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Thursday, January 14, 2010

Double-Dip Worries In Japan and Germany

Whoever said economists are people who don't ever get anything right?

"Economic growth in Germany probably stagnated in the fourth quarter from the previous three months, the Federal Statistics office said. Still, the figure is “surrounded by uncertainty,” Norbert Raeth, an economist at the office, said in a press conference in Wiesbaden today."

So German GDP was probably more or less flat quarter on quarter between October and December. The figure is surrounded by uncertainty, as I pointed out in this post (Is There A Double Dip Risk In Germany? ), quite simply because German growth numbers at the moment are all about net trade and inventories, with domestic consumption in an entirely secondary role. In fact quarterly movements in private consumption have been slight for some long time now, and it fell 0.9% in the third quarter (making a 0.5 negative impact on growth - see below, the large movement which can be seen between Q4 2006 and Q1 2007 is a distortion produced by the reaction to the 3% VAT increase which came into effect on 1 January 2007).

Imports rebounded in the third quarter, meaning the net trade impact was rather negative, but inventories were built up again (after various quarters of destocking) making a large 1.5 percentage points contribution to a final 0.7 percentage points quarterly growth. Things probably inverted in the fourth quarter, with export levels dropping back in both October and November, while inventories if not actually being run down, most likely were more or less neutral (this is what the IFO survey for the quarter shows) and thus won't count as a massive plus for growth. Eventually the whole inventory story is about second derivatives: when destocking slows down, the second derivative effect, mutatis mutandis, pushes GDP up, and and when restocking slows, this pushes GDP down.

So with nothing substantial to push it up, GDP stagnates. As I started to point out back in mid November:
The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories……Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don’t have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports....

That was before we got the detailed breakdown of Q3 growth. On November 28, following the publication of this data, I went on to argue that:
While a positive contribution to growth was made by goods exports, which were up 4.9% on the previous quarter, imports also rose , and by more than exports (up by 6.5%), and the resulting trade balance had a negative effect on growth of –0.5 percentage points. This was more or less the same as the contribution from household consumption (which was also negative by 0.5 percentage points). But what really, really mattered here - see the chart below - was the inventory build-up which added a staggering 1.5 percentage points to growth., while government final consumption expenditure only increased slightly (+0.1%) over the period and effectively had zero impact on the growth number. So, as I said, it is all about inventories in Q3.

Which lead me to conclude that:

In Q4 it is all going to be about trade. Since if German exports hold up, then the run down in inventories need not be that strong, but if exports don’t sustain momentum in December - and what just happened in Dubai is making me very nervous on that front - then German GDP will almost certainly fall back into negative territory in the fourth quarter. On the other hand, if I am jumping the gun slightly here, and German economic activity does manage to eke out some small increase at the end of the year, then I think a return to negative growth in the first quarter of 2010 is almost guaranteed. That is to say, we have a double dip on the horizon. At least, that is my call. Now it is over to you.

Japan's Recovery Also Fails To Convince

Well, my instincts seem to have been more or less good ones, and just to show that my forecast was not simply a fluke (ie that it is backed by some sort of coherent analysis, one that is testable), I would also draw attention to my "twin" post on Japan - Double Dip Alert In Japan, dated 7 December - where I said:

"Despite recent optimism about the apparent renaisance of growth in the Japanese economy, and the heightened sense of enthusiasm which surrounds the surge in economic activity right across the Asian continent there are considerable grounds for caution about the sustainability of the Japanese recovery itself".

Just two days laters Japan's third quarter results were revised down, sharply (and for most analysts unexpectedly sharply).

JAPAN'S economy grew much less in the third quarter than initially reported, revised government data showed today, as a strong yen and deflation weighed on economic activity by prompting firms to hold off on new investments. The new data revealed that July-September's real gross domestic product grew 0.3 per cent compared with the previous quarter, much slower than the 1.2 per cent expansion reported last month, and worse than analysts' consensus forecast of a 0.6 per cent rise.

Japan may have contracted in the fourth quarter, at this point I'm not sure, given the sharp downward revision in Q3. Certainly Japan’s reliance on exports is simply further underlined by the sharp fall in machinery orders from service companies in November. In fact orders from non-manufacturing companies dropped 10.6 percent (from October) to 380.7 billion yen ($4.15 billion), their lowest level since May 1987. In addition core orders from all industries, an indicator of business investment in three to six months, also fell to a record low.

And the Japan composite Purchasing Managers Index (PMI) shows contraction over the whole October to December period. And the drop was lead by Japanese services. The headline seasonally adjusted PMI posted 42.7 in December, up slightly from 42.3 in the previous month, but still pointing to a marked reduction in business activity amongst Japanese service providers. For Q4 as a whole, the headline index averaged a lower reading than in Q3. So, despite manufacturing data pointing to a faster expansion of output, the Composite Output Index (which mirrors GDP) was stuck at a level succesting a solid reduction in private sector activity. The index, which posted 46.5, has remained below the neutral 50.0 threshold for four successive months.

Where Is The Demand?

So what's the point of all this? Well certainly not to say simply "aren't I clever now". The issues is that (for demographic reasons) the German and Japanese economies are totally export dependent (retail sales in Germany have now peaked, and are in long term historic decline, see chart below), and thus it is unrealistic to expect the global recovery to be lead by an expansion in these economies. The recovery will have to come elsewhere (in France, for a start, but with France alone there is not enough) and the export dependent economies can then "couple" to that dynamic. It is difficult to say whether or not the Japanese economy will show some marginal growth in the fourth quarter, since the Q3 revisions make for a much lower base, industrial output has risen considerably on the quarter, but the important services sector has been contracting.

Essentially, until those heavily indebted economies (the US, the UK, Spain, Ireland, Eastern Europe, etc) who formerly ran current account deficits can find a way back to sustainable growth without the aid of large government stimulus programmes, any general recovery will remain extremely weak. And the German result has, of course, implications for four quarter Eurozone growth. As I said in this earlier summary of the Q3 eurozone performance:

So, going back to my original question, is this a whimper recovery, or are we on the verge of a double dip? I think, basically, it is all down to Germany, and those inventories. If external demand weakens in key customer countries then Germany will fall back into negative growth, and with it the whole "eurozone sixteen economy". Since demand in the South and the East of Europe is hardly going to be strong, given the new found need of countries in those regions to run trade surpluses, my inkling is that just this outcome is now a clear possibilty. So while the consensus at the moment seems to be that France disappoints, my view is that it is the German economy we really should be worrying about.

As Gabriel Stein of Lombard Street Research puts it:

The lack of December data obviously adds an element of uncertainty to current estimates, but it does seem fairly clear that German private consumption continued to fall in Q4 2010. Given a deteriorating global environment – monetary tightening now under way in China, an end to the effects of fiscal stimuli and slower inventory drawdown/modest inventory build-up in the US and the UK – the outlook for German exports is unlikely to be that good, particularly with the euro still strong. This is bad news for Germany and for the entire euro area. A weaker euro could ease some of the pain, but that is all it can do.

So, in closing, lets just remember that German GDP fell by 5% in 2009, we are now back round the same level we were at in mid 2006 (see chart below), and we are not exactly springing back up to the old levels. That is the measure of the task we have in front of us.

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