Global Manufacturing Downturn Gathers Pace In July

Global Manufacturing Downturn Gathers Pace In July

Edward Hugh - Barcelona: July 2012July Monthly Manufacturing PMI Report

Manufacturing Visibly Slowing Across The Planet

We live in a globalised world. And what better illustration of this than the way in which manufacturing activity is steadily slowing across the globe. In theory the worsening conditions are a by-product of the Euro Debt Crisis, but in reality there are a multitude of factors at work – the slowdown in China, exhaustion of a credit boom in Brazil, a Japan which can’t export as much as it needs to due to the high value of the Yen, a United States where the various rounds of quantitative easing appear to have run out of steam.

We also live in a world which is structurally in transition. The developed countries are overly in debt (especially when we consider health and pension liabilities looking forward) and ageing excessively. The emerging economies are experiencing a massive demographic, cultural and economic transition. The so called “Arab Spring” is just one example of this. Risk is being re-evaluated, with developed world risk rising, at the same time as risk perception of Emerging Economies improves.

So the paths are crossing. Recessions in the developed world will now be more frequent and the recoveries shallower, while EMs will experience substantial catch up growth, while the recessions will be much more modest than previously.

AsiaViewed as a continent, it is very hard to make generalitzacions about Asia. Japan is among the oldest countries on the planet. Domestic demand is congenitally weak, and exports struggle against the weight of an overvalued yen. The important point to notice is that all last years predictions about Tsunami reconstruction bring a new lease of life to the country have proven to be ill founded. All the associated damage has done is produce more debt. And still the economy struggles to grow. This issue will doubtless become worse after the government introduces the long promised increase in consumption tax.

China is suffering from a real estate adjustment which influences internal demand, while the global trade slowdown harms the export sector. In addition, the country’s potential growth rate, after hitting double digits at one point, is now slowing steadily as China steadily moves from emerging economy to mature economy status.

India continues to advance at rates which are not seen in most Asian economies these days, but the country has an endemic inflation problem which remains unresolved, and growth is also hampered by poor infrastructure and widespread corruption.

The semi developed economies like South Korea and Singapore still struggle to overcome weak export demand, and even new emergers like Vietnam and Indonesia remain challenged to find growth at this point.

Emerging Economies Hanging In the BalanceThe key point to appreciate is that with “risk off” due to the European Debt Crisis, even the Emerging Markets are unable to exploit their huge potential for growth. Capital is no longer flowing in in the way it did after the various rounds of QE in the US and even the LTROs in Europe. Investors are playing safe. In addition, external demand is falling as one economy after another in the developed world slides towards recession.

The China factor is also important. China’s economy is obviously slowing, and it isn’t evident to me that it will bounce back any time soon.

Finally, it is important to stress that the BRIC concept was always far too general. It is just based on population size and underdevelopment. The key factor is age structure, and in this sense India and Brazil look very different from Russia and China. Economic growth is partly about favourable demographics, and partly about institutional quality. Some EMs increasingly have the latter, others never will.

Still, it is impressive how some manufacturing sectors (like Indonesia and Vietnam) are now evidently having a hard time of it, while others (India, Turkey) are managing to keep their heads just above water.

My feeling on China is that we won't see a hard crash landing, but that with exports constantly vulnerable to developed word problems, and the construction and property boom steadily unwinding internally we will see a much more protracted period of slower growth than people are expecting. I also think monetary policy will be relatively ineffective in rekindling property related consumption activity in the short term. Growth could easily fall into the 4% to 6% annual range for a time.

C.E.E.

Europe Sinking Into The Mire ECB Action Depends On Requests For Help and EU Conditionality

As Europe’s leaders continue to fiddle around with the debt crisis, the economies of the Euro Area sink deeper into the mire. The latest round of PMIs suggest that the recession is extending into the third quarter with no let up in sight.

Certainly progress is being made in terms of the liquidity and capital needs of Euro Area banks, and further moves to ease sovereign financing difficulties seem to be at hand, But competitiveness issues are still a long way from finding solution. There is no evidence to back the idea of a surge in German inflation, while VAT hikes in country’s like Spain continue to damage their relative cost position.

The ECB has raised market expectations considerably in recent days. In the short run such expectations have foundered on disappointment. In the longer run, however, the ECB is likely to have few unbreachable limits to its freedom of action.

Movement by the EU and the ECB will require formal requests for aid and involve conditionality. When this happens the most likely policy move with be SMP reactivation by the ECB in the secondary market and EFSF purchases in the primary one.

Finally a reminder: it is important to remember the Greek problem has not gone away, it is simply in limbo. The Troika have gone home for now, but they did leave a message, courtesy of the Ramones, “see you in September”.

Euro Area

Europe’s Recession Worsens Entering Q3 Core Now Affected Along With The Periphery, Recession Risk in Germany

Germany’s economy seems to be headed back into recession. With export growth already weakened by the impact of austerity measures on the periphery, the slowdown in Chinese consumption seems to have acted as some kind of killer app.

As Tim Moore, senior economist at Markit put it in his report, “July’s figures suggest that the German economy has started the quarter on a weaker platform than at any time since the 2008/09 recession”. No Sign Of German Inflation

Despite steady loosening in monetary policy at the ECB, and 3% growth in GDP in 2011, there is no real sign of domestic demand driven inflation in Germany. Inter-annual inflation in Germany was only 1.7% in July, compared with the 2.2% registered in credit crunch driven Spain. Fears of (or hopes for) a substantial surge in German inflation as the ECB moves towards some form of QE are greatly exaggerated. Social engineering isn’t that easy.

Italy’s Recession Deepens As Rescue Nears

Italy's national statistics office, ISTAT, issued its preliminary Q2 GDP report this week, estimating that gross domestic product fell 0.7 per cent quarter on quarter in the three months to June, and fell 2.5 per cent below the level of a year earlier. This makes Italy's recession considerably deeper at this point than Spain's. Confindustria, Italy’s main business association, forecasts a 2.4 per cent contraction for the whole of 2012, and there may even be downside risks here..Despite the shrinking economy, the Italian treasury reported late on Monday that tax revenues rose 4.3 per cent to €191bn in the first half of this year compared with the same period in 2011 thanks to the government’s austerity measures. Given the substantial lack of international competitiveness, the Italian economy will struggle to find growth now that fiscal support has been withdrawn.

The June EU summit decision to support funding costs of troubled periphery countries applied to both Spain and Italy. Italy’s position is becoming ever more precarious as the deepening recession drives up the debt to GDP level, while at the same time support for the government lead by Mario Monti weakens.

As with Spain, there will be nothing significant in the way of Italian bond purchases until the Italian government asks for help and formally signs a MoU. This moment seems farther away at this point than the Spanish bailout, and as such there could be a temporary yield inversion whereby pressure on Spanish bonds relaxes even as it intensifies on Italian ones.

Spanish Debt Sustainability

The main point to emerge from recent EU policy decisions is that the future of Spanish sovereign debt is now very much tied to the evolution of the European debt crisis. If the latter is adequately resolved Spanish debt may not even need restructuring, although even with an adequate resolution some form of Private Sector Involvement (PSI) at some point cannot be totally excluded.

The problem is that no one at this point knows, and there really is no way of knowing, whether the crisis will be adequately resolved or not. We thus face a probability distribution where the only possible outcomes are what would normally be considered unlikely tail solutions - either the Euro Area fuses into one single federation (like the USA) or it splinters apart. There really is no middle way.

Institutionally it is to be anticipated that no stone will remain unturned in the attempt to save the single currency. So obviously things like leveraging the ESM which are currently excluded may well eventually become most probable. Even an eventual QE programme of the sort we have seen in the UK, the US or Japan cannot be excluded. At present directly buying sovereign bonds in the primary market is not within the ECB mandate, but as we have seen time and again during this crisis, mandates are interpreted and reinterpreted as needs must, and the current ECB one may even eventually be changed if the alternative is viewed as disaster.

So the Euro is unlikely to break apart as a result of institutional obstacles. If it does eventually do so it will be because civil society (the electorate, citizens in one form or another) refuse to continue with what they consider to be either an excessively painful or unjust situation. Such a move could come from the Core (as voters realise and become alarmed by the real cost to them of sustaining the Euro), or from the periphery, as the sacrifices demanded become unbearable, and political instability results.

Germany

It is important to understand that Germany is already into the “save the euro” process in a way which makes it increasingly expensive for the country to get itself out. Not only would debt obligations not be repaid in full following any German exit, including those which come via the ECB Target2 clearing mechanism, but the country also depends on exports (it is an ageing society where domestic demand is weak) which would make it hard to live with an over-strong currency (look at Japan). So the German financial, industrial and political leadership are likely to try to avoid this outcome at all costs. The fundamental issue is then, how far can they get the rest of the population to follow them?

Spain

It is important to stress that while recent progress has been made in Spain, the country is not out of the woods by any means. The big danger with Spain was always that Sovereign debt would approach 100% of GDP and then the need for a large financial system bailout would suddenly appear. If resolving the needs of the Spanish financial system was to have been carried out in the Irish manner, then Sovereign debt would have become rapidly unsustainable.

Now that the EU has in principle agreed to directly inject money into Spain’s banks, once the ESM is up and running and the Banking Union sufficiently advanced, this danger recedes. Even if much more money than the initial 100 billion Euros down payment should eventually be needed, and I think it will be, the same applies. Germany is now in the John Paul Getty position whereby having someone owe you too much money means you have the problem.

Naturally, the whole banking union and ESM direct recapitalisation issue will need careful monitoring, since it is the type of thing which may make German voters nervous, and this could lead to delays and then even doubts about final implementation. But if fully implemented it would be a game changer for Spain and it is important to realise that.

Once you take the financial system out of the equation then the whole debt position changes. There are lots of issues, like the FADE electricity fund, the regions, the public companies etc, but they are all manageable within limits.

The two big problems looming are the low economic growth outlook and the mounting pension liabilities. Despite the constant denials, lack of international competitiveness is a major problem for Spain. Growth can only come at this point from exports, and the sector is too small after so many years of neglect. In addition the reputational damage being inflicted and the ongoing conversion risk will make it hard to attract the needed FDI in the years to come. So I think we are facing a long drawn out process – maybe a decade – when unemployment will be high, and public spending will be under constant pressure, and the issue is whether the ordinary Spaniard is ready for this. I personally have my doubts, and feel that before the time is up we will see cracks in the political system.

The second main area of concern is the pensions system. The social security reserve fund is effectively “non functional” since it mainly contains Spain Government Bonds that could only be sold into the market at a loss. So, with the number of people contributing to the system going steadily down, and the number of pensioners going systematically up the system is now in permanent structural deficit, and the position is getting worse. The EU is rumoured to be trying to press the Spanish government to address this as part of the forthcoming bailout conditionality, but either way something needs to be done. The number of people working and paying contributions isn’t going to rebound any time soon, and the demands on the system will continue to grow. Hence one day or another push will come to shove.

There are really two sides to the Irish story. The country is keeping pace with its bailout targets, but the real economy is not recovering as expected. This suggests two things. In the first place the bailout targets were excessively attainable, placing far too much emphasisis on achieving fiscal stability, and insufficient on getting the economy back on a sustainable path.

The housing market is still stuck in a bad place, unemployment is too high, and mortgages are increasingly not being paid. Young educated Irish are leaving, making problems worse.

Oh, I Believe In Miracles........

Never was a truer word spoken, even in jest.

When Mario Draghi clarified for the journalists who assembled before him at last week’s ECB press conference what the expression "The euro is irreversible" actually meant, he replied it "means we are not going back to the drachma, the lira" etc. While some may have noted nothing remarkable in the statement, finding it perhaps almost trite, or commonplace even, I thought to myself, "hmmm, now that's an interesting choice of countries".

The conclusion which I for one drew from this observation was that he was trying to tell us the ECB was not (for the moment at least) contemplating any move to cut off Emergency Liquidity Assistance (ELA) access for the Greek banking system. I mean, you would hardly boost the credibility of the institution you represent by saying no one is going to a certain place and then in September sending someone directly there.

And since shutting off access to Eurosystem backed ELA would be the only effective way of driving a Greece that didn't want to go out of the Eurosystem, I also got the impression that what we are going to see in September is likely to be some further attempt to throw a lifeline to the struggling country, at least as far as the EU is concerned. In terms of practicalities the latest round of cuts will be formally accepted, and applauded, while money will be sent into the country, via the backdoor. Using Francoise Hollande's EU growth stimulus programme, perhaps, be this in the form of EU structural funds or long maturity low-interest loans from the European Investment Bank.

Well, now that the some of the details of what was discussed at the ECB meeting have started to be leaked to the press I am pleased to see that my initial hunch was not such a bad one.

Mario was not making some sort of idle, throw away comment, for he knew of that about which he spoke. In the proximate future Greece will not be going back to the Drachma. Nor will it be introducing a second non-convertible currency, since it already has the ability to generate resources on its own account a highly convertible one. Not only are the ECB's Governing Council not planning to cut Greek banks off from the Eurosystem, if a report this weekend in the German Newspaper Die Welt is to be believed, they have even agreed to increase their credit limit.

Until last week the Bank of Greece was only authorised to accept Greek government T-Bills up to a limit of 3 billion euros as collateral for accessing ELA. As of last Thursday, however, that quantity has been increased to 7 billion euros, giving the government effectively another 4 billion euros with which to pay employee salaries, pensions, etc. Greek banks buy the T-Bills at government auctions, and take them to the national central bank to use as collateral for borrowing, in much the same way commercial banks in Portugal, Spain, or Italy use the ECB. The difficulty in the Greek case is the country's credit rating does not enable the ECB to be used as counterparty in these financing operations.

Now I don't know how long it will take the mainstream Euro Crisis pundits to catch up with what has been obvious to me (and among others Willem Buiter) for months now (over a year in fact, at least since Ireland first started accessing ELA and de facto printing its own euros). The reality is that despite the many evident parallels Greece is NOT Argentina. The country can print its own Euros. Argentina could never print dollars, in fact it had to buy or borrow them in order to keep pace with citizen demands for converting all the pesos it was printing. Greek banks simply access German deposits via Target2 to cover their own lost deposits as they move to Cyprus, as long as the collateral lasts that is. But then there is ELA. In addition Greece can get direct access to fund transfers via the EU structural funds programme, while Argentina never had any such bilateral relation with the US. Details don’t solve the big picture problems, but they do matter here.

So while there is no denying the multitude of structural similarities with the Argentina situation - macro imbalances, a structurally distorted economy, no relief through devaluation due to the presence of a de facto peg, a very deep recession as a consequence - there are a host of details which differ. Monetary Union is not simply a currency peg, and this makes many of the key calculations about what to do and when different.

Naturally, none of this is to say that the end of the story won't be the same, but we aren't there yet, there is still some life in the process, and we can't rule out miracles - not "miracle" recoveries of course, we are unlikely to see one of those, but miraculous conversions of the Saul of Tarsus kind, one of which could just happen one day when you least expect it somewhere along that Autobahn which runs between Frankfurt and Berlin.

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