just in in-tray
FOR PRIVATE CIRCULATION ONLY
Japan Earthquake – Beware broken windows
The horrific events that unfolded in Japan on Friday and over the weekend may be the stuff of the modern media age but the comments of ‘experts’ on the effects of the earthquake and tsunami on the Japanese, Asian and world economies are based on no knowledge. No-one can tell what the costs of this natural disaster will eventually be. One thing is for sure though, stockbrokers will be searching for the ‘angle’ on how to ‘play’ the disaster. Many of them will argue that, terrible though the human cost is, this will result in a boost to the Japanese economy as the rebuilding commences. This is utter nonsense.
Frederic Bastiat wrote about the broken window fallacy in the nineteenth century. It was postulated at that time that if windows were broken then it boosted economic activity because it gave work to glaziers and window makers. Keynesianism is based on the same principles. Bastiat pointed out that every penny spent on mending the broken window resulted in a penny less being spent on all other goods and services. Worse still, since the penny being spent on repairing a hitherto perfectly functioning window has to be diverted from other uses, the broken window results purely in economic loss. Yes, some companies and industries will benefit from the disaster because resources will have to be diverted to them to rebuild and repair. But the Japanese and world economies are simply losers in this whole event because money that would have been spent on other goods and services will have to be spent on rebuilding what already existed beforehand (GDP data, a flow concept, just do not capture this economic loss element – to the stock of economic capacity).
What remains to be seen is how the most deeply-indebted government in the world will be able to respond to the whole reconstruction effort. Japan was already in deep fiscal trouble. The events of Friday and since hasten the day where the supply of government paper will outstrip domestic demand for it. If ever there was an example of why government’s need to run sound fiscal positions – because they never know when a rainy day might become a deluge – this is it.
US retail sales – Duelling taxes
US consumers have at least two competing tax changes to adjust to: first, the explicit reduction in payroll tax withholding which took effect in January, and second, the implicit tax of higher food and energy prices (which we are calling the Global Consumption Tax, or GCT). Of course, the GCT hits households in the emerging markets hardest, as these essential items make up a larger share of the average household budget. Hence, it most endangers the emerging market consumer theme that investors played in spades after Chairman Bernanke first hit the QE panic button in March, 2009. But it would be foolish to ignore the influence of the GCT on a developed nation with, say, a historically high unemployment rate, low nominal wage gains, a hollowed out middle class, a continued household debt contraction, and still falling home prices. In the near term, no doubt the artificial stimulus of the payroll tax cut will dominate as households enjoy the relief of keeping more of what they have earned from their labor effort. However, as we get further into the second quarter, we expect the burden of the GCT take an increasing bite out of consumer spending growth. February’s US retail sales did advance at strong 1% pace, matching expectations of a bounce from the weather suppressed January results. Rather, the surprise came in the form of upward revisions to prior month’s results, and these revisions place higher odds of a 2.25-2.5% real personal consumption gain in Q1 on an annualized quarterly basis. Gas sales did rise 1.4% over January, but autos and parts were also up 2.3%, so no immediate feedback effect of higher gasoline price on discretionary big ticket spending is obvious here yet.
However, we understand from equity analysts that US food producers are set to pass through more of their input cost increases in the months directly ahead, so the GCT should soon become more visible - just as the initial windfall effects of the payroll tax cut wear off. In this regard, we would call your attention to the sharp drop in consumer sentiment in early March, as captured by the University of Michigan survey (see Figure 1 in the attached WeeBits document). Of particular concern is the dive in expectations to 58.3 from 71.6 in February - one of the larger displacements we have seen since the recession. Something has begun to bother US households, and we suspect that something must be the GCT. To avoid a US consumer relapse as the burden of the GCT builds during the second quarter, either private payroll employment gains will need to step up, household savings rates will need to drop off again, or household credit growth will have to return. The Flow of Funds report for the fourth quarter of 2010 may offer some insights on this.
Typically, the domestic private sector (households and firms) goes into a near fetal crouch following large and sustained shocks to their net worth. This effect is all the more dramatic following prolonged asset bubbles, when large private debt has been built up on the back of elevated collateral values. Near the peak of the housing bubble in 2006, the US domestic private sector was deficit spending to the tune of nearly 4% of GDP. Post the asset price bust, households and firms pulled back their spending so dramatically that they achieved a net saving position (with income exceeding expenditures, or equivalently, saving out of income flows exceeding tangible capital investment) of 8.7% of GDP by the quarter following the onset of QE 1. By the Fed’s own admission, QE 1 and 2 are aimed at artificially elevating asset prices in order to reduce domestic private sector net saving via various channels. Primarily, this policy magic is performed through so called wealth and confidence effects on private spending.
Slow movement in that direction was visible through the third quarter of last year, when domestic private net saving had dropped to just 6.7% of GDP. However, the fourth quarter of 2010, when initial QE2 announcement effects should have been visible, saw a jump back up to 7.7% of GDP. The largest contributor to this resurgence appears to have come from the nonfinancial corporate sector, where free cash flow spiked to a near all time high of $280 billion (see Figure 2). We do not wish to overplay a one quarter move, as Flow of Funds data are notorious for large revisions, but this does bring up an essential point that is relevant to the ability of the US consumer to handle the GCT. From an Austrian School perspective, unless firms can find enough opportunities to reinvest their profits in productive capital, economic growth will become dependent upon state sponsored stimulus measures, mercantilist trade policies, or an increasingly leveraged household sector. None of these three tend to be particularly sustainable over the long run (although we admit the longevity of the schemes to keep them going never ceases to amaze us). Total internal funds generated by the nonfinancial corporate sector rose 15% over the year ending last quarter, while fixed capital investment is up only 8% over the same interval. Profits are being reinvested, but not as fast as they are being earned, with the end result being that businesses are in a net saving (or free cash flow) position.
Free cash flow is generally considered a plus for any one company, but if the business sector as a whole is not finding enough reinvestment opportunities, growth will either tend to suffer, or it will become more dependent upon various questionable and artificial schemes. Cash assets sitting on nonfinancial corporate balance sheets have consequently bulged to $1.47 trillion, even though the return on these assets is below 1% in nominal terms, and negative after inflation adjustment. Possibly, the 100% expensing of capital equipment investment under the late 2010 tax compromise will lead to mobilization of some of this cash into productive investment opportunities. Stronger new orders for capital goods are pointing in that direction, but if business reinvestment activities are going to overcome the effects on real GDP growth of the GCT, nothing less than a very sharp acceleration of capital spending is required. Absent stronger business reinvestment rates, the employment growth required to overcome the draining effects of the GCT on US consumer spending power will be hard to come by.
China economy – Why wait?
Yet another slew of Chinese data released last week pointed to the need for higher interest rates but, not for the first time, there was no action over the weekend (no doubt because of the Chinese parliament meetings). Fixed asset investment for February rose 25% YoY while industrial production was up 15% YoY, both ahead of analysts’ expectations. On the other hand, the 19% YoY expected increase in retail sales was missed dramatically and came in at just 11.6%. Consumer price inflation was pretty much in line at 4.9% YoY. All of them spoke to a further tightening in policy and that is what all of the noise out of Beijing points to as well, so why wait? We offer no good explanation except to think that perhaps conditions on the ground are not nearly as firm as the data suggest (more in line with weakening PMI results, perhaps- see Figure 3). Still China needs a more realistic cost of capital and that can only come through higher interest rates. These are just around the corner. Be warned.
Vietnam rate rise – Panic setting in?
As we have warned consistently since our country report in November (Asianomics No 7/2010, Vietnam – Order from chaos?, 10 November) Vietnam faced higher interest rates and the prospect of currency devaluation. Last week refinance rate was raised another 100 basis points – to 12% - taking the total moves since our visit to 400 basis points. The currency has also been devalued by 7.5% with more in the pipeline. The central bank is also curbing loan growth targets for this year in an effort to control the inflation it unwittingly released.
But there are much more worrying signs for potential investors at this point. We wrote extensively in our Asianomics report about the competing currencies in Vietnam (dong, dollars and gold). Some weeks ago the government announced that it was cracking down on gold trading and has attempted to ban gold shops and banks from dealing in anything but gold jewellery (good luck to it). Last week it announced that it was attempting to crack down on the US dollar market as well. Unlicensed dollar traders are being arrested and their currency confiscated. To us this smacks of panic.
Vietnam does not publish data on its international reserves position (it is a state secret) and is also extremely tardy in reporting money supply and loan growth. However, all of the moves in recent weeks – rate rises, devaluation, gold and dollar-trading crackdowns – smack of a central bank that is fast running out of reserves. If anything, we would expect all of these together to result in even more capital flight. The more you keep people in the dark, the more they will assume that something is wrong. Look out for another major devaluation in the near future.
Our Hong Kong Asianomics report is now finished and will be distributed later today. Bottom line is that we need to get back into the property market!
Happy Monday,
Jim |
