Euroland economic news softening on schedule

Posted on Wednesday, February 21, 2018 at 11:59AM by Registered CommenterSimon Ward | CommentsPost a Comment

Previous posts (e.g. here) argued that the Euroland economy would slow from around spring 2018. Weaker February PMI results are consistent with this forecast. As usual at economic momentum peaks, the consensus is likely to emphasise the still-strong level of survey indicators, playing down the change of direction. Money trends, by contrast, suggest a further significant cooling over coming months.

Six-month growth of real narrow money, as measured by non-financial M1 deflated by consumer prices, peaked most recently in June 2017, falling in December to its lowest level since 2014. Allowing for a typical nine-month lead, this signals a likely decline in economic momentum from around March 2018 through September, at least. Two-quarter GDP growth, in fact, may have peaked in the third quarter of 2017, although recent data have tended to be revised upwards – see first chart.

Business surveys lead activity by up to three months, implying that they should reflect monetary trends six months or so later. The second chart shows the manufacturing PMI and output expectations from the EU Commission manufacturing survey, along with six-month real narrow money growth lagged by six months.  The survey indicators appear to have peaked on schedule in December, with the February decline in the PMI likely to be echoed by next week’s EU Commission survey. The relationship suggests a further fall in the PMI towards the 50 level by mid-2018.

Why have monetary trends weakened despite ECB President Draghi’s best efforts to delay policy “normalisation”? The view here is that narrow money is demand-determined and influenced importantly by spending intentions, explaining its leading relationship with activity. Sectoral figures show that money holdings of both households and corporations have slowed. Spending intentions may have been dampened by a combination of higher inflation, firmer long-term yields, euro strength, incipient global cooling, Brexit worries and concern that some governments will face financing difficulties as the ECB’s QE backstop is withdrawn.

Will global money trends stabilise soon?

Posted on Tuesday, February 20, 2018 at 10:30AM by Registered CommenterSimon Ward | CommentsPost a Comment

The global real money measure tracked here appears to have slowed further in January, reinforcing the expectation of a significant loss of economic momentum later in 2018.

The US, China, Japan, Brazil and India have released January monetary data, together accounting for two-thirds of our G7 plus E7 aggregate. Assuming unchanged money growth in other countries, and incorporating near-complete inflation data, six-month expansion of G7 plus E7 real narrow money is estimated to have reached another nine-year low – see first chart.

With six-month industrial output growth expected to have been little changed from December, real narrow money expansion is likely to have fallen short of output growth for a second month, suggesting unfavourable prospects for equity markets – see previous post.

The fall in real narrow money growth since mid-2017 reflects both lower nominal expansion and a pick-up in six-month consumer price inflation – second chart.

Money trends suggest significant downside risk to consensus economic growth expectations but are still far from signalling a recession – every global downturn since the 1960s (at least) was preceded by a contraction of real narrow money. The expectation here is that global real money growth will stabilise or recover slightly over coming months, for two reasons.

First, six-month consumer price inflation may have reached a near-term peak in January, assuming that commodity prices stabilise at their current level – third chart.

Secondly, US narrow money growth may revive into mid-2018 as tax cuts lift disposable incomes and spending intentions. Stronger US monetary data may offset weaker trends elsewhere.

We examined the behaviour of US narrow money growth around three previous major tax cuts, signed into law by Presidents Johnson (1964), Carter (1978) and Reagan (1981). These were the top three initiatives since 1950 ranked by impact on existing revenues, according to a Treasury study, involving losses of 1.6%, 0.8% and 2.9% of GDP respectively. For comparison, the Tax Cuts and Jobs Act of 2017 is projected to cut revenues by 1.1% of GDP*. The three prior reductions occurred against a backdrop of rising interest rates, as now.

Surprisingly, there was a consistent pattern across the three episodes: six-month narrow money growth declined before and just after legislation was passed but then rose for 5-6 months, subsequently falling back again – fourth chart.

This pattern could reflect uncertainty about the success and details of legislation holding back spending and activity pending its passage. In addition, some beneficiaries of tax cuts may lack liquid resources or access to credit, delaying the boost to their spending until reductions flow through to disposable incomes.

The recent monetary slowdown fits the historical pattern and the suggestion is that narrow money growth will recover temporarily in Q2 and Q3 2018.

Such a revival could warrant a more positive view of US economic prospects for late 2018 / early 2019 but would not alter the forecast of a near-term slowdown. Global prospects, of course, will also hinge on developments in China, where money trends suggest an increasing risk of a “hard landing” unless the authorities reverse policy restriction soon – see previous post.

*All figures refer to static impact over four years, except 1964, which refers to full impact in single year.

Chinese money trends flashing danger

Posted on Wednesday, February 14, 2018 at 11:25AM by Registered CommenterSimon Ward | CommentsPost a Comment

Chinese data for January / February can be distorted by New Year timing effects. With this caveat, January money numbers appear notably weak, reinforcing the expectation here of a significant economic slowdown later in 2018.

A negative view of the data may seem odd given that annual growth rates of M1 and M2 rose between December and January – from 11.8% to 15.0% and from 8.2% to 8.6% respectively. The official measures, however, are flawed: M1 excludes household demand deposits*, which are relevant for assessing consumer spending prospects, while M2 has been distorted in recent years by large fluctuations in deposit holdings of financial institutions – such deposits appear to be uncorrelated with future spending / activity.

The analysis here, therefore, focuses on “true M1” – official M1 plus household demand deposits – and M2 excluding financial deposits. Annual growth rates of these measures, in contrast to the official M1 / M2 aggregates, continued to slide in January, reaching their lowest levels since mid-2015 – see first chart.

The preferred measure here for forecasting purposes is the six-month rate of change of real true M1 (i.e. deflated by consumer prices, seasonally adjusted). This fell sharply between August 2016 and January 2017 but then stabilised through September 2017 at a respectable historical level – second chart. This stabilisation was the basis for the view here that the Chinese economy would retain solid momentum through early 2018 – contrary to pessimistic forecasts from followers of the “credit impulse”, among others.

The six-month growth rate, however, resumed its decline in the fourth quarter of 2017 and fell significantly further in January. Allowing for a typical nine-month lead, this suggests economic weakness starting around mid-2018.

Demand deposits within true M1 comprise holdings of households, non-financial enterprises and government departments / organisations. The latter can be excluded to create a “private” variant of the aggregate. This measure has slowed even more sharply – second chart.

Chinese narrow money trends tend to lead house prices, industrial profits and producer prices, in that order – third chart. The monetary slowdown was reflected in a moderation of house price inflation during 2017; profits growth and producer price inflation have turned down more recently – third chart. These trends are likely to extend. Weaker economic data and easing inflationary pressures may prompt a partial reversal of recent policy tightening in mid-2018.

*Such deposits are large – equivalent to 46% of the stock of official M1 – and appear to be inversely correlated with currency in circulation and corporate demand deposits around the New Year.

UK MPC hawkish shift at odds with money trends

Posted on Tuesday, February 13, 2018 at 02:22PM by Registered CommenterSimon Ward | CommentsPost a Comment

Last week’s UK Inflation Report signalled that the MPC intends to raise rates again in May if the economy evolves in line with its forecast. Monetary trends suggest that the Committee should proceed with caution.

The MPC’s new-found hawkishness partly reflects its repeated underestimation of inflation outturns. January consumer price inflation remained at 3.0%, in line with the latest Bank staff estimate but well above a projection of 2.6% for the first quarter of 2018 in the November Inflation Report. The MPC expects inflation to fall back to 2.4% by the fourth quarter of 2018. It may continue to be disappointed – on plausible assumptions, the forecast for late 2018 here is 2.6-2.7%.

Current and near-term high inflation, however, is a consequence of past policy laxity relative to monetary and economic conditions. Belated remedial action risks compounding the error.

The February Inflation Report, as usual, contained no monetary analysis. The MPC’s difficulties, on the view here, stem from its neglect of monetary trends. A key mistake was to ease policy in August 2016 when money growth was high and rising. Annual expansion of the Bank’s broad M4ex aggregate was 5.9% in June 2016 (available to the MPC in August), the highest since 2008, with the narrow non-financial M1 measure growing by 9.2% – see chart.

Monetary trends, that is, signalled that the economy did not require post-EU-referendum support. The MPC’s easing decision magnified the fall in sterling associated with the referendum result, thereby contributing to the current inflation overshoot.

Annual money growth, however, peaked in late 2016 and trended lower during 2017. December numbers released in late January – the first to reflect a full month at the higher level of Bank rate – showed a further significant step down. Annual expansion of non-financial broad and narrow money is the lowest since 2012. The monetary slowdown has been reflected in a moderation of nominal GDP growth.

Monetary trends are not weak enough to suggest imminent economic danger and / or an eventual inflation undershoot. They question, however, the urgency of policy tightening. The MPC, on the view here, should wait for a stabilisation or recovery in money growth before hiking again.

Is the liquidity backdrop for markets now negative?

Posted on Thursday, February 8, 2018 at 09:50AM by Registered CommenterSimon Ward | CommentsPost a Comment

The consensus narrative is that recent equity market declines reflect worries that rising inflation will force central banks to accelerate policy tightening. An alternative possibility is that global monetary conditions are already restrictive and will act as a drag on the economy and markets even if policies are unchanged.

Market prospects, on the view here, are related to the difference – if any – between actual growth in the stock of money and the rate of expansion warranted by (nominal) economic expansion. “Excess” money growth will usually be associated with an increase in demand for financial assets and higher prices of those assets (assuming unchanged supply). Conversely, low money growth relative to economic needs will usually signal weak demand for assets and stagnant or falling markets.

Divergences between actual and required money growth may be reflected in a general trend in asset prices or a sharp movement in a particular market, depending on the economic backdrop, popular investment themes and valuations, among other factors.

The level of money growth required to support economic expansion, of course, cannot be measured directly. A simple approach is to assume that the economic demand for money rises in line with output and prices of goods and services. The sign of the gap between money growth and the sum of output growth and inflation will then be a gauge of whether monetary conditions are positive or negative for asset prices.

Such an approach would have been helpful for assessing global equity market prospects historically. We examined the relationship between the monthly excess return on the MSCI World index in US dollars relative to US dollar cash and the sign of the gap between the six-month rates of change of G7 real narrow money (using consumer prices as the deflator) and industrial output. The mean excess return on equities over cash between December 1969 and December 2017 (48 years) was 3.6% per annum (pa). The mean excess return in months following a positive signal from the real  money / output growth gap was 10.2% pa*. By contrast, equities suffered a mean net loss of 4.8% pa in months following a negative signal.

The chart compares the cumulative return relative to US dollar cash of the MSCI World index and a strategy that switches between equities and cash depending on the sign of the real money / output growth gap**. The strategy would have captured much of the rise in equities while limiting drawdowns***.

The gap between G7 six-month real narrow money growth and industrial output growth was positive between January 2011 and November 2017 but appears to have fallen below zero in December, based on full monetary / price data and partial information on industrial output.

Incorporating China and other large emerging economies does not alter the current signal: G7 plus emerging E7 six-month real narrow money growth also appears to have crossed beneath industrial output growth in December.

Real broad money growth – either G7 or G7 plus E7 – is also now below industrial output growth.

A cautious investment stance may remain warranted until the real money growth / output growth gap reverses back into positive territory.

*The analysis allowed for a two-month reporting lag for monetary / economic data.
**The strategy also requires the six-month change in real narrow money to be positive in order to hold equities.
***The strategy suffered a significant loss during the 2000-02 bear market because it switched back into equities prematurely. Equity market valuations were still historically high when the buy signal was issued.

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