Chinese economy slowing, signals mixed

Posted on Thursday, June 14, 2018 at 02:56PM by Registered CommenterSimon Ward | CommentsPost a Comment

Chinese monetary trends remain worrying but non-monetary leading indicators are giving a more hopeful message for economic prospects. A further slowdown is expected over the remainder of 2018 but weakness may be contained.

The forecasting approach followed here uses non-monetary leading indicators – usefully summarised by the OECD’s composite measures – to cross-check the message from monetary trends. In China’s case, the signals are currently conflicting, reducing confidence in the forecast.

Monetary trends are unambiguously weak. Annual growth of the official M1 measure fell further to 6.0% in May, the least since 2015, while M2 growth was stable at 8.3%, just above December’s record-low 8.1%. The alternative money measures preferred here were similarly soft, as was the “total social financing” credit measure – see first chart.

Previous posts suggested that monetary trends would revive in response to an apparent policy reversal towards easing in April, reflected in a sharp fall in term money market rates, although the timing and extent of a recovery were uncertain. The May money and credit data indicate that the policy shift has yet to gain traction, while money rates have recently partially retraced their decline – second chart.

Activity news for May released today appears, on the surface, to be consistent with the negative message from money trends. Annual growth rates of industrial output, retail sales and fixed asset investment fell from April and undershot consensus estimates. Investment growth weakened particularly sharply – third chart.

Some details of the reports, however, jar with a negative interpretation. Annual growth of housing sales and starts rose smartly – fourth chart. Steel production was also notably strong. The sharp fall in investment growth, meanwhile, reflected weakness in infrastructure spending, with private capex expansion only slightly lower.

The OECD’s Chinese composite leading indicator, meanwhile, rose for a second month in April, according to data released yesterday – fifth chart. The six components of the indicator are: steel production, motor vehicle production, building completions, production of chemical fertilisers, the export orders balance from the PBoC’s quarterly 5000 enterprise survey and stock market turnover. New data for the first three components released today imply a positive contribution to the indicator reading for May, according to our calculations.

The decline in the leading indicator into February suggests an economic slowdown through late 2018, consistent with the message from monetary trends. Prospects further out are cloudy but a pessimistic bias will be retained here pending a revival in money trends.

Is the MSCI EM index fit for purpose?

Posted on Wednesday, June 13, 2018 at 11:10AM by Registered CommenterSimon Ward | CommentsPost a Comment

The characteristics of the MSCI emerging markets (EM) equities index have changed significantly in recent decades, raising questions about its suitability as a benchmark for EM investing.

The index is now dominated by China, the weight of which rose to 33.2% on 1 June following the addition at end-May of more than 200 A shares with an inclusion factor of 2.5% of their market capitalisation.

China’s weight on 1 June, surprisingly, was not the largest single-country weight in the history of the index – Malaysia’s weight was 33.8% at the inception of the index on 1 January 1988, when there were only 10 country constituents, compared with the current 24 – see first chart.

The largest single-country weight, however, has averaged 20.5% over the 30-year history of the index – well below the current Chinese level. China’s weight, moreover, is likely to increase further – the A share factor is scheduled to rise to 5% at end-August, while it is reasonable to assume full inclusion within 10 years. (The phased inclusion of Korea and Taiwan in the 1990s / 2000s occurred over seven and nine years respectively.) MSCI previously estimated that China would account for about 42% of the index if the A shares were included fully, based on then-prevailing market capitalisations.

The rise of China has resulted in the index providing less regional diversification. At end-1999, Europe, the Middle East and Africa (EMEA) accounted for 31.5% of the index, with Latin America at 28.2%. The weights on 1 June were 13.9% and 10.6% respectively, with Asia up to 75.5%. Asia’s weight could exceed 80% if / when the Chinese A shares are fully included – second chart.

The index has also become less “emerging”. The third chart shows the relative income levels of the EM index (a market capitalisation-weighted average of the constituent countries) and selected countries. Relative income is measured by GDP per capita at purchasing power parity expressed as a percentage of the G7 level. At its inception in 1988, the index represented countries with an average income of about one-third of the G7 level. That proportion has risen to about a half, mainly reflecting the inclusion and rapid growth of Korea and Taiwan. Taiwan’s GDP per capita is now close to the G7 average while Korea’s is within the G7 range. From an economic perspective, neither country should be represented in an EM index.

Investors, arguably, should now allocate to Korea and Taiwan within the developed markets portion of their equity portfolio. Removing them from the EM benchmark, however, would further magnify China’s dominance. There is a case for separating out China, to reflect its size and unique economic characteristics, and to make explicit the allocation decision between China and the rest of EM – in the same way that investors often separate a developed markets portfolio into US and “international” buckets.

Stripping China, Korea and Taiwan from the MSCI EM index would create a benchmark with similar characteristics to the “old” EM index: GDP per capita of the benchmark constituents would be less than 40% of the G7 level – third chart – while the weights of EMEA and Latin America would be much closer to that of Asia – fourth chart.

Are the profits / investment cycles peaking?

Posted on Tuesday, June 12, 2018 at 10:15AM by Registered CommenterSimon Ward | CommentsPost a Comment

Underlying profits growth in the G7 economies cooled in the first quarter of 2018 and is modest by historical standards, casting doubt on expectations of economic strength based on a further pick-up in business investment.

The underlying profits numbers are from the national accounts and refer to the gross domestic operating surplus of corporations (or the closest available measure), which is equivalent to “EBITDA” (i.e. earnings before interest, tax, depreciation and amortisation). The G7 series is a GDP-weighted average of country data. Annual underlying profits growth was 2.8% in the first quarter of 2018, down from 3.7% in the fourth quarter of 2017 and below an average of 3.8% since 1995 – see first chart.

The G7 series has been dragged down by slowdowns in Japan and the UK. Euroland profits growth has also eased, while US growth has been stable but modest – second chart.

Post-tax US profits, of course, have been boosted by recent tax changes, growing by an annual 8.9% in the first quarter versus 3.9% for the pre-tax measure. Tax cuts, however, are less likely to feed through to business investment if underlying profitability is deteriorating.

Operating margins in the US and several other G7 countries are under threat from rising unit wage cost growth due to stretched labour markets and weak productivity trends. The gap between the US unemployment and job opening rates is an indicator of labour market slack and has displayed a leading relationship with margins historically, with the current message very negative – third chart.

Annual growth of G7 real underlying profits (i.e. current-price profits divided by the GDP deflator) is correlated with, and usually leads, annual business (i.e. non-residential) investment growth. Real profits growth appears to have peaked in the second quarter of 2017, suggesting that investment growth is at or close to a top – fourth chart.

A peak in investment growth would be consistent with the assessment here that the seven- to 11-year Juglar business investment cycle will enter a downswing by 2019. As the fourth chart shows, the annual change in G7 business investment reached lows below -3% in 1975, 1983, 1993, 2002 and 2009. The interval between troughs, that is, ranged from 7.25 to 10.5 years, consistent with the longer-term historical evidence on the length of the Juglar cycle. With the last bottom reached in the second quarter of 2009, another trough is scheduled by the second quarter of 2020 at the latest, implying a downswing starting in 2018-19.

Euroland GDP details downbeat

Posted on Thursday, June 7, 2018 at 12:10PM by Registered CommenterSimon Ward | CommentsPost a Comment

A post in March argued against consensus positivity about Euroland economic prospects, noting that domestic final demand had already slowed while net export strength was likely to fade as a result of euro appreciation and falling global momentum. GDP expenditure details for the first quarter released today are consistent with this assessment. Monetary trends suggest further weakness in domestic final demand while net exports may continue to struggle without a much more significant fall in the exchange rate.

The GDP report confirmed a 0.4% increase in the first quarter, down from 0.7% in the fourth quarter of 2017. Domestic final demand – i.e. consumption and fixed investment – rose by 0.35%, while net exports subtracted 0.15 percentage points (pp) from the quarterly GDP change. Total final demand, therefore, expanded by just 0.2%, down from 0.8% in the fourth quarter. GDP growth was supported by a 0.2 pp contribution from inventories – stockbuilding rose to a nine-quarter high.

Euroland narrow money trends lead GDP developments but appear to have an even closer relationship with domestic final demand. Two-quarter demand growth peaked as long ago as the second quarter of 2016, following a peak in six-month real narrow money growth in January 2015 – see chart. The two-quarter demand change recovered slightly in the first quarter, as expected here in March on the basis of a temporary revival in narrow money trends in the first half of 2017. The subsequent fall in real narrow money growth to a five-year low in April suggests that domestic final demand will slow further into late 2018 / early 2019.

Net exports are unlikely to take up the slack against the backdrop of an expected global economic slowdown and a current effective exchange rate level still 3% above its 2017 average (Bank of England measure).

The rise in inventories in the first quarter, meanwhile, was probably involuntary and fits with the view here that the global stockbuilding (Kitchin) cycle is approaching a peak and will act as a drag on economic growth in late 2018 / 2019. 

Leading indicators still softening

Posted on Wednesday, June 6, 2018 at 01:28PM by Registered CommenterSimon Ward | CommentsPost a Comment

The OECD’s G7 composite leading indicator continues to soften, supporting the forecast here, based on monetary trends, of a global economic slowdown.

The OECD will publish an April update of its leading indicators on 13 June but most of the component information is already available, allowing an independent calculation.

The first chart shows the ratio of G7 GDP to the OECD’s estimate of trend together with the "normalised" (i.e. trend-adjusted) leading indicator – both official and independently-calculated. The indicator is estimated to have declined again in April, increasing the likelihood that the recent peak marked a significant turning point. The indicator, that is, has switched from signalling above-trend economic expansion in 2017 to below-trend now.

The estimated April decline in the indicator was again driven by European countries and Japan but the rise in the US indicator slowed, suggesting that it is approaching a turning point – second chart.

The components of the US indicator are: housing starts, durable goods orders, consumer sentiment, the ISM manufacturing purchasing managers’ index, average weekly hours worked in manufacturing, share prices (NYSE composite) and the slope of the yield curve (10-year Treasury yield minus effective fed funds rate). All components enter as deviations from their estimated trends. The recent slowdown in the indicator reflects negative contributions from the survey measures (consumer sentiment, ISM PMI), share prices and housing starts; its continued rise has been driven by the “hard” manufacturing components – durable goods orders and average weekly hours.
 
The OECD country indicators do not, in most cases, include a monetary aggregate, so they provide an independent, though less timely, cross-check of monetary signals. Another drawback relative to the monetary data is that the indicators can sometimes be revised significantly, mainly reflecting changes to the estimated trends in the components as new information is incorporated. 

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