Asia Sentry Dispatch

August 03, 2012

A Troika of Disappointment
The past week could well prove to be a turning point in market pricing of the risk outlook. To my mind, the three key takeaways from a full week of data points and events are: With policy operating in the unconventional zone, the abilities of the G3 central banks to offer frequent and/or effective additional easing measures are severely curtailed. The risk-on rally that followed Draghis pronouncement that the ECB would do whatever it takes looked overdone at the time, but even more so today given the inability of the ECB to deliver a unanimous and immediately workable easing protocol. 2. Asia is slowing by a greater amount and at a faster pace than the consensus holds or is forecasting. The consistent element of the woeful Asia regional PMIs for July was manufacturers identifying a synchronized weakening in demand from Europe, the US and China. The problem with syncronised slowdowns, particularly for trading economies such as Asia, is they tend to reinforce each other. 3. Austere developed-economy consumers no longer must have the latest handset, camera phone or flat-screen TV. The first week of the London Olympics has seen typical consumer electronic Games darlings, such as Sharp and Sony, absolutely punished on slashed full-year forecasts and slumping demand. Coming a week after a rare earnings miss by Apple, we remain strongly of the opinion that the consumer led global ICT cycle is failing fast. There is no immediate remedy or policy prescription to remedy these woes. Hence, things will get considerably worse in coming months as these dynamics continue to play out. 1.

Friday, August 03, 2012.

Page |1

Sentry Dispatch: The High Frequency Letter of Asia Sentry Advisory.

Growth retrenchment underway across Asia.

Asian manufacturing ended the second quarter on a frail footing and, rather than stabilizing, we would interpret the regional PMIs as pointing to significant further weakness. Since the slowdown in Asia began in the second half of 2011, the adjustment in output has occurred with a stable labour stock given greater flexibility in managing hours worked and overtime. Ominously, the July PMIs suggest that the manufacturing sector pan-Asia has now moved into job-shedding mode. All the major economies we track in Asia, with the exception of India, reported manufacturing job shedding in July with Taiwan and China both shedding jobs at the fastest pace in nearly five years. This highlights an interesting business cycle dynamic. When final demand adjusts, firms tend to maintain their existing stock of labour and either work it harder (if demand increases) or less intensively (if demand weakens) before committing to adjusting the labour stock. Despite a fairly large adjustment in final demand and output in 2008-09, firms that did not shed labour were able to enjoy the strong rebound in production that occurred on the back of China and the regions stimulus packages. As for now, with final demand and output having been on a persistent and consistent decline since H2-2011, July appears to be the tipping-point where firms are now actively retrenching labour. Net Effect a more pronounced weakening in domestic demand in Asia will now work alongside ongoing weakness in external demand to further pressure Asian industrial output. Common Threads in the July Regional PMIs
Headline PMI Output Japan Fell sharply Sharpest decline in 15 months Down sharply Australia Fell sharply Down sharply South Korea Fell sharply Fell sharply Taiwan Fell firmly Fell firmly China HSBC Rose firmly Up marginally India Fell firmly Small rise

New Orders

Down sharply

Fell sharply

Export Orders

Down sharply

Down sharply

Fell sharply

Backlogs Employment

Sharpest drop since Jun 2009 Shedding jobs

N.A. Large job shedding

Decline at record pace Shedding jobs

Fastest pace of contraction this year Fastest pace of contraction this year Fell Workforce reduction fastest in 37 months Factory gate prices fell substantially

Unchanged

Deteriorating

Slowest pace of rise in 8 months Falling

N.A. Job-shedding at fastest pace in 40 months Costs continue to decline

First reduction since 9/11 Modest job creation

Prices

Average costs Falling Input prices declined at decline at fastest pace in fastest pace 32 months since 2006 Source: Asia Sentry Advisory, Markit and various regional sources.

Output prices rising

Alert: Watch for the confluence of inventories and deflation

The biggest danger sign for Asia at the moment is that inventories remain elevated whilst a significant disinflationary impulse is building. The combination of the two is toxic for output growth, and if they intersect, Asian IP growth will slow dramatically in the second half of this year.

Friday August 03, 2012.

Page |2

Sentry Dispatch: The High Frequency Letter of Asia Sentry Advisory.

Producers are adverse to excess inventories at the best of time, but particularly so in a deflationary environment. As Japans lost decade(s) reveal, in a deflationary environment, slow-moving inventories lose value, hence firms become even more adverse to holding them. Production is immediately curtailed in the event of unintentional inventory accumulation and firms become highly cautious about prematurely restarting production. The signs of a deepening disinflationary impulse were also readily apparent in the regional PMIs. With the exception of India, again, all the major economies we track in Asia reported falling input and/or output prices. For Japan and South Korea, where we would assess the greatest deflation risk, costs and prices are now declining at the fastest pace seen in years. South Korean inflation undershot expectations by a wide margin, with the CPI falling by 0.2%MoM in July vs consensus expectations for a 0.2%MoM increase. That 4.8% annualised miss cannot be adequately explained by falling commodity prices. Like Japan, where disinflation was also an unwelcome guest in July, we suspect that the deterioration in the Korean price profile is more likely due to a wider than expected output gap, and the widening in that gap having occurred faster than expected. Again, this highlights the importance of the persistence of a change in demand conditions as opposed to a profound, though short lived demand adjustment. Over 2008-09 demand collapsed, however, Asian policy makers were able to engineer a vshaped recovery in output, largely as China became the principal source of external demand for Asia and created new domestic demand for itself. Now, the persistence of the weakening in external demand that has been in play since H2-2011 has led to a widening of output gaps sufficient to place significant downward pressure on producer prices. If this trend were to continue, Asian firms would be highly reticent to over produce and production would most likely take another step-down in Q3.

This weeks conclusion. The key point that we are taking away from this weeks data is that a retrenchment in Asian industrial production is now in play. The extent and duration of that retrenchment will depend on how successfully external policy makers address deteriorating final demand in Europe and the US. Policy inaction in the past week suggests current forecasts are at the optimistic end of the spectrum in that regard. The most crucial dynamic will be the interaction of Asian inventories and deflation. If the trends currently underway in an economy such as South Korea (where production is missing estimates and disinflation is much more pronounced than thought) were to continue, than IP would take a further significant step down over the third quarter.

Friday August 03, 2012.

Page |3

Sentry Dispatch: The High Frequency Letter of Asia Sentry Advisory.

Asia Sentry Advisory Pty Ltd Suite 9, Level 40, Northpoint Tower 100 Miller Street, North Sydney, NSW, 2060, Australia. Ph: +61 2 9931 7820 Fx: +61 2 9931 6888 M: +61 401 548 820 www.asiasentry.com gbmaguire@bloomberg.net glenn@asiasentry.com

Asia Sentry Advisory Pty Ltd is a boutique economic consultancy established to meet the growing demands of clients seeking greater exposure to the most dynamic economic region in the post-crisis global economy, Asia. Asia Sentry Advisory marries keen judgment with a rigorous model-based approach and a deeply intuitive understanding of Asia that can only come from on-the-ground experience to deliver market out-performing analysis and forecasts.
How closely are you watching?
Follow us on Twitter, @AsiaSentry Watch us on YouTube. Asia Sentry Advisory See us analyze in real-time on LiveStream, Asia Sentry Advisory