The Office for National Statistics (ONS) left its estimate of the change in GDP in the fourth quarter unrevised at -0.2% in today’s second release. The suggestion that the economy contracted is at odds with an above 50 reading of the purchasing managers’ composite output index as well as resilient labour market indicators and could be explained by a larger-than-usual fall in working days between the third and fourth quarters – see previous post. (The ONS does not apply a working day adjustment to quarterly GDP, although some of the monthly input variables are corrected.)

The apparent conflict between the GDP number and PMI / labour market data is reminiscent of the third quarter of 2009 – the quarterly GDP change was initially estimated at -0.4% but has subsequently been revised to +0.2%.

A monthly GDP estimate calculated from data on services, industrial and construction output (99% of the economy) was 0.05% above its fourth-quarter average in December, implying marginally positive carry-over into 2012 – see chart. The services sector ended the year solidly, with December output 0.3% above the fourth-quarter average and “only” 1.7% below a peak reached in November 2007.

The expenditure breakdown reveals a “surprise” 0.5% rise in household consumption last quarter after a 0.1% third-quarter decline. This confirms, belatedly, an assessment here last May that consumer prospects were improving, in contrast to media and MPC gloom at the time. The recovery appears to have continued in early 2012, with January retail sales volume 1.5% above the fourth-quarter average.

GDP weakness reflected a 5.6% fall in business fixed investment and lower stockbuilding. Investment figures are often revised heavily and the scale of the decline is difficult to square with a 1.7% rise in import volumes of capital goods last quarter.

The view here remains that the economy is pulling out of a “soft patch” that has been exaggerated by GDP data and media reporting, with a recession unlikely barring a negative external shock.

The Bank of Japan’s 14 February decision to expand its asset purchase program (APP) by ¥10 trillion to ¥65 trillion appears to represent a serious effort to loosen monetary conditions and may contribute to a further weakening of the yen over coming months.

The APP was introduced in October 2010 and stood at ¥44.5 trillion on 20 February. The aim is to reach the new ¥65 trillion ceiling by the end of 2012, suggesting a monetary boost of about ¥20 trillion over the next 10 months, equivalent to $250 billion or 4.25% of Japanese annual GDP.

Sceptics, however, argue that the BoJ is, once again, using an expansion of the headline APP target to deflect political pressure and is unlikely to follow through with a significant liquidity injection. They point out that the rise in the APP to ¥44.5 trillion since October 2010 has not been fully reflected in the size of the BoJ’s balance sheet and the monetary base (i.e. notes in circulation plus bank reserves) – BoJ assets have increased by ¥23 trillion and the base by only ¥16.5 trillion.

Less than 40% of the APP “injection”, in other words, has fed through to the monetary base. On this basis, the planned ¥20 trillion expansion by the end of 2012 may boost the base by only about ¥8 trillion.

To understand why this is probably too pessimistic, it is necessary to examine the reasons for the limited impact to date. The current ¥44.5 trillion APP total comprises “fund-supplying operations against pooled collateral” of ¥33.5 trillion and securities holdings of ¥11 trillion. Banks have used a large proportion of the funds accessed under the former facility to repay existing borrowing from the BoJ. Total BoJ loans have risen by only ¥11 trillion since October 2010, explaining the slippage between the APP and balance sheet expansion.

The even smaller impact on the monetary base reflects, in addition, an increase of ¥8 trillion in BoJ repo borrowing, which drains reserves from the banking system.

Looking ahead, the planned ¥20 trillion APP expansion by the end of 2012 is intended to be achieved mainly via a ¥19 trillion expansion of securities holdings, implying an equivalent boost to the size of the balance sheet. The BoJ’s new commitment, meanwhile, to target inflation at 1% over the medium to long term would seem to preclude sterilising this liquidity injection by increasing repo borrowing further. The APP rise, therefore, should be broadly matched by the monetary base.

The chart shows straight-line projections for BoJ assets and bank reserves assuming that 1) the planned increase in securities holdings is achieved, 2) there are no other influences on the size of the central bank’s balance sheet or the monetary base and 3) notes in circulation are stable so the rise in the base is reflected in reserves. The suggestion is that BoJ assets will expand to about ¥159 trillion by end-2012 versus a previous record of ¥150 trillion reached after the March 2011 earthquake / tsunami, with bank reserves rising by nearly three-quarters from their current level.

The Markit Chinese manufacturing purchasing managers’ survey seems to be less reliable than its official counterpart but today’s flash results for February are consistent with the view here that downside economic risks have increased, warranting policy easing beyond the 0.5 percentage point cut in reserve requirements announced over the weekend.

The key new orders index was flat at 49.1 in February despite a positive impact from an earlier-than-normal New Year holiday, while the finished goods inventories index rose – a probable dampener on production plans.

The official survey, released next week, deserves more weight and may confirm weakness, judging from a leading indicator derived from the OECD’s Chinese leading index – see chart.

The Eurozone flash PMIs also released this morning did not, as suggested in a post yesterday, surprise positively but the manufacturing new orders and services new business indices continued to recover, reaching their highest levels for seven and six months respectively – the message from the earnings revisions ratio was directionally correct.

As previously discussed, the key purchasing managers’ manufacturing new orders indices correlate well with “revisions ratios” of equity analysts – the net proportion of company earnings estimates revised higher each month. February ratios suggest that new orders will top out soon in the US (consistent with evidence presented in yesterday’s post) but continue to recover solidly in Euroland – the “flash” PMIs are released tomorrow.

Today’s public sector finances numbers for January – a key month for tax receipts because of self assessment returns and quarterly corporation tax payments – cast further doubt on the upward revisions to borrowing forecasts by the Office for Budget Responsibility (OBR) in its November 2011 Economic and Fiscal Outlook.

With the January number better than expected and borrowing in earlier months of 2011-12 revised down, the targeted PSNB ex measure (i.e. public sector net borrowing “excluding the temporary effects of financial interventions”) was £15.7 billion lower over April to January than in the corresponding period of 2010-11. PSNB ex is on course to total about £119 billion in 2011-12 compared with an OBR forecast of £127 billion – wrongly revised up in November from £122 billion despite satisfactory year-to-date developments.

The suggested £119 billion outcome, indeed, is close to the OBR’s £116 billion forecast for 2011-12 made at the time of Chancellor Osborne’s first Budget in June 2010. It would equate to 7.8% of GDP compared with peak borrowing of 11.1% of GDP in 2009-10.

A bigger story that may go unreported, however, is the faster decline in the “old” PSNB measure that includes the surplus of the public sector banks and net interest income of the Bank of England’s Asset Purchase Facility (APF). PSNB is on course to fall from £109 billion last year to about £85 billion – £16 billion lower than the OBR’s November forecast and equivalent to “only” 5.6% of GDP.

QE income accounts for about £9 billion of the estimated £34 billion difference between PSNB and PSNB ex in 2011-12 and should rise further to about £11 billion in 2012-13, based on announced plans to expand the APF and assuming no change in Bank rate. (A previous post argued that the Treasury should “book” this income by requiring the APF to pay an annual dividend. Such a treatment would be equivalent to that adopted in the US, where the profit of the Federal Reserve, including its net income from QE, is distributed to the Treasury. The Fed has estimated that the distribution relating to 2011 will be $76.9 billion, up from $31.7 billion in 2008, with the increase mainly reflecting the expansion of its balance sheet due to asset purchases.)

PSNB includes the entire surplus of the public sector banks and their subsidiaries – an estimated £25 billion in 2011-12 – but the government’s economic ownership of Royal Bank of Scotland and Lloyds Banking Group is 83% and 41% respectively. (It also owns the mortgage books of Northern Rock and Bradford & Bingley.) Only about 60% of the banks’ surplus, therefore, should be attributed to the public sector. Such a treatment suggests “true” net borrowing of about £95 billion in 2011-12, or 6.2% of GDP. (The attributable surplus, of course, is not available to finance immediate government spending. With no dividends being paid, however, the surplus results in a rise in the book value of the government’s shares, an increase that should be reflected in the proceeds of the banks’ eventual sale.)

A post last week argued that the current mini-upswing in global growth would peak this spring, based on a slowdown in real narrow money since late 2011. Such a scenario should be flagged by a topping out of widely-watched manufacturing purchasing managers’ survey indices – the forward-looking new orders component in particular.

A peak in the US ISM manufacturing new orders index within the next couple of months is suggested by recent falls in three-month retail sales volume growth and the expected orders balance in the Philadelphia Fed regional manufacturing survey. Both measures tend to lead ISM new orders, as the following charts show.

The prospect of less upbeat global economic news from the spring may warrant investors trimming overweight positions in equities and other risk assets. It may, however, be premature to move underweight, for several reasons.

First, equities have tended, if anything, to lag the economic cycle in recent years. The March 2009 US stock market low, for example, followed a December 2008 bottom in ISM manufacturing new orders. The July / August 2011 sell-off, similarly, occurred after a May plunge in the ISM. On this basis, a March 2012 peak in new orders could be consistent with equities remaining firm until May / June.

Secondly, while investors have embraced risk recently, available evidence does not suggest that positions are extreme. Fund manager cash levels are normal rather than low, according to the February Merrill Lynch survey. The Credit Suisse risk appetite measure, similarly, is far below the “euphoria” region that often marks cycle tops.

Thirdly, global liquidity conditions remain favourable, with G7 real narrow money outpacing industrial output and central banks continuing to inject liquidity – the second ECB three-year LTRO coupled with stepped-up JGB purchases by the Bank of Japan may lift G7 bank reserves above their late 2011 high. The mid-2011 economic cycle peak, by contrast, occurred when the G7 real narrow money / industrial output growth gap was negative and US QE2 was ending, possibly explaining the severity of the subsequent risk sell-off.

Finally, markets may “look through” a modest weakening of economic indicators on the view that this would give a trigger-happy Fed an excuse to launch QE3. True, US “core” inflation is proving uncomfortably resilient – see below – but modern central bankers routinely ride roughshod over facts in pursuit of ideologically-driven policy prescriptions, as recent UK experience amply demonstrates.