Lack of global aggregate demand

Bill Gross had some really good words in his March letter (link), discussing the lack of global aggregate demand:

“To begin with, let’s get reacquainted with the fundamental economic problem of our age – lack of global aggregate demand – and how we got to where we are today: Twenty years of accelerated globalization incrementally undermined the real incomes of most developed countries’ workers/citizens, forcing governments to promote leverage and asset price appreciation in order to fill in what is known as an “aggregate demand” gap – making sure that consumers keep buying things. When the private sector assumed too much debt and asset prices bubbled (think subprimes and houses, or dotcoms/NASDAQ 5000), American-style capitalism with its leverage, deregulation, and religious belief in lower and lower taxes reached a dead end. There was a willingness to keep on consuming, there just wasn’t the wallet.”

An old world piling on debt to overindulge. At some point the debt to income ratio reaches a limit and default start to grow. The financial system breaks down, welcome to the credit crisis. On the other side you have a new world continuously adding on new production capacity, and following a mercantilist policy, without caring about having a matching global demand. Now the old world can’t afford more, while the new does not show much interest in creating internal demand and rebalancing its growth model. And why would it, it worked so well in the last decade.

This split is also true between “new” and “old” world countries, like the Eurozone, with Germany in the role of China, and the PIIGS replacing the US. Germany has no desire to rebalance, the country has enjoyed a nice ride…

So this is the current state of the world economy: a global lack of aggregate demand.

So where do we go from there? Is there an alternative to rebalancing? Can government provide a smooth transition by stepping in and temporary creating demand? That was the idea, within the framework of a global “Keynesian” ideology. So for now governments are using their credit cards to support the aggregate demand by taking on more debt. Unfortunately, by doing so they are not removing the previous imbalances. On the contrary, they are increasing them.

The US for example is promoting consumption, by providing relief for the consumers (mortgage refinancing, tax relief, longer unemployment, generalized healthcare). On the contrary, a country like China is promoting the offer side, with easy credit for large corporations and local governments. Those have been mostly used to add new production capacity, build infrastructures and real estate, and speculate. It might be a bit oversimplified, but for now, nothing has been done to push US saving rates higher or to help households to reconstitute their balance sheet, nor boosting chinese household real income, in order to grow consumption at a rate faster than production.

In the end, rebalancing will happen, as Michael Pettis puts it, either in a good way, or a hard way. The good way would be to use the governments credit cards to smooth the transition while implementing worldwide “rebalancing” policies. Sounds realistic? No, not really… But door B might not be very appealing. Trade tensions escalate and the adjustment is not done by an increase in demand from surplus countries, but by a decrease in production from them, having tougher time reaching their external markets. And this seems to be the path we are taking, so far.

PS: As an aside, in those overindulging countries, households added on debt to consume more than they can afford. Now overleveraged, those households have become overly dependant on higher asset prices. In those countries, central bankers are boxed. Damned if the raise interest rates, damned if they don’t. Although the effects of very low interest rates are probably going to be felt later in the decade, which means it is the path of least resistance.

Goldman vs. Chanos

I finally caught-up with some reading and finished Goldman’s note on China’s fixed asset investment (FAI). Published mid-February, the conclusion was pretty clear : “Did China invest too much in 2009?” No, “we believe most of such investment is justifiable for current and future economic development and will not cause a structural over-investment problem, as many fear.”

Those were the main arguments:

1) Yes, too much investment were made if judgment based only on reported investment’s share in GDP (+43%), or the share of its contribution to GDP growth (+92.3%).

2) But it is partly due to the fact that the drag from net export was considerable in 2009, otherwise the share would have been much lower. Investment contributed to +8% of the GDP headline (of +8.7%). Massive. The remaining +0.7% came from consumption, at +4.6%, plus net export, which was a negative contributor, at -3.9%.

3) Also, for 2009, FAI was probably over-reported, as many local governments “recorded the total amount of investment projects (including the uncompleted portions), instead of the actual realized amount.” They wanted to look good.

4) On a more structural note, GS also mentioned a statistical bias leading to an overestimation of the investment series. It is due to an insufficient deduction of land costs and price change, which mechanically increases the FAI number. In the case of land costs, they have been accounted for less than 30% of total real-estate capex spending, while property developers reported numbers between 45% and 50%. The difference appears as investment, but nothing has been built/created. The FAI deflator does the same thing by understating the price change. In 2007 for example, “it was at +3.9% despite the commodity price rally and significant price increases in investment goods.” In the end, counting a portion of the price change as FAI.

5) And finally, “the strong recovery in domestic investment was policy induced initially and can be seen as part of the cyclical adjustment measure (…), especially the government led portion, [which] should be seen as a cyclical management tool.”

Now let’s sum up. Those abnormal high 2009 FAI figures are the consequence of:

• Temporary effects (negative export contribution, over-estimation by local governments and temporary boost as part of a cyclical management tool)
• Structural effects (over-estimation due to statistical bias in the reporting of land costs and change in prices)

So GS made some interesting points. The real impact of FAI, net of statistical bias and temporary policies is probably a few points lower. But is that really the core of the issue? No.

The real matter is not how much FAI has really been taking place in 2009. It is a too short time frame. It also does not include the other side of the story, how much was needed, and will actually contribute positively to future growth. And this is where GS analysis is getting pretty light:

“Some overhang capacity exist in some sectors and areas, but we believe it is not structural.” A strong GDP growth, around 10%, will help removing overcapacity much more quickly than in other slower growth countries. “For example, the excess capacity problem populated in 2002 disappeared quickly in most sectors in 2003, some of which turned into bottlenecks by early 2004.” In the end, this crisis was opportunity to catch-up on some investment needs in infrastructures, which will contribute to future growth.

Overcapacity? Easy, high growth will remove them, as it did before. Nothing on the level of urbanization, or investment capacity already existing. High growth baby. There is nothing it won’t cure. Problem: that was true 7/8 years ago. But high level of investments have been made since. And Jim Chanos said it well, the probability of this strategy to work is diminishing every year, as more bridges, schools and factories are being built, urbanization and production capacity increase, and the need for more decreases, at least relative to GDP.

Now there is a second major point: “China still needs to rebalance toward consumption-driven growth”. How? “by implementing measures that increase household real income.” Hard to argue, every one seems to agree. So where is the difference? On whether or not this process has been already taking place.

GS is optimistic, and will give you 20 figures to show how fast the Chinese consumption is growing… but is it enough? No. As Michael Pettis (http://mpettis.com) often says, high consumption growth is not enough to rebalance the economy. You need consumption to grow faster than GDP, in order to gain a higher share of it. Otherwise, FAI in percentage of GDP will continue to grow. And so far, it has probably not been the case.

In concluison, I am surprise that some of the key points, ie. need for more infrastructures, high GDP growth quickly removing excess capacities and rebalancing on its way, have been the least developed by GS. It is interesting to show that the  FAI share of GDP in 2009 might have been a point or two lower than it had been stated. But that is not changing the core of the issue:

• After 20+ years of very strong growth and high rate urbanization, how much more does China need?
• Why should we assume that the same will happen to excess capacities, 10 years into one of the strongest investment cycle?
• What would be necessary for the Chinese economy to rebalance, and has it been put in place?

Chanos vs. Goldman : Chanos wins the first round, on the overall logic and global picture. But the match is not over.

What a low US mutual fund cash holding could mean

Mutual fund cash holding is usually the lowest at the peak of stock market indexes. So with only 3.6% of their asset in cash, could we be close to a top?

The following graph represents the S&P 500, in orange, versus cash holding, in white, inverted:

It definitely shows a sharp decrease from the “top” of March 2009, where 5.7% of mutual fund assets were in cash. It is a direct consequence of the ultra low return on cash, which gave strong incentives to money manager to “find” investments, and its corollary, a quick return of investors’ risk appetite.

This current level, 3.6%, has usually been associated with a high risk tolerance, which itself precedes major market tops. So in term of risk appetite, this indicator suggests a top could be close.

However, cash level seem to be trending lower since 1993, and we could imagine reaching a new low before a new top, especially since return on cash is litteraly zero.

The US labor market is improving. Isn’t it?

Some data have suggested the US labor market might be improving. For example the household survey, used to calculate the unemployment rate, has shown job creation last quarter, leading to a drop in unemployment rate to 9.7%. Weekly claims have also significantly decreased from the top of last year.

But other data are showing different picture. Yes the unemployment rate has decrease. But only on a seasonally adjusted (SA) basis. The non-seasonally adjusted (NSA) data are still showing an increase (at 10.6%):

Why should we look at the NSA data? Because the Bureau of Labor Statistics has to make assumptions about the seasonal impact. And as we discussed previously (link), the current crisis might have temporary altered some of those effects.

Secondly, the labor participation rate (ie. ratio between employed + unemployed and the overall size of the national population of the same age range) for men has significantly decreased:

Finally, the employment to population ratio (same ratio with only the employed) for men is at an historically low level:

Why does it matter? Because in a deleveraging economy, cash-flow is key to determine the speed of the adjustment. On the US households side, employment is the first source of income. So it is the variable to watch, especially if you believe there won’t be another asset bubble any time soon, propping up US household wealth.

US household total income vs. total debt

The New Normal, term coined by Mohamed El-Erian from Pimco, describes a new paradigm for the US economy. One of its aspects is the deleveraging of the US household. The main reason: 30 years of increasing debt burden, to finance the gap between their consumption and earnings, the former increasing much faster than the latter.

The next two graphs are showing this effect. The first one compares the increase in total income (in orange) versus the increase in total debt (in white) since 1980. Total income grew by +452% in nominal term, versus +1,031% for total debt:

And since 1952, for a long-term perspective. Total debt grew 3.5 times faster than total income:

As a consequence, households debt as a percentage of GDP grew significantly, especially in the last 10 years : special thanks to the housing “bubble” and home equity extraction. This is what you can see in the graph below, comparing nominal GDP versus total household debt (ratio debt to GDP at the bottom):

As you can see in all those graphs, this trend have paused. It could be only temporary, as some economists “hope”. We would then return to the old paradigm. Or it could be the beginning of a New Normal, where the American consumer deleverages. The reason I believe in this second narrative is because on the long-term, households have to match their debt growth with their cash-flow and asset growth.

And on the cash-flow side, it has not been the case for a long time. With a debt burden of more than 90% of GDP, it is hard to imagine how the US households will be able to add on more debt. Unless… the asset side of their balance sheet increases. But after a stock and a real estate bubble, it is hard to find a new asset class in their balance sheet that a) has not been hammered and b) that could have the potential for double digit annual returns.

So forget the American consumer, at least for now, he has to restore its financial ratios.

Chinese oil demand, where does the growth come from?

Where does the growth come from? Probably not from where you would expect it. According to Harry Tchilinguirian, senior oil analyst at BNP Paribas:

” China’s oil demand grew by 7.7% in 2009 according to IEA estimates but has been uneven across products. Gasoline’s growth in particular has been modest relative to booming sales of passenger vehicles. The top performance came in ‘other products’, which includes distillation residues like bitumen and coke, used in road building, and lubricants. Year-on-year growth in this category reached in excess of 350 kb/d, which is not surprising given China’s construction and infrastructure efforts. The other major growth product was naphtha, following large additions in capacity to China’s petrochemical industry. “

First surprise : modest growth in gasoline demand relative to the new car sales. Having a car there reflects a social status. But it is an inefficient mean of transportation in a those jammed city. So most new cars are barely used.

Second surprise: high growth in other products, which are used in construction and road building. This is probably another effect of the high level of fixed asset investments in China, especially in real estate and infrastructure. So if there is a slowdown in this sector, it would strongly impact China’s oil import growth. And probably for a long period of time.

Federal reserve balance sheet and bank reserves

In case you wondered were all the freshly printed money went, look at bank reserves. The following graph compares the FED balance sheet (in white) to the total bank reserves (in orange). The bottom graph calculates the ratio:

Most of the increase of the FED’s balance sheet is now sitting there, as bank reserve. With no increase in lending in sight, it probably will remain this way for a while. So far the FED has been successful at lifting asset prices, but has failed at channeling it into the economy. That is the limit of money creation, you can’t control were this new money will go.

Two scary graphs

I recently came across two graphs reflecting some of the underlying weaknesses of the US economy.

The first one charts the outstanding amount of asset-backed commercial papers. It is still deep diving:

As a reference, at the peak this market represented as much as 60% of the outstanding amount of all commercial papers:

The second one, in green, represents the number of auto sales in the US, adjusted for the change in population:

We are still very close to the bottom…

Consumer confidence

This morning te conference board consumer confidence number came lower than expected, at 46 vs. 55 expected (bloomberg survey).

“Stock market down, confidence down” I read somewhere… Probably. Those two data should have some level of correlation, as they are both related to the underlying strength of the US economy. Also, the wealth effect of increasing stock prices should have some impact on the American households confidence level:

Now the best correlation remains – very logically – with the US unemployment rates. The graph below charts the consumer confidence vs. the unemployment rate (inverted) :

“The money hole”

It is hilarious:

The Onion: Should The Government Stop Dumping Money Into A Giant Hole?