by Andrew Hunt
Perhaps rather unexpectedly from the perspective of the global consensus, whatever that may be, we find that a careful analysis of the available data shows that, far from continuing to expand, Asian export growth in volume terms appears to have virtually halted sometime during the fourth quarter of last year and possibly as early as October.
Indeed, we find that Chinese export volumes have essentially been flat for the last six months and that Singaporean export volume trends, which have often a reliable indicator of Asian trends as a whole, have been relatively downbeat over the same period despite occasional periods of pharmacy related strength.
Meanwhile, on the other side of the world, we find that in Brazil export volume trends been notably weak of late and that domestic retail trends also began to cool slightly towards the end of last year.
In Australia, we are now finding signs of recession in much of the country while in Europe and Japan, although the economic data has clearly been particularly weak over the last few months as a result of specific events, this in some senses hides the fact that the recent trend towards weakness actually predates the Tsunami / latest instalment of the Euro Crisis. For example, Euro Zone industrial production growth actually peaked in December last year and the German orders data also appears to have put some form of ‘top' in around the November - February period (the adverse weather made the data quite volatile at that time).
We believe that a clue as to why this peak in trade and production activity (and subsequent deceleration or in some cases reversal in growth) occurred is offered by the G7 retail sales data.
Unfortunately, even much of the G7 does not produce volume data for retail sales or in some cases even seasonally adjusted data series but if we attempt to conduct both adjustments and then combine the various G7 retail volume series into a GDP-weighted aggregate series, we find that notwithstanding a modest post New Year bounce (which seems to have been due to a spurt in UK activity ahead of planned sales tax hikes, the effects of the US tax cuts and a weather related rebound in the German data), G7 retail volumes are today essentially unchanged from their level six - seven months ago.
Certainly, if we look at the growth rate data, we can also see a marked slowdown in retail sales growth in the G7 of late.
Indeed, if we split the G7 data into its US and non- US component series, we find that despite France's continuing retail sector revival, the G7 ex-US series for retail sales has essentially fallen consistently since September 2010 (when a tax-related surge in Japanese sales of ‘green goods' had lifted the series) and that OECD retail growth had therefore become entirely dependent on US trends towards the end of last year, which as the chart below shows are now also slowing quite sharply.
Admittedly, Euro area sales did spike upwards in January but as we note that was for particular one-off reasons and if we were to include the non-G7 member parts of the European economy, the chart would undoubtedly look much worse as a result of the adverse events within the PIGS.
Interestingly, and perhaps rather surprisingly for someone often assumed to be ‘monetarist', we would have to infer from these trends that fiscal policy in the post GFC world has evidently mattered rather a lot to the global growth outlook.
It was, for example, in August-September that both the US and Japanese fiscal impulses peaked (the bulk of the increase in Obama's government spending occurred in late 2010Q2 when the underlying Federal deficit hit close to $1.8 trillion at an annual rate and Q3 was also the period in which Japan's green tax breaks occurred and its budget deficit peaked).
Moreover, it is also clear that the spikes that are clearly visible in US retail sales growth have generally occurred in the months immediately following tax cuts (be they Bush or Obama tax cuts). Finally, we must also note that mid 2010 was the period during which the Euro Zone authorities began their fiscal retrenchment programmes and the UK was to follow their lead a little after that in early 2011.
It therefore seems to us that much of the post GFC recovery in retail sales volumes (which as our chart shows have yet to regain their pre-crisis highs - currently we are still 3-4% below the 2007 peak) was initiated and in reality funded by the various governments' fiscal policy measures rather than by Bernanke & Co's increasingly desperate monetary experiments.
We suspect that many readers will have been slightly shocked at our conclusions that the current soft patch in global activity seems to have been both rather longer and rather more pronounced than they might have previously believed.
Certainly, the bulk of consensus economic forecasting and reporting during Q1 was talking of continued rapid growth and a sustained recovery (and this persisted even until a few weeks ago) and it was also very apparent that there was a tendency towards the rather selective reporting of strong ‘sentiment indicators' such as purchasing managers indices that undoubtedly gave rise to an impression within financial circles (but significantly not in the real economies) that a global recovery was well underway and if anything gathering pace.
We would attribute this divergence between opinion and apparent reality to two things. Firstly, as we note, there was an unusual amount of positive spin and selective reporting by many commentators even by the standards of bull markets (note that even the 2006-7 real economic data such as that shown in our first chart was not that strong but it was nevertheless portrayed in a positive - and as we now know completely erroneous - light by many analysts at that time, presumably as a result of a need to justify ex post the bull market that was going on in asset prices at that time).
Secondly, we also suspect that markets were facing a degree of money illusion.
When Bernanke launched Quantitative Easing 2, we suggested that the main impact of the QE would be inflationary for commodity prices and traded goods prices in general. As it happened, QE2 turned out to be even more inflationary (both in terms of quantum and spread) than we had envisaged but what this rise in prices did was to inflate many commonly watched nominal variables such as Asian export values, retail sales values and even the German orders data.
Quite simply, much of the growth so enthusiastically reported during Q1 was not real growth at all, it was simply the effects of price inflation. For example, if one adjusts Chinese export trends for the effects of rising Chinese export prices as we do above, one obtains a very different view of the situation than one gains from the value data alone.
In fact, in one of the greater ironies of the post GFC world, it was the higher inflation caused by QE that virtually ensured that the global economy slowed in late 2010 as the fiscal stimuli increasingly waned. Rising food, fuel, transport, rent and import prices all served to sap consumer real incomes and thereby ensure that not only personal consumption trends were soft but that companies had no real reason to increase their levels of CAPEX beyond either replacement activity or inventory building as the fashion of just-in-time inventory management faded following not only the rise in transport costs but also the increase in the incidence of natural disasters that threatened what had become rather extended supply lines.
Therefore, while it is true that QE2 lifted the earnings of some parts of the US and global economies (i.e. the investment banks and property companies in the EM), and helped hugely in funding the budget deficits, in terms of its effect on the real economies it seems that QE may have actually been counter-productive.
In short, the consensus appears to have been hoodwinked by the effects of the very inflation that was actually causing the global economy to lose momentum but in fairness to many managers and analysts, we suspect that this occurred because many of them wanted to be hoodwinked. Specifically, under the influence of the QE-inspired liquidity boom that we have described many times before, global asset prices and capital flows were booming in early 2011 (just as they had in 1999-2000 and again in 2006-7 despite the deteriorating economic situation) and it was only human nature that the brokers wanted to keep the boom going and that portfolio managers wanted to see their assets under management rise ‘one last time' before the regulators or reality caught up with them. Even private investors, who simply could not find sufficient returns in riskless assets such as bank deposits probably needed to believe that the bull-market was based on solid fundamentals.
Now, however, QE is clearly ending and the chimera that had obscured global trends is falling away with the result that the weakest members of the global economy such as the Euro PIIGS are entering crises of their own (as they always do when global growth slows and liquidity trends deteriorate at the margin). At a global level, the first casualty of these events should be inflation expectations, firstly in the financial markets (as we have already seen) and secondly in the real economies as well. Indeed, within a few quarters, we suspect that, aside from some of the more structural aspects of inflation such as the effects of sales taxes and infrastructure user charges, global inflation trends which have so far overshot investor expectations this year will begin to undershoot them once again - and this may be one of the things that Treasury bonds are telling us.
Moreover, as we have noted, if Treasury yields remain low, then equity market valuations will remain generally undemanding and therefore supportive of prices in these markets in the medium term, despite the weak economic data (although the latter may continue to weigh on them in the near term). However, those assets which appear to be overvalued relative even to T-Bonds, such as credit spreads; commodities; illiquid investments such as cars, art and wine, and even many EM / Antipodean currencies may suffer rather more challenging environments as the myth of the 2011 recovery fades in the near term.
For equities, however, the primary risk that we see for a major correction from here is less the global slowdown outlined above but more a renewed global crisis - be it a failure to resolve the US public debt ceiling or a crisis that emanates from a breakup of the Euro.
Unfortunately, both are difficult to analyse in an objective way, dependent as they are on the personalities and politics involved. In the case of the US debt ceiling, we perhaps have some confidence that ultimately the politicians will seek to ‘do the right thing' but in the case of the Euro, the situation even following events in Greece in the last week of June are still much too close to call accurately.
As an economist we can point out that far from converging, peripheral unit labour costs (aside from those in Ireland) are continuing to diverge from those in the core, suggesting that rather than "re-equilibrating", the intra Euro Zone competitiveness imbalance problem is worsening rather than improving. From this, we can gather that the Euro periphery needs yet more deflationary pressure applied to it, or the core needs more inflationary pressure applied to it.
However, given the current global environment and given the ECB's current monetary policy settings, significant inflation in the core seems an unlikely prospect at this juncture and hence we can assume that the implied deflationary pressures on the periphery must therefore be increasing significantly. The data and the deteriorating domestic political environments would seem to support this conclusion.
One result of this intensifying deflationary pressure, which the EU seems intent on magnifying even further through more fiscal austerity, has been the ongoing deposit runs in the peripheral banking systems. Presumably, depositors in these countries are now fearing either bank failures or a Euro break up (or a combination of the two) and hence they seem to be fleeing their domestic banking systems.
However, it is these deposit runs that have given rise to not only the signs of renewed and presumably highly deflationary private sector credit crunches in the Euro Zone (outside France at least) but also to the public debt crises now sweeping the region. In 2008-2010, the Euro Zone banking system provided the lion's share of the financing for the European budget deficits but, as the banking crisis has intensified with the deposit runs, the banks have become obliged to ‘fire sale' their public bond holdings merely to survive and it is this that has given rise to the public debt crises.
Moreover, we also note that the banks also appear to be shedding non-Euro assets and incurring more non-Euro liabilities, the proceeds of which they are remitting into Euro in order to shore up their balance sheets, with a wholly counterproductive impact on the value of the EUR.
Indeed, while these flows persist, the EUR will likely remain firm and therefore of little use in restoring competitiveness levels in the region. However, despite the banking crisis, the Franco-German dominated ECB still appears to want to tighten its monetary policy settings further.
Rarely when one writes economics does the level of adrenalin rise but we found that as we wrote the previous three paragraphs, we were in a similar ‘place' to that which we found ourselves when we wrote our reviews just as the Japanese Bubble in late 1989 was about to burst, the Asian Crisis was about to unfold and the GFC was beginning.
Our conclusion is therefore very simple, there is so much currently wrong and "out of equilibrium" within the Euro System that it should in theory be about to break. However, the Euro is not an economic-animal it is a political one-and in theory, the Europeans could collude sufficiently in order to overcome their current adverse situation and so save the system through massive de facto monetised aid package to the periphery, even though this might (would) cause higher inflation in the core over the medium term.
Quite simply, we believe that the familiar Euro Zone policy default option of procrastinate and offer a few soothing promises at a press conference will no longer suffice.
For the Euro to survive, it needs some form of fiscal union and a heavily monetised rescue package from within the Euro Area that takes some of the pressure off the PIIGS and implicitly transfers it to the exchange rate.
Vague promises of stability pacts and fiscal cooperation will no longer suffice, it is time for the ECB to step in and save the Euro but if the ECB fails to act and the Euro Zone does split, then even in the heavily collateralised system in which the global financial world now operates, the impact on the global credit boom will be immense and without the credit boom, asset prices as we have seen would be very vulnerable given the back drop in the real economies at present.
Andrew Hunt International Economist London
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