) were hit hard in 2Q, slipping to an annualized 0.91 from 1 in 1Q, and although they edged up to 0.93 in 3Q, this has not been enough to rescue the 12m multiple, which fell marginally to 0.939. This is as low as this multiple has been (and the same as in 4Q09), but it is not impossible it will fall further in 4Q.

In addition, corporate Japan's ultra-conservative attitude towards the balance sheet needed no adjustment to the disappointment in 3Q topline growth: net debt fell by Y2.92tr qoq, and cash on hand rose by Y4.375tr, cutting the net debt/equity ratio by 1.2pps to 53.5%, another record post-Bubble low.

The result is that for both ROA and ROE, the margin gains being squeezed out of the workforce were lost this quarter by the fall in asset turns and leverage.

Nevertheless, whilst the recovery in ROA and ROE has stalled, cashflows remain very strong: investment in plant and equipment came to Y9.45tr in 3Q, up 5.5% yoy, whilst net debt fell Y2.92tr during the quarter. In all, then, that amounts to Y12.36tr of cashflow achieved in 3Q, up 55.5% yoy and up 64.1% on a 12m basis.

The problem is that nothing in these balance sheets suggest any increased willingness to deploy that cash back into the economy. Although investment spending over the last 12m is up 5.2%, this amounts to only 77% of cashflow: meanwhile, amount of cash on the balance sheet amounted to 11% of total assets, the highest since the immediate aftermath of the Bubble. And it's still climbing. Meanwhile, the Y9.45tr in 3Q capex is actually slightly less than the Y10.715tr claimed in depreciation expenses: unless Japan's depreciation schedules are unrealistically aggressive (but they are!), this implies an actual shrinkage of the the capital stock of corporate Japan. And 3Q was not exceptional in this regard: over the last 12 months, capex spending was only 2% more than the depreciation expenses booked!

US - Searching for the Cycle

In 'My Firmest Conviction' I argued that to date, the current expansion has been unusual for not developing any of the normal cyclical accelerators which usually give dynamic drive to a business cycle.  Rather, it has been what one might call a steady-state supply-led expansion. This lack of cyclical development is extremely unusual in recent US economic history, and it surely won't last for ever.

So it is important to keep a keen eye out for the emergence of pro-cyclical accelerators. These would include:
• an break-out of capital investment coming in response to rising demands on existing capacity;
• an acceleration in wage inflation in response to tightening labour markets;
• a spurt in consumption demand as inflationary expectations and a fall in precautionary motives allow a fall in the personal savings rate; and, of course,
• a solid inventory cycle.

The last two weeks have brought data which bears on all of these. For the investment cycle and for labour market cycle there are enough indications to keep expectations alive, but also in both cases there is no sign yet that these signs are generating predictable economic consequences. For the consumption cycle, the reported recovery of consumer demand is flatly contradicted by consumer behaviour, as personal savings ratios rise and consequently dampen consumer spending. Finally, there is no sign of life in the inventory cycle.

Investment Cycle Accelerator  October's capacity utilization rate came in at 78.9%, retreating from September's 79.3%, the highest it has been since pre-crisis mid-2008. It has been a long grind to get there, but utilization rates have essentially recovered to pre-crisis levels, and are still grinding higher. The implication is obvious: one should expect an acceleration in investment spending to kick in soon. Capital spending is growing, but there’s little sign that it is accelerating sharply: rather, the rise in orders of capital goods (nondef, ex-air) has been volatile, whilst fundamentally sticking to a 2010-2014 trendline which implies growth of around 5% pa in nominal terms.

This week, the NFIB’s Small Business Optimism survey for October, rose modestly to 96.1pts, which was one of the most optimistic post-crisis readings,  but was still 0.7SDs lower than the 2004-2008 average. More importantly, the subindex tracking the proportion of respondents planning to increase capex in the next 12m rose to 26%. Now, although this is one of the highest readings of recent years, it is still far lower than the proportions maintained pre-crisis. In fact, even with this reading,  capex intentions have recouped only about half the ground lost in the financial crisis.  Conclusion: the rise in capacity utilization is not yet enough, and probably not nearly enough, to engender an investment accelerator to the cycle.

Labour Market Confidence and Wage Inflation  When labour markets tighten, they tend to generate higher wages, primarily because with the pool of possible employees narrows, a company needing to fill an opening has to offer higher wages in order to lure away an employee from his/her existing job, or perhaps attract him/her back into the labour force. But the willingness to demand higher wages is also a function of an employee’s confidence in the labour market, and that will be revealed directly by the quit ratio (ie, the proportion of employees quitting their job in any given month). When quit ratios are low, it implies that workers are extremely unwilling to leave a job, presumably on the grounds that another job is difficult to find. When quit ratios are high, it implies greater employee confidence in the underlying strength of the labour market.  

Now, the current US expansion seems to be supply-led, and one of the signs of that is that the openings rate (number of new openings as a proportion of the labour force) has not only recovered to pre-crisis levels in the past four months, but at 3.4% in August rose to the highest level since early 2001. But contrary to expectations, this has not generated any significant wage pressure: in fact wage growth has been stuck at around 2% pa since 2010.  One explanation has simply been that employees have had very little confidence in the underlying strength of the labour market, and have consequently been unable/unwilling to demand higher wages. And that interpretation is borne out by the quit ratio, which fell from around 3.5% in 2007 to a low of around 1% in 2009, and has only very gradually and partially recovered. However, September’s JOLTS survey showed the quit ratio jump to 2% in September, which is finally within reach of pre-crisis levels.  Needless to say, it is probably a long way from here to a significant acceleration in wage pressures, but this week’s news perhaps brings that prospect nearer.

Consumer Confidence, Spending and Saving  Consumer confidence surveys, whilst not absolutely unanimous, suggest consumer perspectives on the economy have improved substantially: this week, for example, the Uni of Michigan November confidence survey reported the most optimistic assessment of current conditions and the outlook since July 2007, and in this it mirrored the Consumer confidence index’s conclusion for October, which was the strongest since October 2007. The natural corollary of this is that one would expect a fall in precautionary savings ratios which would accelerate retail sales. Has it happened?

It has not, because whatever respondents may be telling confidence surveyors, their wallets are telling a different story.  Retail sales rose 0.3% mom in October,  only reversing the 0.3% mom fall recorded in September and, as the chart shows, sales are struggling to maintain the growth rates maintained since 2010. The wider measure of personal spending tells the same story: the 0.1% mom fall in personal spending in September pushed the dollar total to furthest below the 20102-14 trend since the worst days of the 2013-2014 winter.  But at the same time, the personal savings ratio rose to 5.6%, which is the highest since 2012, and 40bps above the Sept 2013 level. In fact, if the rise in savings ratios seen throughout 2014 is maintained, it will take personal savings ratios back to 2010-2012 early-recovery levels. Far from revived confidence generating a boost in consumer spending based on falling precautionary savings and/or rising inflationary expectations, the reverse seems to be happening.   A rise in savings ratios, perhaps partly based on falling inflationary expectations (also reported in the Uni of Michigan’s November confidence survey), is compromising consumption demand.  

Inventories  There are no such complications about the inventory cycle: what data we have does not suggest any significant volatility: inventory ratios have been almost entirely flat since 2010 and remain so. This week saw wholesalers’ inventories up 0.3% mom in October, as did total business inventories.  

Japan's 3Q GDP: Not Quite The Disaster It Seems

Although no-one anticipated the 1.6% fall in Japan's quarterly real seasonally adjusted and annualized GDP preliminary estimate, beyond the volatility, the underlying picture remains surprisingly still intact.

Let's start with the obvious: no-one knows how to forecast Japan's quarterly real annualized GDP results. The last consensus was 2.2%, my own pin-the-tail-on-the-donkey effort was 2%, and the result was minus 1.6%. Not one of the 28 economists contributing to the Bloomberg consensus forecast a contraction, and I'm not gloating: I've spent year trying and rejecting various ways to make this forecast, and, except upon request, no longer make the attempt.

In any case, it's not clear that the quarterly seasonally adjusted annualized 'real' GDP growth is any longer the most important measure for Japan:

1. with population declining by around 0.2% a year, arguably what matters more is the longer-term trend in GDP and GDP per capita. After today's estimates, 'real' GDP is growing around 1% pa on a 12m basis, and so, roughly 1.2% real GDP per capita.
2. Given Japan's history with deflation, and its overhang of public debt, nominal GDP is surely just as important as 'real' GDP. Now, nominal GDP was disappointing, rising only 0.8% yoy in 3Q (whilst the deflator rose to 1.9%), which cut the 12m nominal growth to 1.9% (with a deflator of 0.8%).

These perspective make Japan's 3Q GDP performance already seem rather less disastrous than today's headlines proclaim. Clearly April's tax rise introduced volatility not just into Japan's GDP numbers, but also into various aspects of Japanese economic behaviour. But if you're prepared to look beyond that volatility (and that's a big if – most people aren't), the picture looks to be improving in several important ways.

First, the capital cycle is probably still intact: non-residential investment rose by 3.9% yoy, almost holding historic seasonal trends, and by my estimates (depreciating all nominal non-residential investment spending over 10 years), Japan's capital stock is now finally rising for the first time since 1Q09. More, despite the volatility of the last two quarters, nominal GDP expressed as a return on capital stock is still rising, and is now approaching pre-crisis levels, which, incidentally, were the best since the bubble years. Beyond the tax-generated volatility, one would expect the historically high and rising return on capital indicator to perpetuate the investment cycle.  

Second, despite the poor headline GDP numbers, output per worker, when deflated by changes in capital stock per worker, continues to rise, which underpins continued employment gains. During 3Q, employment rose 0.7% yoy, and in the 12m to September total output per worker rose 1.3% when deflated by changes to capital per worker. Continued productivity gains should underpin continued employment growth, just as rising asset turns/ROC can be expected to underpin the capital cycle, despite the current volatility.

Third, compensation rose by 2.6% yoy in 3Q and was up 1.6% on a 12ma: this may not sound much, but these are the highest rises in so far this century. It pushed compensation as percentage of GDP to 51.8% in the 12m to September: this is not a record, but it is a full standard deviation higher than the average this century. And it is rising. What is more, the rise in compensation now exactly matches the rise in nominal private consumption, which also rose 1.6% in the 12m to September.

Using the Kaleckian idea of disaggregation elements of profits (Investment; Consumption minus Wage; Net government spending), it seems likely that profits inched up in the 12m to September, but with the pace slowing to a crawl. Those profits are underpinned by increased investment spending and, to a lesser extent, consumption minus wages, whilst they are being eroded by fractional fiscal tightening and the growing trade deficit.  Above all, however, the fact is that the source of Japan's profits are now more obviously aligned with likely sources of sustainable growth than they have probably ever been. The picture is almost classically 'normal'.

  

  

Finally, to return to the problem: the reason why it's rare to forecast Japan's quarterly GDP with any accuracy or certainty is that there appears to be no stable relationship between what is reported on a monthly basis, and what tumbles out of the quarterly national accounts.  For that reasons it is worth understanding what that monthly data is telling us. Here are my monthly momentum indicators for the industrial economy, for domestic demand, and for monetary conditions, showing the 6m trendline, which expresses how many standard deviations away from seasonalized trends the data currently is running:

These tell what I think is a coherent and plausible story: the industrial momentum trendline clearly shows the pre-tax acceleration which peaks in March and subsequently rapidly subsides. It shows a similar trajectory for domestic demand, which rallies up to February 2014 as purchases are brought forward to pre-empt the tax rise, only to slump proportionately afterwards. In both cases, there is a hint of stabilization visible by September (when the industrial and domestic demand momentum indicators end).  But already there is some response in monetary conditions, with a modest expansion opening up from July onwards, and still developing. (And since this indicator ends in October, it has yet to reflect the impact of Bank of Japan's expansion of QE, or the full extent of the Yen's depreciation). 

That hint of stabilization in industrial conditions and domestic demand shows up more clearly when one includes the monthly noise as well as the 6m signal line: 

In the case of industrial momentum, September produced the most positive set of data since April, with industrial production up 2.9% mom sa, which was enough to raise capacity utilization rates to 99.9 (0.4SDs above long-term average), whilst exports rose 6.9% yoy (in yen terms), which was enough to reverse the run-up in inventory/shipment ratio seen since April. 

Aggregate domestic demand indicators also produced the most positive deviation against seasonal trends in September since May's dead-cat bounce.  Employment rose 0.7% yoy, on a monthly movt which was 0.8SDs higher than historic seasonal trends, and average monthly cash earnings also rose 0.7% yoy, which was 0.2SDs above trend.  Retail sales rose 2.3% yoy, which was the highest since March, on a monthly movt which was 0.6SDs above trend, and vehicle sales fell only 5.5% yoy against a tough base of comparison and on a movt which was a full SD above trend.  Set against this, however, was a 45.2% yoy slump in private construction orders, which was 0.9SDs below trend. Overall, however, the continuing strength of labour markets coupled with renewed industrial momentum suggests there may be more to the strength of September's gains than the dead-cat bounce of May. 

My Firmest Conviction

'So what are your firmest convictions?'  What a question! My firmest conviction is that, all being well, the sun will rise again tomorrow – although even that has been subject to doubt from Hume onwards. More pertinently, I think Hayek is absolutely persuasive when he argued  that competition is justified only because it discovers information which can be discovered in no other way. Yes, this does undermine one's faith in economic forecasting, but  I can't see how it can be wrong, and what's more, our everday experience forces us to acknowledge it is right.

Nevertheless, one learns something from failure. And the failures which have pressed themselves upon me this year have been my efforts to anticipate swings in the business cycle. I spend a great deal of time looking at factors effecting returns on capital and labour, measuring swings in private sector savings/investment balances and the underlying cashflows associated with them. This year, this approach has not so much failed, as been largely beside the point. The expected dynamics of the business cycle have either not appeared, or have been so weak as to be only marginal drivers of economic outcomes.  Subcycle dynamics in investment behaviour, in inventory behaviour, in savings/investment choices, in credit totals,  in pricing, and in labour markets have all simply not driven economic cycles as one would expect.  Where expansions are obvious – and particularly in Anglo-Saxon economies – they have been resolutely a-cyclical.

For example, in the US the recovery of capital spending has been maintained, but has hardly accelerated beyond the 2010-2014 trendline, as one would expect. In US labour markets, the quit rate has remained stubbornly low despite the sort of rise in the openings rate that you would expect to get people moving jobs.  And wages have simply not responded to the rise in the net openings rate.  It's much the same in the UK, where investment spending has remained muted, wage growth negligible, inflation receding and credit growth negative even as economic growth accelerates.

Globally, movements in private sector savings surpluses, which can normally be relied on to super-charge domestic demand in the early stages of business cycles,  have generally moved only sluggishly. In the US, for example, the private sector savings surplus appears to have been relatively static around 1.6%-1.7% for most of the last year.  In the Eurozone, the surplus has fallen maybe 50bps over the last year to around 5.1%. In Japan, the fluctuations around 6.6% of GDP over the last two years has been historically muted.  Only in the UK (and China) have there been significant fluctuations, and in both cases, private savings surpluses have risen, muting domestic demand rather than expanding it.

Why this a-cyclicality has emerged and persisted, and what characteristics a-cyclical expansions might show are for a later post.  For now, however, the conclusion is this: that in the absence of  sub-cyclical dynamics, economic outcomes will be determined by something far simpler and more fundamental: what's happening to growth factors. That is 'my firmest conviction'.

Absent the accelerators and dampeners which usually shape a business cycles, growth patterns will be determined by additions or subtractions of factors responsible for production.  The two most important of these are capital stock and labour. In practice, growth can be (crudely) disaggregated as the change in labour employed plus the change in output per worker. Output per worker, meanwhile, can be expressed as a function of changes in capital per worker. This crude arithmetic can be almost infinitely elaborated, but the underlying idea remains the same:  what comes out (GDP) is a function of what goes in (labour & capital).

Neither are easy to measure properly (plenty of people would argue you cannot measure capital stock at all), and they are obviously not the only factors. In the examples which follow, I estimate capital stock simply by depreciating all nominal fixed capital investment over a 10yr period (after 10yrs of data, you get an estimate) – where possible I exclude real estate investment in the calculation.  This tally obviously changes only slowly. For labour, I take have simply accepted official employment statistics.

Without elaborating, I think the charts which follow offer a reasonably clear-headed guide into the likely growth of the world's major economies (except China), and some likely characteristics of that growth. In some cases, it will also suggest some challenges.  At this point, I'm keener on demonstrating the set-up than elaborating conclusions.

US 

Comment: With capital stock growth likely to continue rising smoothly,  there is a likely growth trajectory of 3%-3.1%. With growth in capital stock now beginning to outpace employment, we can expect recovery in labour productivity which leaves room for modestly rising real wages. 

Britain

Comment: Recovery of capital investment seems likely to continue, but the rise in employment is so fast that capital per worker is still stagnant. So productivity gains unlikely to accelerate, and wage growth likely to remain muted/disappointing. 

Eurozone

Comment: There are two problems here. The first is that since there's no sign that capital stock is likely to start growing any time soon,  the modest (but real) uptick in employment is unlikely to be accompanied by growth in labour productivity, so growth prospects are not good. The second problem is that the Eurozone is not best characterised as a single economy: rather, distinctly different fates would seem to await Germany and the rest.  We should expect this divergence of fates to hamper policy-making.  It is noticeable that official forecasts can barely acknowledge the underlying problem.

Germany

Comment: With capital stock growing at a healthy clip, and faster than employment, we should expect labour productivity to grow as well as employment.  Not only does that suggest a re-acceleration in GDP growth, but it also leaves rooms for real wage rises too.  It is difficult to share the official pessimism about this economy - I would expect upside surprises.

Eurozone Ex-Germany

Comment: The situation for the rest of the Eurozone could hardly be more different. Currently both labour and capital stock are shrinking, and even if employment does continue its tentative recovery, it is hard to expect labour productivity to rise when capital-per-worker is falling. As a result, it is difficult to expect much GDP growth, if any.  

Now, how does one set policy for 'the Eurozone'?

Japan

Comment: This is genuinely interesting: by the beginning of 2015, it is likely that both labour and capital stock will be growing, and the difference between the two will be narrowing. This forms a genuinely improving foundation for GDP growth. And given that downward pressure on labour productivity is likely to be the result of the rise in capital stock, that growth would at this point be likely to survive even a short-term downturn in hiring. It might be best to forget about the ability or inability of Abenomics to re-set Japan's economic assumptions, and just look at the improving growth-factors picture.