After a preceding day when they were unsure of their direction US equity markets had no such doubts yesterday. The Dow Jones Industrial Average surged some 254 points to 10269 on the back of some new data on the US economy which was positive for once. Also European equity markets had already been rallying strongly before the Dow opened with talk it was on the back of an improved Chinese Purchasing Managers Index or PMI which rose to 51.4 from the previous July reading of 49.4. Although some may already have spotted that on the day the Chinese Shanghai Composite equity index had fallen by 0.6% to 2623 so the truth was maybe more that markets were looking for an excuse to rally. There was also talk that a big fund was switching from bonds to equities.
In terms of commodity price movements then the price for Brent crude oil followed equity markets as it rose by US $1.96 per barrel to just over 76.5,whilst the CRB spot index rallied by 1.99 to 457.39 on the back of rising metal prices. So overall a day which was consistent if nothing else.
US Economic Data, The ISM Report
After a period where most measures of the US economy had been signalling a slowdown then this from the Institute of Supply Management was much more positive.
“Manufacturing activity continued at a very positive rate in August as the PMI rose slightly when compared to July. In terms of month-over-month improvement, the Production and Employment Indexes experienced the greatest gains, while new orders continued to grow but at a slightly slower rate. August represents the 13th consecutive month of growth in U.S. manufacturing.”
Putting this into numbers then the headline PMI rose from 55.5 in July to 56.3 in August. Also if you read further down the report the employment indicator rose from 58.6 in July to 60.4 in August which seems hopeful as employment levels are currently a problem for the US economy. However on the day an employment report was issued by ADP which stated that the service sector in the US had created 30,000 jobs in August but that the goods producing sector had lost 40,000 creating a net negative of 10,000.
The first real question is to consider the reliability and usefulness of this report. On this subject ISM itself is confident as it points out the following.
In addition, if the PMI for August (56.3 percent) is annualized, it corresponds to a 4.8 percent increase in real GDP annually.
Whilst it is one of the more prompt indicators one needs to take a little care here I think as the ISM numbers for the spring of 2010 were strong with April recording a reading of 60.4 and yet we know that growth slowed in the second quarter of this year in the US, so the relationship between PMI and economic growth is not as linear as ISM suggests. It would not be the first indicator to change its predictive behaviour at this time. So good news yes, a full explanation for a 254 point rally in the Dow Jones no. A better number certainly ignites the debate.
Another revealing number in the report was that the price index rose from 57.5 in July to 61.5. So it would appear that manufacturers are able to pass on price rises which are probably from import costs. So at first this is also bullish except these price rises will squeeze the US consumer so there will be a negative effect over time. For those who feel that disinflation and perhaps deflation is just around the corner then this report shows that in August manufacturers were able to raise prices.
US Government Bond Prices
These fell back significantly on this news as at their current yield levels any sign of a pick-up or even a stability in inflation and inflationary expectations is significant. The US long bond (30 years) yield rose from 3.54% to 3.66% with the price dropping a couple of points. Any pick-up in the economy or sign of one is likely to have an impact on US Treasuries as their prices are set at these yield levels for quite a slowdown and perhaps worse.
European and Greek PMI
These figures were not as optimistic but seemed to be ignored in the melee. It als indicated yet again a divergence between the euro zone core and the periphery. The number fell from 56.4 last month to 55.1 this whilst Germany was at 58.2. So somebody had to decline and there were several with Italy slipping to 52.5 and then there was Greece.
The Manufacturing Purchasing Managers’ Index (PMI) for Greece fell to 43.0 points in August from 45.3 in July. So not only is it well below 50 which on such a scale indicates contraction but it declined further to indicate a more severe contraction. If one looks at the detail of the report then it does not make good reading. Production and new orders have now been in decline for some 11 and 12 straight months respectively, which means that there are excess capacity at manufacturing plants which led to reductions in work backlogs as well as stocks of finished goods and employment. An example of this is that the index for work backlogs fell considerably to 34.5 from 45.1 in July.
Just to complete an unhappy picture companies continued to shed jobs in August and at the fastest rate in nearly a year and a half. The shedding of jobs has now continued for the 28th consecutive month. We find also that manufacturers’ costs rose also in August and these cost rises were driven by higher raw material prices, taxes and transport costs. However weak demand meant that they were unable to pass these on.
On Monday we also got an update on Greek retail sales for June. The overall volume index fell by 4.4% continuing a sequence of falls that has been in place for some time. The sections which fell most heavily were department stores and clothing and footwear which both fell by 11.5%. Perhaps the most chilling way of looking at this number is to see that the index is at 91.6 on a series based at 100 in 2005. Yes your eyes do not deceive you in volume terms Greek retail sales are lower than in 2005. We are not used to such sustained falls in modern times and the numbers continue to fall. At least the decline is not as bad as the figures for May perhaps we should be grateful for that but I still worry that the full effects of Greece’s austerity programme have not hit her economy.
One way this is playing out in the Greek economy is that the level of deposits in her banks are falling and indeed it declined from 238 billion Euros at the end of 2009 to 216.5 billion Euros in June. This,of course is exactly what the what the weak Greek banking sector does not need and will make it even more reliant on funding from the European Central Bank. Here we have several of my themes colliding as Greek problems lead to Greek banking weakness leading to the ECB being unable to exit from its stimulus programmes, and it is likely that the ECB will announce an extension of some of its support programmes at its meeting later today.
The IMF issues a staff paper calling sovereign default “unnecessary, undesirable and unlikely”
In a curious piece of timing a staff paper published by the IMF comes to this conclusion for advanced economies and one of the economies in question is Greece. They feel that the “current market indicators of default risk seem to reflect some market overreaction”. This is an interesting view when one of the main measures of market risk is interest rates which on many government bond markets around the world are very low.Even Greece is currently borrowing at quite low rates for her circumstances as she has the EU and IMF to borrow from in the main for now anyway (she is borrowing herself on a short-term basis).
In essence the theories expressed in this paper are expressed in this excerpt.
The essence of our reasoning is that the challenge stems mainly from the advanced economies’ large primary deficits, not from a high average interest rate on debt. Thus, default would not significantly reduce the need for major fiscal adjustment. In contrast, the economies that defaulted in recent decades did so primarily as a result of high debt servicing costs often in the context of major external shocks. We conclude that default would not be in the interest of the citizens of the countries in question. Fiscal adjustment supported by reforms that enhance economic growth is a more effective response
I enjoy reading papers such as this which challenge existing thought but to my mind there are issues with this.
1.Just like a first world war general they are subject to the criticism that they are fighting the last war and not the current one. Much has changed over the period of the credit crunch and the pattern of defaults and restructuring may well have changed too.
2.It is true that average interest rates are low at this time and so in many cases are marginal ones indeed as I often report on here in many cases they are very low. However market expectations and rates can change very quickly. I am afraid that using current rates as a proxy for the future has gone wrong many times in the past.
3. Sadly my view for Greece’s economic future is for a lower trajectory that the IMF forecasts. I feel that it almost has to be optimistic given its involvement.
4. Countries have indeed attained the level of fiscal adjustment required in the past but apart from point one we are starting to see countries reject the IMF programmes imposed on them at least for the short-term (Hungary).
5. “Countries do not strategically decide to default” needs to have the words so far following it.
One area where I completely agree is that “Reforms are needed to improve potential growth and external competitiveness, thereby easing the fiscal adjustment process.”
In essence this is what a call a type of steady state analysis which looks forward with relatively rose-tinted glasses. In the end the real problem is that the world is dynamic and unpredictable and unless there is a quantum leap forward in mathematics the equations used in economics do not represent this adequately at all.