Revisiting four dark clouds

In July this year I wrote a post called Four dark clouds. In it I described the challenges confronting the the globe’s four largest economies:

Japan is far worse than markets or bullhawk economists predicted earlier this year. According to the NAB World In Two Pages report:

In Japan, the tsunami and power shortages associated with the nuclear emergency have had a far more severe impact on activity than initially indicated in the BOJ’s special Tankan survey. Real GDP fell by 0.9% in March quarter and the partial data available for the June quarter shows that activity levels are still low. Manufacturing output fell by 15% in March but recovered by only 1% in April. The monthly Shoko Chukin small business survey shows worsening falls in sales to June month. We have revised our 2011 forecasts down to flat output.

In the US, we’ve got a well publicised slowdown in industrial production. Last night the Philly Fed Index fell off a cliff, suggesting the big falls in the ISM last month are a harbinger of worse. Housing is going nowhere, the sharemarket is falling and very respectable commentators have declared the consumer dead and are forecasting recession in the near to medium term.

In the EU, it’s a debacle as usual. My guess is Greece will come through this latest round of crisis with a new bailout (that’s what the EU does best at the 11th hour) but so what? The new austerity package will only kick the can again and the periphery will remain in recession or at stall speed. The UK too is slowing again, with the retail rush stoked by the Royal wedding, hurriedly reversing.

In China, we still have good growth. But we also have the mother of all bailouts transpiring at local government level, a stubborn inflation problem, simmering unrest and the inevitability of more rate rises even as the housing market stalls. As an aside, India too has a big inflation problem and is now swiftly tightening.

And behind all of that, we have the withdrawal of QE2 stimulus hitting Wall St which drives the entire global reflation trade through emerging market equities, currencies and commodities. It is possible to climb the wall of worry when policy-makers are giving you the incentive to do so. When they’re not, in the face of all of the these threats to growth, just forget it.

It is little wonder that since then we have seen markets swoon.

But, equities and more importantly, some credit markets, are now bouncing. Is it sustainable? Let’s first revisit Japan. First, from NAB’s World on two pages:

The Japanese economy has been recovering from the tsunami and nuclear accident earlier this year with industrial output recovering most of its losses. Recent results from the monthly Shoko Chukin business survey show that output has continued to expand through September. We are expecting Japanese growth to accelerate through the next 18 months as output bounces back from supply disruptions and rebuilding gets under way, boosting construction.

True enough, except the manufacturing PMI fell in September. And it did so because:

Respondents indicated that subdued demand conditions had led to the contraction in incoming new business, which was the first in four months. Reflecting the strength of the yen and weak demand from external markets, with China mentioned in particular, new export orders also fell in September. The rate of decline was marked, and the fastest since April.

So, for the time being, at least, Japanese reconstruction is facing an increasing headwind in weakening offshore demand and safe haven flows to the yen.

In the US, signals have been better without being spectacular. September saw a 1% jump in consumer spending but October confidence slumped. The September manufacturing PMI continued modest growth. Housing remains weak, though there are some rumours of a Spring bounce. The services PMI is chugging along but forward orders weakened materially in September. If left in peace, the US could probably muddle through. Q2 GDP was 1.3 annualised, up from.4 in Q1. However, it has something in the region of 1.5% of GDP cuts scheduled for next year.

My perspective on Europe is unchanged. Although it looks like I was right that Greece will get its bailout and other measures will probably come through to recapitalise banks, I see no prospect of further peripheral support coming without the BIG, FAT condition of further austerity. In my view, it is as certain as economics gets that Europe is going into recession. Such a contention is supported by the the September composite PMI (both services & manufacturing):

At 49.1, down from 50.7 in August, the final Eurozone PMI Composite Output Index for September signalled the first drop in private sector activity since July 2009. The final reading was broadly unchanged on the earlier flash estimate of 49.2.

The average reading for the third quarter as a whole was just 50.3 – signalling a stagnation of activity – down from 55.6 in Q2 and 57.6 in Q1. Manufacturing production fell for the second month running, albeit at only a very modest rate. Meanwhile, services activity fell to a greater extent than signalled by the preliminary estimate, contracting at the fastest rate since July 2009.

By country, activity at the composite level fell in both Spain and Italy for the fourth successive month, dropping at the fastest rates since July 2009 and August 2009 respectively. However, weakness was not confined to these nations. Activity rose only very marginally in both France and Germany, signalling that these recoveries, which both commenced in August 2009, have almost ground to a halt.

…In a sign that activity may fall further in October, incoming new business in the Eurozone fell for the second month running. Furthermore, the rate of decline accelerated since August to signal the largest drop in demand since July 2009. New orders fell in manufacturing and services at the steepest rates since June 2009 and July 2009 respectively. Manufacturing new orders have now fallen for four successive months, while the decline in services was the first since August 2009.

China has also clearly slowed but is still going OK. The recent composite PMI showed a decent rebound for September:

More importantly, as Zarathustra explained over the weekend, there is now real hope that inflation has peaked, leading to the possibility that we’ll see policy easing by year end, meaning both Europe and the US could receive a boost to external demand going into the first quarter of next year. That, however, hinges on clean soft landing scenario in which the Chinese housing and shadow bank shakeout does not turn unruly. I am 50/50 on that.

So, has the outlook changed for a Western recession? According to Bill Gross of Pimco (h/t Zero Hedge):

So where do we go from here? Our internal growth forecast for developed economies is now 0% over thecoming several quarters and the portfolio more accurately reflects this posture.

To me that statement makes no sense. I don’t think an economy can go forward at neutral. As I’ve said before, businesses react to such subdued demand conditions by seeking margin in cost-cuts. That means job losses, causing demand to diminish further. That triggers and inventory cycle, recession and recovery.

In sum, I am less worried about a catastrophic outcome in Europe but more concerned about a conventional recession. I am more worried about a hard landing in China, though also more hopeful that it can be managed. The US and Japan look roughly similar to July. The global composite PMI for September captures things for me:

A small September bounce but growth slow and vulnerable to another shock. The ongoing withdrawal of public support is that shock. I can’t see it replaced by private demand. Hence I do not see the current equities bounce as sustainable. My base case remains a Western recession developing next year.