4/10/15: Wither Capital: Why Euro Area Lacks New Investment Opportunities

Here is an unedited version of my 3Q 2015 contribution to the Manning Financial newsletter covering the topic of  capital investment in the Euro area.

Wither Capital: Why Euro Area Lacks New Investment Opportunities

Despite the positive signs of an improving economy, the euro area is hardly out of the woods, yet, when it comes to the post-crisis adjustments. The key point is that the cure prescribed for the ailing common currency area economies by Dr Mario Draghi might less than effective in curing the disease.

The key risk to the euro area today does not stem from the lack of funding for investment that ECB QE and other unorthodox policies target by attempting to flood the markets with cheap liquidity. Instead, they stem from the lack of sustainable demand for new investment.

Here are three facts.

One: between 1991 and 2001, Euro area member states were moderate net investors, with annual capital spending exceeding savings by 0.6 percent of GDP on average, close to the World average of 0.8 percent of global GDP. This meant that savings generated within the Euro area were finding opportunities for investment at home, and to attract some net investment from the rest of the world.

Two: over the period of 2002-2014,  annual investment in euro area was, on average, lower than savings by some 1 percentage point of GDP. And, based on the IMF forecasts, this gap is expected to increase to 3.5 percent over 2015-2020 horizon, even as economy officially recovers. This implies that the future euro area recovery will be driven not by investment, but by something else. Per IMF forecasts, this new driver for growth will be external demand for goods and services from the euro area, plus a bounce from the abysmal years of the crisis. In other words, new growth will not be anything to brag about at the G7 and G20 meetings.

Three: as investment demand dropped across the euro area since 2002, global savings excess over investment actually rose, rising from a net deficit of 0.8 percent of GDP prior to 2002, to a net surplus of 0.2 percent over 2002-2014 period and to a forecast surplus of 0.3 percent of GDP for 2015-2020 period. This suggests that returns on private investment are likely to stay low, globally, pushing down net inflows of capital into the euro area. Chart 1 below illustrates.

Investment Funding Lacking?

Taken together, the above facts suggest that the euro area does not lack funding for investment, but lacks opportunities for productive capital allocation. Consistent with this, QE-generated funding, is flowing not to higher risk entrepreneurial ventures and capital investment, but into negative returns-generating government bonds. And, in the recent past, liquidity was also rushing into secondary markets for corporate debt, to be used to finance shares buy-backs instead of new technology, R&D or product innovation, or old fashioned building up of productive capital.

As the result we are witnessing a paradoxical situation. Companies’ reported earnings are coming increasingly under scrutiny, with rising investor suspicions that sell-side analysts are employing 'smoke and mirrors' tactics to 'tilt' corporate results to the satisfaction of the boards. Corporate earnings per share metrics are being sustained on an upward trajectory by shares repurchases. All along, bonds markets are running short of liquidity even as ECB is pumping more than EUR60 billion per month into them.

Recent analysis of S&P500 stocks in the U.S. has revealed that the difference between adjusted earnings and unadjusted bottom-line earnings or net income has increased dramatically in recent years. Some 20 percent of all companies surveyed posted adjusted earnings more than 50 percent higher than net income. According to the report complied by the Associated Press and S&P Capital IQ, some companies reporting profit on adjusted earnings basis are actually loss making. European markets data is yet to be analysed, but given the trends, it won't be surprising if euro area leading corporates receive a similar 'tilt'.

Of Debt, Leverage & Loose Monetary Policies

All of this reflects cheap debt and leverage finance available courtesy of central banks activism.

Loose monetary policy, however, can provide only a temporary support to the financial assets. It cannot address the deeply structural failures across the real economies.

The key problem is not the short term malfunctioning of the monetary transmission mechanism between ECB record-low interest rates and real investment, but the exhaustion of the structural drivers for growth. Over the 1990s and early 2000s, European economies accumulated debt liabilities to fund growth in domestic demand (public and private investment and consumption). Now, even at extremely low interest rates, the system no longer is able to sustain continued growth in debt. Germany, Italy, the Netherlands and Austria - the net saving economies - are getting grey at an accelerating speed, reducing investors' willingness to allocate their surplus savings to productive, but risky, investments. Their companies, faced with slow growth prospect at home, are investing in new capacity outside the euro area - in Asia Pacific, Central and Eastern Europe, MENA and Africa.

The euro area has been leveraged so much, there is no realistic prospect of demand expansion here over the next decade.

As the result of this, surplus production generated in the saving countries has been flowing out to exports creating a contagion from domestic excess supply to external surpluses on trade accounts. Historically, reinvestment of surpluses converted them into investment abroad. The result was decline in interest rates worldwide. The Global Financial Crisis only partially corrected for this, erasing excess domestic demand and temporarily alleviating asset markets mis-pricing. But it did not correct for debt levels held in the real economy. In fact, current debt levels in the advanced economies are at the levels some 30 percent higher than they were during the pre-crisis period.

Neither did the surplus production and trade imbalances do much for a structural increases in productivity or competitiveness.

Since the start of the crisis, productivity growth declined in the euro area more than in any other developed region or major advanced economy.

At the same time, euro area's favourite metric – the unit labour costs-based index of harmonised competitiveness indicators – on average signaled lower competitiveness during the 2009-2014 period compared to the pre-euro era in eight out of the twelve core euro area states. Another two member states showed statistically zero improvement in competitiveness compared to pre-euro period.

The Key Lessons

The key lesson from the euro area's failed post-crisis adjustment is that debt overhang in the real economy compounds the problem of zero exchange rate flexibility within the common currency area. Flexible exchange rates allow countries to compensate for losses in productivity, competitiveness and for long term external imbalances. Flexible exchange rates also help to deleverage private economies whenever household and corporate debt is issued in domestic currency. In the case of the euro area states, this safety valve is not available.

Creation of the euro has amplified, not reduced, internal imbalances between its member states, while dumping surplus savings into global investment markets and contributing to the declines in the global return to capital and inflating numerous asset bubbles. Surplus supply euro economies, have in effect fuelled housing and financial assets bubbles in the ‘peripheral’ economies of the euro area.

The problem has not gone away since the burst of the bubble. Instead, it has been made bigger by the ECB policies that attempt to address the immediate symptoms of the disease at the expense of dealing with longer term imbalances.

Continuing with the status quo policies for dealing with these imbalances implies sustaining long term internal devaluation of the euro area. Table below shows the gap to 2002-2003 period in terms of overall labour competitiveness currently present in the economies, with negative values showing road yet to be travelled in terms of internal devaluations.

Large scale internal devaluations are still required in all new euro area member states, ex-Cyprus, as well as in Ireland, Italy, Belgium, Finland and Luxembourg. Sizeable devaluations are needed in Austria, France, Netherlands and Slovenia. Of all euro area member states, only Cyprus and Portugal are currently operating at levels of competitiveness relatively compatible with or better than 2002-2003 period average.

The problem with this path is that internal devaluations basically boil down to high unemployment and declines in real wages. In the likes of Ireland, for example, getting us back to 2002-2003 levels of competitiveness would require real wages declining by a further 16.7 percent, while in the case of Greece, maintaining current gains in competitiveness means keeping sky high unemployment unchecked. Political costs of this might be too high for the euro area to stay the course. And ECB policies can’t help much on this front.

An alternative to the status quo of internal devaluations would be equally unpleasant and even less feasible. This would involve perpetual (or at the very least - extremely long term) transfers from Germany, Austria and the Netherlands to the euro area weaker states. It is an unimaginable solution in part because of the scale of such transfers, and in part because the euro area core itself is running out of steam. Germany is now operating in an environment of shrinking labour force and rising army of retirees. The Netherlands and Austria are, potentially, at a risk of rapid growth reversals, as exhibited by Finland that effectively fell into a medium-term stagnation in recent years. Going by the structural indicators, even turning the entire euro area into a bigger version of Germany won’t deliver salvation, as the currency area combines divergent demographics: Berlin’s model of economic development is simply not suitable for countries like Ireland, Spain and France, and unaffordable for Italy.

The third path, open to Europe is to unwind the euro area and switch back to flexible currencies, at least in a number of weaker member states.

Speculations on the future aside, one thing is clear: euro area is not repairing the imbalances that built up over the 1998-2007 period. Even after the economic crisis that resulted in huge dislocations in employment, wages, investment and fiscal adjustments, productivity is not growing and demand is stuck on a flat trajectory.

Support from the ECB via historically unprecedented monetary measures and billions pumped into some economies via supranational lending institutions, such as EFSF, ESM and IMF are not enough to correct for this reality: euro area is new Japan, and as such, it simply lacks real opportunities for a new large scale boom in investment.

4/10/15: CFR: Global Debt Bubble

My recent column for the Cayman Financial Review on the Global Debt Bubble: http://www.compasscayman.com/cfr/2015/08/19/The-global-debt-bubble-/.

4/10/15: Secular Stagnation and the Promise of the Recovery

An unedited version of my recent requested guest contribution for News Max on the issue of secular stagnation (July-August 2015).

Secular Stagnation and the Promise of the Recovery

Recent evidence on economic growth dynamics presents a striking paradox. As traditional business cycles go, recovery period following a prolonged recession should follow certain historical regularities. Shortly after exiting a recession, growth in productivity, output, investment and demand accelerates and exceeds pre-crisis growth.

These stylized facts are absent from the data for the major advanced economies to-date, prompting three distinct responses from the economic growth analysts. On the one hand, there are proponents of two theories of secular stagnation – an idea that structurally, long-term growth in the advanced economies has come to a grinding halt either due to the demand side collapse, or due to the supply side exhausting drivers for growth. On the other hand, the recovery bulls continue to argue that the turnaround reflective of a traditional recovery is likely to materialize sometime soon.

In my opinion, neither one of the three views of the current economic cycle is correct or sufficient in explaining the lack of robust global recovery from the crises of 2007-2009 and 2011-2014. Instead, the complete view of today’s economy should integrate the ongoing secular stagnation thesis spanning both the supply and the demand sides of the global economy.

The end game for investors is that no traditional indexing or asset class approach to constructing investor portfolios will offer a harbor from the post-QE re-pricing of economic fundamentals. Instead, longer-term strategy for addressing these risks calls for investors targeting smaller clusters of opportunities in sectors that can be viewed as buffers against the secular stagnation trends. Along the same lines of reasoning, forward-looking economic policymaking should also focus on enhancing such clustered opportunities.

Investment-Savings Mismatch

The demand-based view of secular stagnation suggests that the global growth slowdown is linked to a structural decline in consumption and investment, reflected in a decades-long glut of aggregate savings over investment.

This theory, tracing back to the 1930s suggestion by Alvin Hansen, made its first return to the forefront of macroeconomic thinking back in the 1990s, in the context of Japan. By the early 1990s, Japan was suffering from a demographics-linked excess of savings relative to investment, and the associated massive contraction in labor productivity. During the 1980-1989 period, Japan's real GDP per worker averaged 3.2 percent per annum. Over the following two decades, the average was 0.81 percent. Meanwhile, Japan's investment as a percentage of GDP gradually fell from approximately 29-30 percent in the 1980s to just over 20 percent in 2010-2015.

The Great Recession replicated Japanese experience across the majority of advanced economies. Between 1980 and 2014, the gap between savings and investment as percentage of GDP has widened in North America and the Euro area. At the same time, labor productivity fell precipitously across all major advanced economies, despite a massive increase in unemployment.

Some opponents of the demand side secular stagnation thesis, most notably former Fed Chairman Ben Bernanke, argue that low interest rates create incentives for investment and reduced saving by lowering the cost of the former and increasing the opportunity cost of the latter.

However, this argument bears no connection to what is happening on the ground. Current zero rates policies appear to reinforce the savings-investment mismatch, not weaken it, rendering monetary policy impotent, if not outright damaging.

How can this be the case?

Today's pre-retirement generations are facing insufficient pensions coverage. For them, lower yields on retirement investments, tied to lower policy rates, are incentivizing more aggressive savings, further suppressing returns on investment. Meanwhile, middle age workers face severe pressures to deleverage their debts accumulated before the crisis, while supporting ageing parents and, simultaneously, increasing numbers of stay-at-home young adults.

To address the demand-side of secular stagnation in the short run, requires lifting the natural rate of return on investment, without increasing retail interest rates. This will be both tricky for policymakers and painful for a large number of investors, currently crowded into an over-bought debt markets.

The only way real natural rate of return to investment can rise in the environment of continued low policy and retail rates is by widening the margin between equity and debt returns for non-financial assets and reducing tax subsidies awarded to physical and financial capital accumulation. In other words, policymakers must rebalance taxation systems to support real enterprise formation, entrepreneurship and equity investment, while reducing incentives to invest in debt and financial assets.

Good examples of such policy tools deployment can be found in the areas of gas and oil infrastructure LLPs and property REITs used to fund long-term physical capital investments via tax optimized returns structures. Transforming these schemes to broader markets and to cover non-financial, technological and human capital investments, however, will be tricky.

From the investor perspective, the demand-side stagnation thesis implies that  longer-term investment opportunities will be found in allocations targeting entrepreneurs and companies with organic growth that are debt-light, technologically intensive (with a caveat explained below) and human capital-rich. There are no real examples of such companies currently in the major stock markets’ indices. Instead, the future growth plays are found in the high risk space of start ups and early stage development ventures in the sectors that bring technology directly to end-user engagement: biotech, nanotechnology, remote health, food sciences, wearables, bio-human interfaces and artificial intelligence.

Tech Sector: Value-Added  Miss

The caveat relating to technology investments briefly mentioned above is non-trivial.

Today, we have two distinct trends in technological innovation: technological research that leads to increased substitution of labor with technology and innovations that promise greater complementarity between labor and human capital and the machines.

The first type of innovation is what the financial markets are currently long. And it is also directly linked to the supply-side secular stagnation thesis formulated by Robert Gordon in the late 2000s. The thesis challenges the consensus view that the current technological revolution will continue to fuel a perpetual growth cycle.

Per Gordon, "The frontier established by the U.S. for output per capita, and the U. K. before it, … reached its fastest growth rate in the middle of the 20th century, and has slowed down since.  It is in the process of slowing down further." The reason for this is the exhaustion of economic returns to technological innovation.  Financial returns are yet to follow, but inevitably, with time, they will.

Gordon, and his followers, argue that a sequence of three industrial or technological revolutions explains the historically unprecedented pace of growth recorded since the mid-18^th century. "The first with its main inventions between 1750 and 1830 created steam engines, cotton spinning, and railroads. The second was the most important, with its three central inventions of electricity, the internal combustion engine, and running water with indoor plumbing, in the relatively short interval of 1870 to 1900.” However, after 1970 “productivity growth slowed markedly, most plausibly because the main ideas of [the second revolution] had by and large been implemented by then.” Thus, the computer and internet age – the ongoing third revolution – has reached its climax in the late 1990s and the productivity gains from the new computer technologies has been declining since around 2000.

Gordon’s argument is not about the levels of activity generated by the new technologies, but about the declining rate of growth in value added arising form them. This argument is supported by some of the top thinkers in the tech sector, notably the U.S. tech entrepreneur and investor, Peter Thiel.

The older generation of players in the tech sector attempted to challenge Gordon’s ideas, with little success to-date.

A recent study from IBM, titled "Insatiable Innovation: From sporadic to systemic", attempted to show that technological innovation is alive and well, pointing to evolving ‘smart’ tech, globalization of consumer markets, and universal customization of production as signs of potential growth capacity remaining in tech-focused sectors.

However, surprisingly, the study ends up confirming Gordon’s assertion. Tech industry today, by focusing on substituting technology for people in production, is struggling to deliver substantial enough push for growth acceleration. The promise of new technologies that can move companies toward more human capital-intensive modes of production remains the stuff of the future. Meanwhile, marginal returns on investment in today’s technology may be non-negligible from the point of view of individual enterprises, but they cannot deliver rapid rates of growth in economic value added over time and worldwide.

Disruptive Change Required

In my view, the reason for this failure rests with the nature of the modern economy, still anchored to physical capital investment, where technology is designed to replace labor. As I noted in a number of research papers and in my TED presentation a couple of years ago, long-term global growth cycles are sustained by pioneering innovation that moves economic production away from previously exhausted factors (e.g. agricultural land, physical trade routes, steam, internal combustion, electricity, and, most recently capital-enhancing tech) toward new factors.

Thus, the next global growth cycle can only arise from switching away from traditional forms of capital accumulation in favor of structurally new source of growth. The only factor remaining to be deployed in the economy is that of human capital.

Like it or not, to deliver the growth momentum necessary for sustaining the quality of life and improvements in social and economic environment expected by the ageing and currently productive generations will require some radical rethinking of the status quo economic development models.

The thrust of these changes will need to focus on attempting to reverse the decline in returns to human capital investment (education, training, creativity, ability to take and manage risks, entrepreneurship, etc) and on generating higher economic value added growth from technological innovation.

The former implies dramatic restructuring of modern systems of taxation and public services to increase incentives and supports for human capital investments and their deployment in the economy.  The latter requires an equally disruptive reform of the traditional institutions of entrepreneurship and enterprise formation and development.

From investor perspective, this means seeking opportunities to take equity positions in companies with more horizontal, less technocratic distributions of management and ownership. Cooperative, mutual, employees-owned larger ventures and firms offer some attractive longer term valuations in this context. Entrepreneurs who are not afraid to allocate wider ranges of managerial and strategic responsibilities to a broader group of their key employees are also interesting investment targets.

Within sectors, companies that offer more flexible platforms for research and development, product innovation, customer engagement and are design and knowledge-rich will likely outperform their more conservative and rigid counterparts over the long run.

The new world of structurally slower growth does not imply lack of opportunities for investors seeking long run returns. It simply requires a new approach to investment allocation across asset classes and individual investment targets. When both, supply and demand sides of the economic growth equation face headwinds, safe harbours of opportunities lie outside the immediate path of disruption, in the areas of tangible real equity closely linked to the potential drivers of future growth.

2/10/15: BRIC Manufacturing PMI: 7th month of Sectoral Recession in September

Manufacturing PMIs for BRIC countries for September generally remained on the downward trend established some 7 months ago.

• I have covered Russian Manufacturing PMI earlier here with index reading signalling slower rate of decline in the sector activity in September, rising to 49.1 from 47.9 in August. This is the highest reading in the series since February 2015, but marks 10th consecutive month of sub-50 readings.
• China Manufacturing PMI was covered in detail here showing a strong signal of continued deterioration in the economy.
• Meanwhile, Brazil posted a rise in Manufacturing PMI from horrific 45.8 in August to ugly 47.0 in September. This was the eighth consecutive month of sub-50 readings in Brazil Manufacturing sector, with extremely weak performance setting in back in Q 2014 and continuing basically without interruption since then. Per Markit, “although rates of contraction in new orders and production eased, the downturn remains sharp. Companies continued to shed jobs and reduce inventory levels.” Quarter performance was poor, but I will cover this in a separate post. Brazil is now the worst performing BRIC economy in Manufacturing sector activity for 8 months running.
• India continued to break the BRIC trend, posting another above 50 PMI reading for Manufacturing Sector. India Manufacturing PMI in September was running at 51.2, down from 52.3 in August and marking the slowest pace of growth in seven months, “mirroring a slower increase in new orders. Staffing levels were, consequently, reduced and purchasing activity rose at the weakest pace since December 2013. …New business from abroad expanded at the slowest pace in the current 24-month sequence of growth and one that was marginal overall.”

Table below summarises key readings:

Chart below illustrates key trends:

Overall, Manufacturing activity remains on a downward trajectory in 3 our of 4 BRIC economies, with negative trends accelerating in the case of China (second worst performer for the third month in a row), remaining steady in the case of Brazil (worst performer over last 8 months), slightly moderating in terms of contraction in Russia (third worst performer over the last three months). Meanwhile, growth in India is declining toward anaemic levels of activity. 

2/10/15: The plight of Irish self-employed and our backward economic policies

This is a copy of the Business Retail Union of Ireland public letter sent to the Minister for Social Protection regarding equal treatment of the self-employed in Ireland:

Source: @brui_ie

The key questions raised in this letter are other questions of great importance to this country for a number of reasons are:

1. Per latest CSO data there were 327,500 self-employed persons in Ireland in 2Q 2015, constituting 16.9 percent of total employment in the country. The number of self-employed persons is roughly comparable to the current counts of people on Live Register (332,000). Which means these are hardly ‘negligible’ or ‘small’ numbers. What is being done to make sure these people have access to basic, normal, civilised levels of representation in the economic and social system that is, allegedly, modern Ireland?
2. Self-employed people in Ireland face upfront tax penalty for their activities in terms of higher rates of taxation and higher cost of tax compliance. Why? Where is the balance between proportionality of taxation and representation?
3. Self-employed people in Ireland have no access to basic social protection benefits that PAYE workers can avail of. Why? Where is the balance between social services access based on need vs access based on privilege of arbitrary categories of employment?
4. Self-employed people in Ireland have no access to basic training and jobs activation schemes that PAYE workers can avail of. Why? Again, per (3) above, where is that balance?
5. Self-employed people in Ireland are discriminated against in access to state pensions. Same questions as in (4).
6. Self-employed people in Ireland have to deal with huge degree of income volatility with our tax system inducing more uncertainty in their after-tax income than PAYE workers. Why is that the financial markets operate on a basic principle of risk premium, whilst markets for human capital operate on the basis of risk penalty?
7. Self-employed people in Ireland have no basic supports in terms of annual holidays, sick leave, family leave, etc and are often placed at severe disadvantage compared to some PAYE and public sector workers in terms of jobs-related benefits. Which, of course, is understandable, but reinforces the point made in (6) above.

Many of the above differences cannot (and probably should not) be removed by state policies (e.g. (7)). Others can. None have been removed and no one - in our leadership establishment - appears to, frankly put, give a damn.

However, the reality of modern workforce is that:

• Self-employment is going to rise dramatically in the future as our economy moves further and further along the lines of developing skills, professional occupations employment and a ‘gig’-economy. In simple terms, global economy is becoming more and more self-employment intensive and Ireland can’t avoid the same fate, no matter how ignorant our policymakers remain;
• The recent decline (on pre-crisis trend) in self-employment is driven by the sheer mass of economic activity destruction in Ireland since the onset of the Global Financial Crisis, highlighting the extreme nature of jobs and income security volatility faced by the self-employed;
• Self-employment is set to expand in the future as we become more entrepreneurial and intrapreneurial.

If anything, current penalty to the self-employed should not only be erased, but reversed, due to higher risk nature of their work, they deserve a risk premium, not a risk penalty in the markets.

It is high time we gave a thought as to how on earth can we continue developing an entrepreneurial modern, human capital-based economy whilst penalising starting entrepreneurs and people taking risk deploying their skills through self-employment. Bragging about ‘entrepreneurial Ireland’ and ‘knowledge economy’ at international venues can’t get us anywhere, if we fail to first reform ourselves. The mentality of civil service ‘jobs-for-life’ entitlement culture that dominates our policy formation has to change. Good starting point - addressing the above issues for the self-employed.

1/10/15: Emerging Markets Debt v Equity

Debt, not equity, is the real China Fault Line, even if tremors are rocking its stock markets:

What we have in the above is a record of debt/equity in corporate valuations across the EMs and China. While debt pile relative to equity valuations has grown in the EMs ex-China (though it still sits below parity), in China, growth in debt has been exponential. Inly in 2007 did Chinese debt/equity ratio come close to parity (albeit from above 1) and ever since, debt growth outpaced expansion in equity valuations.

Bad enough. Except when one considers an even more dangerous side to this markets: debt growth likely led equity valuations. Which implies, if confirmed, that Chinese markets investors have simply ignored debt valuations in their balancesheet pricing of Chinese companies. In other words, straight out of Krugmanite book (for countries), 'debt doesn't matter'.

Good luck with that...

1/10/15: Of global equities and Gold

Bloomberg's @M_McDonough just posted a fresh chart for major global stocks indices rebased to the start of 2015:

The scary bit is that this is in own-currency terms and that the rot is well beyond the EMs and China.

I cover some of these issues in a guest contribution to GoldCore's quarterly review for 3Q - read in full here.

1/10/15: Russia Manufacturing PMIs: Some Easing in Contraction

Russia’s manufacturing PMI released by Markit showed slower rate of decline in the sector activity in September, rising to 49.1 from 47.9 in August. This is the highest reading in the series since February 2015, but marks 10th consecutive month of sub-50 readings.

Per Markit: both output and new orders posted “negligible growth” in September. More importantly:

• “…excess capacity remained prevalent, leading to further job cuts, while price pressures continued to intensify due to a lower value of the rouble against other major international currencies.”
• “Contributing to the rise in the PMI in September were improved trends in output and new orders, following a period of contraction. In particular, the intermediate goods sector performed well, recording rises in both output and new work. There were reports from the survey panel that domestic demand had firmed over the month and was a key support to production and order books.”
• Key driver to the upside, therefore, was imports substitution. 
• “International demand, in contrast, continued to deteriorate, as highlighted by a fall in new export orders for a twenty-fifth successive month. The rate of contraction was again solid, but nonetheless the slowest since June.”

Overall, Manufacturing PMI signal, in my view, is not yet consistent with expected stabilisation of the economy. Remember, I recently noted that previous hopes for economic recession bottoming out in 2Q 2015 have been squashed by the data, with new consensus outlook for stabilisation in 3Q. Based on the data to-date, this stabilisation did not take place. We are now looking at another quarter of below zero growth and most likely will see sub-zero GDP growth through 4Q 2015 as well.

Chart to illustrate manufacturing sector activity trends:

Note: I covered China Manufacturing, Services & Composite PMIs for September in an earlier note here http://trueeconomics.blogspot.ie/2015/10/11015-china-pmis-signalling-deeper.html. Overall, Russian Manufacturing PMI (and the exports component of the index especially) are broadly in line with Chinese data so far.

1/10/15: China PMIs: Signalling Deeper Problems Ahead

Latest Manufacturing and Services PMI data for China posted a strong signal of continued deterioration in the economy.

Manufacturing PMI came in at the lowest levels since March 2009, posting 47.2 in September, compared to 47.3 in August, and marking 7th consecutive month of sub-50 readings. Over the last 12 months, Manufacturing PMI reached above 50.0 in just two months, hit exactly 50.0 in one (marking zero growth in the sector) and was below 50 (marking contraction of activity) in the rest. Last time Manufacturing PMI was statistically above 50.0 was in July 2014 and last time it happened before then was in October-November 2013. In other words, there has not been statistically significant growth singled by Manufacturing PMIs for some two years now.

Per Markit release, things were even worse than the headline Manufacturing index suggested:

• “Total new work fell at the quickest rate in over three years, partly driven by a steeper fall in new export business. 
• “As a result, companies cut output at the sharpest rate in six-and-a-half years, while staff numbers fell at the quickest pace since the start of 2009. 
• “The health of the sector has now deteriorated in each of the past seven months. Furthermore, the latest deterioration was the most marked since March 2009.”

On Services side, Markit’s Services PMI for September came in at 50.5, the lowest reading since July 2014. Services PMI for China has never posted a sub-50 reading in the series history, so there is little we can tell about actual levels of activity in the sector based on this data. Still, 50.5 reading is so bad, it ranks as the second lowest reading in the history of the series.

Which brings us to the Composite PMI. China’s Composite PMI posted another sub-50 reading, falling from August 48.8 to September 48.0. This implies the fastest rate of contraction across the economy since January 2009.

Per Markit:

• “Employment trends continued to diverge across the manufacturing and services sectors in September. Manufacturers cut their workforce numbers at a solid pace that was similar to that seen in the prior month, while service providers continued to increase their payroll numbers. However, the rate of job creation was only slight, despite improving upon August’s fractional pace. Consequently, employment at the composite level declined for the fourth successive month.
• “Manufacturing companies signalled a further increase in outstanding workloads in September, which was often linked to reduced productive capacity. Meanwhile, softer growth in new work enabled service sector firms to work through their unfinished business in September and at the fastest rate in ten months. Overall, backlogs of work declined again at the composite level, albeit at a marginal rate.”

In simple terms, whatever growth was squeezed out of both sectors, that growth came from depleting outstanding orders, rather than signing new business.

Two charts to highlight these trends:

28/9/15: Blow Outs in the Markets: Beware of Debt Financing

 This is an unedited version of my article in the Village Magazine from June 2015.

Three recent events, distinct as they may appear, point to a singular shared risk faced by the Irish economy, a risk that is only being addressed in our policy papers and in the mainstream media.

Firstly, over the course of May, European financial markets have posted surprising rises in Government and corporate bond yields amidst falling liquidity, widening spreads and increased volatility.

Secondly, both the IMF and the Irish Government have recognised a simple fact: once interest rates revert back to their 'normal' path, things will get testing for the Irish economy.

And thirdly, the Irish Government has quietly admitted that the fabled arrears solutions to our household debt crisis are not working.

Deep below the lazy gaze of Irish analysts, these risks are connected to the very same source: the massive debt overhang that sits on the back of our struggling economy.

Stability? Not So Fast.

Take the first set of news. The problem of spiking yields and blowing up trading platforms in the European bond markets was so pronounced in May, that the ECB had to rush in with a bold promise to accelerate its quantitative easing purchases of Government paper to avoid an even bigger squeeze during the summer. All in, between January and the end of May, euro area government bond yields rose by some 6 basis points, cost of non-financial corporate borrowings rose by around 9 basis points, and banks' bond yields were up 1 basis point. All in the environment of declining interbank rates (3-month Euribor is down 10 basis points) and massive buying up of bonds by the ECB.

In one recent survey completed by the Euromoney before May bond markets meltdown almost 9 out of 10 institutional investors expressed deep concerns over evaporating market liquidity (higher costs of trading and longer duration of trades execution) in the sovereign bond markets. In another survey, completed in late 1Q 2015 by Bank of America-Merill Lynch, 61% of large fund managers said that European and U.S. stocks and bonds are currently overvalued - the largest proportion since the survey began back in 2003.

In the U.S., current consensus expectation is for the Federal Reserve to start hiking rates in 3Q 2015. In Europe, the same is expected around Q3 2016. And recently, both estimates have been moving closer and close to today, despite mixed macroeconomic data coming from the economies on the ground. If the process of policy rates normalisation coincides with continued liquidity problems in the bonds markets, we can witness both evaporation of demand for new government debt issues and a simultaneous increase in the cost of funding for banks, companies and the Governments alike.

Cost of Credit

Which brings us to the second point - the role of interest rates in this economy.

In recent Stability Programme Update (SPU) filled with the EU Commission, the Department of Finance provided a handy exercise, estimating the impact of 1% rise in the ECB key rate. The estimates - done by the ESRI - show that in 2017, a rise in ECB rate to 1 percentage point from current 0.05% will likely cost this economy 2.1% of our GDP in 2017, rising to 2.4% in 2018 and 2019. By 2020, the effect can amount to the losses of around 2.5% of GDP.

This increase would bring ECB rates to just over 1/3rd of the historical pre-crisis period average - hardly a major 'normalisation' of the rates. Which means that such a hike will be just a start in a rather protracted road that is likely to see rates rising closer to 3-3.5 percentage points.

But here is a kicker, the ESRI exercise does not account fully for the realities on the ground.

In addition to the ECB rate itself, several other factors matter when we consider the impact of the interest rates normalisation on the real economy. Take for example cost of funds in the interbank markets. Average 12 months Euribor - prime rate at which highest-rated euro area banks borrow from each other - averaged 3.29% for the period of 2003-2007. Today the rate sits at 0.18%. Which means rates normalisation will squeeze banks profits line. If euro area, on average, were to hike their loans in line with ECB increases, while maintaining current 12 months average lending margins, the rate charged on corporate year and over loans in excess of EUR1 million will jump from the current 2.17% to 3.37%.

It turns out that due to our dysfunctional banking system, Irish retail rates carry a heftier premium than the euro area average rates, as illustrated in Chart 1 below. Which, of course, simply amplifies the impact of any change in the ECB base rate on Ireland’s economy.

The reason for this is the pesky issue of Irish banks profitability - a matter that is distinct from the euro area average banking sector performance due to massive non-performing loans burden and legacy of losses carried by our banking institutions. Per latest IMF assessment published in late April, Irish banking system is the second worst performing in the euro area after the Greek when it comes to existent levels of non-performing loans. In today's terms, this means that the average lending margin charged by the banks in excess of ECB policy rate is 3.4% for house purchase loans, 5.63% for loans to Irish companies under EUR1 million with a fix of one year and over, and 4.0% for loans to same companies in excess of EUR1 million. Which means that a hike in the ECB rate to 1% will imply a rise in interest rates charged by the banks ranging from 0.84% for households loans, to 0.92% for smaller corporate loans and to 1.22% for corporate loans in excess of EUR1 million.

Chart 2 below highlights what we can expect in terms of rates movements in response to the ECB hiking its base rate from the current 0.05% to 1%.

No one - not the ESRI, nor the Central Bank, nor any other state body - knows what effect such increases can have on mortgages arrears, but is pretty safe to say that households and companies currently experiencing difficulties repaying their loans will see these problems magnified. Ditto for households and companies that are servicing their debts, but are on the margin of slipping into arrears.

While the ESRI-led analysis does enlighten us about the effects of higher rates on tax revenues and state deficits, it does little in providing any certainty as to what happens with consumer demand (linked to credit), property investment and development (both critically dependent on the cost of funding), as well as the impact of higher rates on enterprise formation and survivorship rates.

In addition, higher rates across the euro area are likely to imply higher value of the euro relative to our major trading partners' currencies. Which is not going to help our exporters. Multinational companies trading through Ireland are relatively immune to this effect, as most of their trade is priced internally and stronger euro can be offset by accounting and other means. But for SMEs exporting overseas, every percentage point increase in the value of the euro spells lower sales and lower profits.

Debt Overhang: It Matters

Across the euro area states, there are multiple pathways through which higher rates can drain growth momentum in the economy.

But in Ireland's case, these pathways are almost all invariably adversely impacted by the debt overhang carried by the households and the corporate sectors. Current total debt, registered in Irish financial institutions as being extended to Irish households and resident enterprises stands at just over EUR263.7 billion. And that is before we take into the account our Government debt, as illustrated in Chart 3.

A 1 percentage point increase in retail rates can see some EUR2.64 billion worth of corporate and household incomes going to finance existent loans - an amount that is well in excess of EUR2.28 billion increase in personal consumption recorded in 2014 compared to 2013, or 24% of the total increase in Ireland's GNP over the same period. Add to that added Government debt costs which will rise, over the years, to some EUR1.5 billion annually.

What is not considered in the analysis is that at the same time, rising cost of credit is likely to depress the value of the household's collateral, as property prices are linked to credit markets conditions. Which means that during the rising interest rates cycle, banks may be facing an added risk of lower recovery from home sales.

The effect of this would be negligible, if things were relatively normal in Irish mortgages markets. But they hardly are.

At the end of Q4 2014, total number of mortgages in arrears stood at 145,949 accounts, amounting to the total debt of EUR29.8 billion or 18% of total lending for house purchases. 94,929 accounts amounting to EUR14.94 billion of additional debt were restructured and are not in arrears. Roughly three quarters of the restructured mortgages involve 'solutions' that are likely resulting in higher debt over the life time of the restructured mortgage than before the restructuring was applied. We cannot tell with any degree of accuracy as to how sensitive these restructured mortgages are to interest rates changes, but arrears cases will be much harder to resolve in the period of rising rates than the cases so far worked out through the system.

When, Not If…

You'd guess that the ESRI and Department of Finance would do some homework on all of the above factors. But you would be wrong. There is no case-specific risks analysis relating to interest rates changes performed. Perhaps one of the reasons why majority of analysts have been dismissing the specific risks of interest rates increases is down to the lack of data and models for such detailed stress-testing.

Another reason is the false sense of security.

Take the U.S. case. The U.S. economy is now in an advanced stages of mature recovery, based on the most recent survey of economic forecasters by the BlackRock Investment Institute. But the underlying weaknesses in growth remain, prompting repeated revisions of analysts' expectations as to the timing of the Federal Reserve rates hikes. Still, the Fed is now clearly signaling upcoming rate hike.

The Fed is pursuing a much broader mandate than the ECB - a mandate that includes the target of full employment. The twin mandate is harder to meet than the ECB's singular objective of inflation targeting.

While the European inflation is low, it is not as low as one imagines. Stripping energy - helped by the low oil prices - inflation in the Euro area was estimated to be at 0.7% in April 2015. Combined, prices of gas, heating oil and fuels for transport shaved 0.66 percentage points off headline inflation figure. Although 0.7% is still a far cry from 'close to but below 2%' target, for every 10% increase in energy prices, HICP metric watched by the ECB will rise approximately 1.06 percentage points. So far, in April 2015, energy prices are down 5.8% y/y - the shallowest rate of decline in 5 months. Month on month prices rose 0.1 percentage points.

Sooner or later, interest rates will have to rise.  In the U.S., explicit Fed policy is that such increases will take place after the real economy recovers sufficiently to withstand such a shock. In the euro area, there is no such policy in place, in the aggregate, across the entire common currency area, and in the case of specific weak economies, such as Ireland, in particular.

24/9/15: Ireland's Remittances and Foreign Workforce

In a recent post, titled  "Ireland: a land of un-remarkable savers",  I covered EU Commission research on savings rates across different countries.

One interesting finding in the report relates to the issue net remittances or transfers from the country to foreign destinations net of inflows of funds from abroad into the country. These figures cover household remittances, so no direct effect of FDI and other investment flows in them.

Take a look at the following chart:

In absolute terms, Ireland leads the EU in terms of net remittances outflows abroad as percentage of the Gross National Income. Keep in mind - Cyprus was in an emergency funding situation from January 2012 on (when the country first received Russian emergency loans) and requested assistance from the EU in mid-2012, with actual bailout package agreed a year later. In other words, much of 2012 net outflows of household funds from Cyprus was probably down to relatively panicked situation in the country financial sector.

Ireland's net remittances outflows were running, in contrast, against more stabilised situation and inflows of funds from a number of emigrants who left during the crisis. Demographically, these can be divided into three categories:

• Returning migrants (who have little connection to Ireland and, thus, were more likely to take funds out of Ireland on their exit);
• Younger Irish workers (who would have left older family behind and whose earnings abroad would not have allowed for them to become net sender of funds into Ireland) and
• Middle-aged families, who often left properties behind with outstanding mortgages that required regular remittances into Ireland to fund.

The key for Ireland's position at the bottom of the European remittances table is, most likely, foreign workers in Ireland sending their surplus earnings/savings abroad for the lack of interest in investing in Irish assets (property and financial assets). If so, we have a problem: Ireland attracts large numbers of highly skilled younger workers who come here to work in MNCs-led sectors, such as ICT and ICT services, as well as Financial services. These workers, judging by remittances outflows, have little anchoring in the Irish economy.

As the result of remittances (counting only unrecorded remittances, and omitting the deeply negative official remittances), Irish savings rate falls from 14th in the EU to 17th in the EU:

24/9/15: The Ugly Faces of Trade Protectionism

Neat chart from Credit Suisse summarising the extent (and distribution) of new protectionist policies across several key economies:

Several points worth making:

• The obvious one: the U.S. leads in terms of protectionism. Which is ironic, given the U.S. championship of open trade agreements (TTIP and TPP being the most current ones) and the U.S. tendency to de-alienate the world into 'Free Trade' and 'Protectionist' groups of countries.
• BRIC come second and Europe comes third. Which is again highly ironic as BRIC rely heavily on trade-driven model for growth and Europe can't get over how (allegedly) free trade it is.
• Everywhere, save Russia and the U.S., state aid & bailouts is minor segment of trade protectionism policies.
• Export subsidies are meaningful in China and India.
• Trade defence and finance measures dominate in the U.S., India, Brazil and Europe, and are weaker in Japan and China, while virtually non-existent in Russia.

All-in - a pretty ugly picture of reality post-crisis.