I have been posting about the seriousness of cyber warfare for a while. In case you thought I was over-egging my previous post, here’s a quote from today’s BBC News web pages:
“This week the Pentagon said that computer sabotage coming from another country can constitute an act of war, to which it may respond using traditional military force.”
At some stage the US is going to retaliate against the constant attack by Chinese hackers on US companies and government institutions. The latest (and one of the most sophisticated) attacks has been on Lockheed Martin. FT story. Telegraph story.
The Chinese may think they have huge leverage by owning a shed load of US Treasuries, but this is actually a weakness. If the US said “stuff you”, the Chinese will be holding a load of worthless paper. Even more serious, a collapse in trade with the US would destroy the Chinese growth model and cause huge social upheaval. The US would clearly suffer huge dislocation through a jump in bond yields and inflation, but ultimately it could reconfigure its economy. At some stage cyber warfare could tip the world into a dangerous conflict. You have been warned.
Despite a wet and windy week, I had a good time in the Lake District. On my return I discover storm clouds once again gathering in the global economy and markets.
Is the ECB insolvent?
I really can’t bear to comment any further on the Euro. It just looks a total mess. The can might be kicked down the road again. In the past I’ve mentioned that central banks are potentially insolvent. For the US and UK this is only a technical issue because they can print money to recapitilise. For the ECB, the issue is more serious and immediate as this article in Der Spiegel points out. In the early stages on the GFC, it seemed that the ECB was taking the most conservative line and limiting its credit risk. Unlike the Fed and the BoE, its asset purchases were tiny and it confined itself to providing copious liquidity to the euro banking system through its repo operations. It now looks like the collateral posted will expose the ECB to huge default risk.
US activity weakening
Looking through last week’s economic releases, the regional Fed surveys, which I always look at, are confirming a soft patch in growth. Of particular note are the Chicago National Activity Index, Kansas City Fed and the Richmond Fed Manufacturing Surveys. These confirm other surveys like the Philadelphia Fed Survey. It’s also interesting to note that the ECRI (Economic Cycle Research Institute) leading indicator has also started to decline and the annualised growth indicator has been declining since mid April. This is not a recessionary warning yet.
Europe, not so good either
In Europe, the National Bank of Belgium Business Barometer declined for the second month. When I was gainfully employed, this was always reckoned to be a good leading indicator for eurozone economic activity as Belgium is a very open economy with strong links to its neighbours. It might be better than the Ifo Business Climate Index, which was unchanged. I was a little surprised to see that the Norwegian economy contracted in 1Q11. True 4Q10 was strong and oil & gas production was weak in 1Q, but domestic consumption was also unchanged. While Norway is not an important economy, it weathered the GFC better than most, so a patchy recovery here may be indicative of the deep-seated problems in Europe. Retail sales numbers were weak in both Italy and Spain. It’s not all gloom. Some of the business sentiment indicators were OK and consumer sentiment bounced in the UK.
What’s the Chinese for Ponzi?
Another empty city in China: Kangbashi. Michael Pettis on unusual ways Chinese private companies are accessing borrowing.
I had a busy week last week and I’m off to the Lakes for a bit of walking on Tuesday, so I’ve not had much time to look at what’s going on in economies and markets, but here’s some brief observations on what I have seen.
Inflation pressures in Europe
Further evidence of inflationary pressures was provided by the rise in the eurozone CPI which rose by 2.8% yoy. This will put further pressure on the ECB to raise interest rates again soon. German producer prices rose by 6.4% yoy, suggesting that more pricing pressure is in the pipeline. UK CPI also surprised on the upside at 4.5%, increasing the policy dilemma for the Bank of England.
Weaker German confidence
The ZEW survey weakened for the second month in a row. The ZEW often leads the more important Ifo business sentiment survey. While it doesn’t necessarily indicate an immediate slowdown in German growth, it may be the harbinger of a weaker patch later in the year.
US surveys also suggest impending weakness
Still on the theme of a potential slowdown in economic growth, in the US we saw the Conference Board leading indicator decline unexpectedly and weaker readings from both the Philadelphia Fed Survey and the NY Empire State Manufacturing Survey. Of particular interest was the Philly Fed Survey which suggested that the inventory cycle, which had been driving US growth is now beginning to weaken.
The Economic Cycle Research Institute is suggesting an impending global slowdown in growth (not recession). Chimes with my recent thoughts.
Hidden debt in Spain. Investors may trust the Spanish government but what’s hidden beneath at the regional level? Don’t forget, misleading debt statistics started the Greek crisis.
Hacker attacks on UK Treasury. Plenty of evidence that China is the worst offender on cyber attacks. When will the West lose patience?
Gary Shilling on the US housing market. It’s still a long way from being fixed. It’s going to take at least a decade, in my view. Oversupply is the real killer. While prices have fallen, they may not have fallen enough to clear the market. Some chilling parallels with Spain, except Spanish prices haven’t fallen nearly enough.
I see that the EU is proposing to impose tariffs on Chinese glossy paper exports to the EU. It may be just one of those things or it could be the harbinger of a more muscular stance by the EU. Certainly something to watch. One of my themes for the next decade is rising protectionism. Robust global growth has put this on the back-burner, but any weakness in growth might bring protectionism back as an issue.
OECD leading indicators
The OECD leading indicators suggest that global growth is continuing. The US, China, Germany and Russia all saw the leading indicator rise. Falls were registered by the Eurozone, UK, Mexico, India and Brazil. It would be wrong to suggest that these falls are indicative of an impending recession in these countries. However, it does suggest that some economies are starting to struggle. India is in the midst of monetary tightening and heightened inflationary pressures. Brazil is grappling with the appreciation of its currency, high inflation and the implications for competitiveness. The UK is suffering from the structural overhang of indebtedness and fiscal retrenchment.
Strong German and French GDP numbers are good and bad news
Both Germany and France reported stronger than expected GDP growth figures for 1Q11. While this might be seen as good news in many quarters, it may be less positive for the Eurozone periphery. The strong trade surplus suggests that net exports are still an important driver to German growth. In truth, the periphery needs German domestic demand to strengthen and for German inflation to rise. Even then, it is open to doubt whether strong consumption will drag in imports from the periphery. However, strong German (and French) GDP growth may give the ECB further cause to raise interest rates, which just what the periphery countries don’t need.
US small business confidence declines again
The National Federation of Independent Businesses, the small business organisation in the US, reported a decline in small business confidence for the second month. The weakest components of the survey were the economic outlook, expected credit conditions and earnings trends. This is somewhat worrying, given that small businesses are an important driver of both growth and employment trends. Another potentially concerning feature is that a net 24% of respondents intend to raise selling prices.
I think I’m turning into Victor Meldrew. I find it exasperating that two quarters of poor GDP growth can be interpreted so negatively. It’s not difficult to see why the UK might be growing more slowly than the Eurozone. Firstly, its economy is more exposed to the financial sector, which will take a long time to recover. Secondly, the UK’s budget deficit blew out more aggressively than most countries, especially when compared with Germany and France. A more aggressive fiscal consolidation will necessarily induce slower growth, but is entirely necessary to maintain foreign confidence in the UK. Thirdly, UK consumers are much more leveraged than the Eurozone average.
Why is bad news good news? Well, the rebalancing of the UK economy needs the trade deficit to shrink and net exports to provide a growth kicker. That is more likely to occur when our largest trading partner (the Eurozone) is growing faster than the UK. It might persuade UK companies to become more aggressive in export markets. If I were in charge of government industrial policy, I would be looking at ways I could help UK exporters. Unfortunately the UK’s politicians seem to be caught up in side issues rather than concentrating on getting the economy back on track.
Sorry to put a dampener on the German GDP figures but strong German growth is not necessarily good news. Unless growth is coming from increasing imports from the periphery it might actually be bad news. There’s no breakdown of the figures, but it’s reasonable to assume that German export growth has been strong.
Probably, there has been a positive contribution from net exports. We really want to see a negative contribution form net exports, which would mean that German import growth is faster than export growth. Of course this would be happening if Germany still had the Deutsche Mark rather than the Euro, as the DM would have appreciated substantially.
Commentary suggests a pick up in consumption, but are German consumers buying Greek/Irish/Portuguese goods? They might be buying Irish goods as Ireland’s trade balance has moved into surplus, but I strongly doubt that Greece and Portugal are benefiting. My guess is that German consumption will be satisfied by Asian imports of consumer goods.
There is also a suggestion that construction and investment is strong. Again, very little of this will feed through to the periphery as construction is mainly a domestic enterprise and investment goods are likely to be supplied by German manufacturers or Asian or US companies.
The reason why German growth may be bad news for the periphery is that it will raise average growth (and possibly the rate of inflation), making the ECB more likely to raise interest rates. This is exactly what the periphery doesn’t need.
The best policy for the Eurozone would be for Germany to recognise the insolvency of the periphery, agree to a debt restructuring and use its current economic strength to recapitalise the German banking system. If Germany doesn’t recognise the weakness in its banking system, it runs the risk of a liquidity and credit crunch when the periphery countries default, which they surely will under present policies.
I watched the Bank of England’s Inflation Report press conference this morning. Mervyn did his usual trick of making the assembled press seem like first year graduates asking not quite the right question. However, if you listen carefully and take notice of the charts that he highlights, then some clues as to the MPC’s thinking emerge.
Source: Bank of England
The first chart to highlight is on page 14 of the report and shows the funding premium of UK banks over base rate by combining LIBOR with credit default swap premia. The current spread is just over 150bp. If, for whatever reason, CDS premia decline, then it would free the MPC to put up interest rates. I’m not sure that anyone else has spotted this. CDS spreads have drifted down recently. If we saw a further tightening, it might lead to a surprise rise in interest rates. The other element, LIBOR, has less room to compress. However, a tightening in LIBOR could enhance any decline in CDS spreads and it would indicate a return of confidence and an easing of funding pressures for the banking sector.
Source: Bank of England
The second interesting chart is 3.1 on page 23 comparing GDP and some sectoral components. What it emphasises is the weakness of the construction sector, which was a major factor in the weakness of GDP growth in Q410. There has been a bit of controversy around whether the ONS is measuring construction output correctly. Even allowing for weather disruption, it seems a bit extreme. What I take away from this is that the less volatile manufacturing and services elements of the economy are expanding steadily and that there could be some upward revisions to activity later in the year. This is not to say that activity is robust, just that it may not be as bad as the headlines suggest, which would be in line with the various business surveys.
Source: Bank of England
Another fascinating chart is 3.4 on page 26. This shows labour productivity. Productivity in both the service and manufacturing sector took a dive in the recession. Manufacturing productivity has resumed its upward march, but the service sector is flatlining. As the service sector is much larger than the manufacturing sector, this suggests that productivity growth in the UK may disappoint over the next few years. The corollary is that trend growth will be lower, which is not good for fiscal consolidation. The flip side is that if the UK rebalances towards manufacturing then there could be a productivity surge in a few years’ time as manufacturing productivity tends to grow faster than service sector productivity. If I were in charge of government policy, I would be incentivising investment in manufacturing industry.
Source: Bank of England
The last chart to point out is chart 4.1 on page 30. This disaggregates the influence of energy and import prices and the rise in VAT from “other” factors. You can clearly see that the “other” factors, where the MPC has some influence with interest rates has contributed zero to inflation. The Increase in VAT, for example, is estimated to have contributed over 100bp to the rate of inflation (the pass through rate is estimated to be 75%). I think the neatly illustrates the dilemma for the MPC. Raising interest rates would have a minimal impact on inflation, unless the currency rose markedly. Not only that, any rise in the exchange rate would be a de facto tightening of monetary policy and hinder the rebalancing of the UK economy. It may not be popular, but the MPC, wisely in my opinion, has chosen to look through the factors over which it has no control.
So, what are the takeaways?
I’m always surprised at how little notice is taken of leading indicators. While not perfect, they have a good track record in picking the ups and downs of the economic cycle. The latest set of leading indicators from the OECD were published yesterday. They produce a fascinating split in global growth.
The good news is that the OECD leading indicator is still rising, so global growth should continue at a reasonable rate. The US, China and Germany all had leading indicators that are rising. Falls were registered by the Eurozone, France, UK, Mexico, India and Brazil.
It would be wrong to suggest that these falls are indicative of an impending recession. However, it does suggest that some economies are starting to struggle. India is in the midst of monetary tightening and heightened inflationary pressures. Brazil is grappling with the appreciation of its currency and the implications for competitiveness. The UK is suffering from the structural overhang of overindebtedness and fiscal retrenchment. None of this is particularly new.
However, France has come out of the credit crisis relatively well. It is intriguing that the French economy appears to peaking. Recently, there was an article on Bloomberg suggesting that France’s fiscal position was worse than perceived and that bond investors are too complacent. Sarkozy is immensely unpopular. French banks have significant exposures to periphery sovereign bonds. It would be wrong to read too much into one month’s decline, but if the leading indicator falls over the next two months, then investors may have to revise their views on the robustness of the French economy.
A refreshing article in the NY Times by economist Greg Mankiw admitting that economists guess rather than know what’s going on. We should always be wary of pundits who are too confident in their own prognostications.
In a UK context, the thing that really bothers me is whether inflation expectations will lose their anchor. The latest surveys suggest that, despite recent rises in many everyday items, inflation expectations are still surprisingly contained (report by Citigroup/YouGov).
Commodity turmoil
The catalyst for this week’s spectacular reversal in commodity prices may have been some weak economic releases, but it also indicates the increasingly speculative nature of price movements (have a look at this). No metal illustrates this better than silver, the poor man’s gold, where prices fell 30% in five days. Investors have also fretted that the flotation of Glencore might signal the top of commodity markets. Any further weakness may be a boon to the global economy as it will reverse some of the recent upward pressure on input costs and moderate inflationary pressures. If economic growth is resilient, then commodity prices will probably show a measure of recovery with strong demand from Asia. The biggest concern is that excessive commodity price volatility might have unexpected consequences in the financial system if some institutions have become overextended or overexposed.
Signs of economic weakness
There have been some signs of economic weakness this week, particularly in Europe. It is always difficult to know whether this is just noise or something more serious. In the Eurozone we saw weak retail sales for March, although this is no surprise as we already knew most of the country data. More concerning was the unexpected fall in German manufacturing orders. This is a very volatile series, so one month hardly makes a trend. Also very weak was Spanish industrial production, which is concerning it suggest that the rebalancing of the Spanish economy is coming from the deflation of domestic demand rather than a growth in exports. A more dovish than expected position from the ECB on monetary policy perhaps indicates increasing concerns over Eurozone growth by policymakers. In the US, the ISM Non-manufacturing Index was unexpectedly weak (although in line with other service sector PMI’s in Europe), but elsewhere activity indicators were generally satisfactory.
US employment confusion
Headline payroll numbers were better than expectations and there were some upward revisions to the previous three months. Confusingly, the unemployment rate rose as the household survey indicated weaker employment conditions. Markets were also concerned about the strong rise in weekly jobless claims. However, two of the more forward looking indicators give some cause for optimism. The Monster Employment Index (a measure of online job advertising) rose strongly for the third month in a row, suggesting that firms are beginning to look at hiring more aggressively. Also the Challenger Report, which logs job losses, saw a substantial decline for the second month. Tangentially, the Federal Reserve’s Senior Loan Officer Survey indicated strong demand for loans from the business sector for the second quarter in a row. If businesses are demanding credit for expansion, it seems likely that the jobs market will also improve.
It is possible that the killing of Osama bin Laden marks the zenith of the American empire. Since the end of WW2, the USA has been the world’s policeman. The end of the Cold War brought a peace dividend of lower military expenditure, but the War on Terror partially reversed this. While the US was financially strong, this was bearable. Now that the US is faced with a dire fiscal and private debt position, it is increasingly difficult to sustain its overseas military position.
US military spending in 2009/10 was $685bn, about 4.7% of GDP, significantly higher than other developed countries. Military spending is about 20% of the total federal budget. The US accounts for about 40% of the total world military spending. With acute budgetary pressure, the need to cut military expenditure to reduce the deficit will be intense.
Many prominent US commentators are questioning what benefit the US gains from its enormous military effort. Here’s one example from Foreign Policy from Douglas Macgregor, a former Colonel in the US army. People and countries can only stand pain and vilification for so long. The US appears to be wearying of being the world’s most hated country.
The death of bin Laden is a pivotal moment as the US can claim that it has eliminated the two most prominent antagonists of the past twenty years: Saddam Hussein and Osama bin Laden. It can claim that it has achieved closure even it cannot claim total victory. The war against Islamic militancy will drag on for the foreseeable future and Iraq is likely to remain unstable. Nonetheless, the US can say that those that challenged it have been eliminated and serve as a lesson to those that might try in the future.
The psyche of the US is still heavily influenced by cowboy movies. A murder is perpetrated; the sheriff and posse is sent out to exact justice. The criminal is caught and hanged. The sheriff and posse return home to resume their lives. Clearly, the real world is more nuanced than that, but there will be a strong feeling in the US that their objective has been achieved and justice has seen to be done.
The process of disengagement in Iraq has already begun. Unless the Iraqi government asks the US otherwise, the US military will leave by the end of this year. With the death of bin Laden, it becomes more likely that the US will seek an honourable withdrawal from Afghanistan.
While the US is likely to retain a strong presence in Asia, not least because China is flexing its military muscles, elsewhere around the globe a measure of retrenchment and disengagement is likely. The Middle East is tricky as on the one hand withdrawal from Iraq will mean a smaller commitment, the US will want to maintain a deterrent to Iran’s regional ambitions as well as safeguard the flow of oil. The big game changer would be any technological advance freeing the US from its dependence on imported oil, but that is likely to be at least a decade away.
In some ways, there are parallels with the Britain and the dissolution of its empire. After the Second World War, it became clear that the UK was no longer in a position to maintain an empire. The cost of two world wars had been too great. With the bogey of German aggression, epitomised by Adolf Hitler removed, Britain decided to retrench and recuperate. Arguably, this process is still not complete.
The US has probably reached the same point, where it has become excessively stretched, both financially and motivationally. As with Britain, this process will stretch over a decade or two. Unlike Britain, it doesn’t have to grant independence to countries, so the process might be more rapid. However, those that vilify the US, might regret what they wished for. A world where the US is less inclined to be the policeman is likely to be more volatile and unstable.
lemmings can teach nothing 