A "monetarist" perspective on current equity markets

Posted on Wednesday, October 10, 2018 at 12:54PM by Registered CommenterSimon Ward | CommentsPost a Comment

“Goldilocks” is over. The economic backdrop for markets has been unusually favourable in recent years, with growth mostly solid but not strong enough to produce capacity strains, allowing monetary conditions to remain loose. Now, growth has gone cold but hot labour markets are pushing up wage costs, squeezing profits and causing central banks to turn more hawkish.

Previous quarterly commentaries suggested that the global economy would lose momentum progressively during 2018. This forecast is on track: six-month growth of industrial output in the G7 economies and seven large emerging economies* peaked in December 2017 and fell sharply over April-June 2018, with no significant recovery in July-August – see first chart. Business surveys suggest a near-term further slowdown: the global manufacturing purchasing managers’ index (PMI) fell for a fifth consecutive month in September, reaching a 22-month low.

The key forecasting indicator followed here – six-month growth of G7 plus E7 real (i.e. inflation-adjusted) narrow money** – bottomed in February 2018 and has moved sideways through August. Allowing for a typical nine-month lead, the suggestion is that industrial output growth will reach a low around November, stabilising at a weak level into early 2019. If correct, the manufacturing PMI may bottom out soon while remaining soft by recent historical standards.

The suggested scenario of below-trend but stabilising economic growth would imply some easing of labour market pressures but would be unlikely to result in sufficient slack to reverse wage acceleration – unemployment rates are below estimated non-inflationary levels in most major economies. Recent stronger wage growth reflects worker demands for compensation for higher inflation as well as labour shortages. Faster growth of wage bills has contributed to a slowdown in profits in Japan, Euroland and the UK, a trend that may extend to the US during the second half – second chart.

There have been three notable monetary developments since our last commentary. First, growth in our preferred US money measure, real non-financial M1***, fell sharply in the second quarter, signalling a likely loss of economic momentum in late 2018 / early 2019 – third chart. Business money holdings, surprisingly, have contracted despite tax cuts and repatriation of foreign retained earnings, with corporations choosing to step up equity purchases and lower borrowing rather than boost their liquid reserves.

Secondly, Chinese money trends continued to weaken through August despite a recent shift towards policy easing. This could reflect a normal response lag; alternatively, easing to date may have been insufficient, with the authorities maintaining their clampdown on shadow credit. Other leading indicators, meanwhile, are now confirming the negative message from money trends, suggesting heightened downside economic risk.

Thirdly, real money growth has stabilised in Euroland and recovered modestly in the UK, therefore improving compared with US / Chinese trends. Our inclination, however, towards greater optimism about European economic / equity market prospects is tempered by coming challenges – the withdrawal of QE support for weaker sovereign bond markets and a brewing Italy / EU fiscal clash in the case of Euroland, and possible further Brexit turmoil in the UK. The UK monetary recovery, moreover, could be aborted by the August rate hike.

Global economic prospects for later in 2019 will depend on monetary developments over the remainder of 2018. The forecasting approach here does not attempt to predict monetary trends but further weakness seems more likely than renewed strength. Fed policy tightening is being transmitted globally via the strong US dollar: central banks in 12 out of 32 developed and emerging markets raised official rates during the third quarter, while none cut. Recent oil price gains, meanwhile, could result in a larger inflation drag on real money trends.

Chinese money growth should be supported by policy easing but a 2015-style surge is unlikely, given official reluctance to reopen the credit floodgates. Reserve injections, moreover, could boost capital outflows, increasing downward pressure on the currency and limiting the authorities’ room for manoeuvre. China was rescued from this dilemma in 2016 by the Yellen Fed putting its rate-hike campaign on hold for a full year, relieving upward pressure on the dollar; the Powell Fed, judging from recent communications, is unlikely to be so accommodating.

The current monetary backdrop, in our view, warrants a cautious stance towards equity markets. Previous commentaries discussed two rules for switching between equities and cash based on monetary indicators. The first rule moves into cash if G7 plus E7 six-month real narrow money growth crosses beneath industrial output growth; the second does so if G7-only annual real narrow money growth falls below its long-run average of 3%. Both rules would have outperformed buy-and-hold significantly and both were in cash at end-September.

The first rule is likely to switch back into equities at end-October, based on available August monetary and output data, with the second rule remaining in cash. Historically, average equity returns have been below the long-term mean when the rules have given different signals, and significantly negative when they have both favoured cash.

A cautious view of economic and market prospects is also suggested by cycle analysis, which we use to provide longer-term context for monetary signals. There are three key economic cycles: the 3-5 year stockbuilding cycle, the 7-11 year business investment cycle and the 15-25 year housing cycle. Shorter cycles “nest” within longer ones, in the sense that troughs tend to coincide. All three cycles hit bottom in 2009, explaining the severity of the 2008-09 recession.

Downswings in the stockbuilding cycle in 2011-12 and 2015-16 were associated with extended “soft patches” in the post-crisis economic upswing. Based on its average historical length of about 3.5 years, another stockbuilding cycle trough could occur in 2019, while the business investment cycle is scheduled to bottom by 2020 at the latest. The cycle analysis, therefore, suggests preparing for further economic weakness in 2019-20.

The stockbuilding cycle appears to be an important influence on financial market trends. Risk assets tend to weaken in the 18 months leading up to a cycle trough and rebound strongly in the first 18 months of the upswing. The fourth chart shows our suggested dating of cycle troughs and the implied 18-month “risk-off” periods for markets (shaded). Six of the last seven such periods were associated with a crisis and / or major bear market in one or more assets.

Based on our judgement that the last trough occurred in the first quarter of 2016, and assuming that the current cycle is of average length, the next low could occur in the third quarter of 2019. This would imply that another 18-month negative period for markets started in early 2018.

The table compares the performance of different assets since end-February 2018 with averages calculated over the previous seven 18-month negative periods. The pattern of returns is consistent with the assumption that markets entered a negative phase in early 2018, with overall equity market performance lacklustre, US stocks outperforming, cyclical sectors and emerging markets underperforming, the US dollar strengthening and a basket of commodity prices weakening.

If the current cycle returns were to conform to the historical averages, and assuming that our dating of the cycle is correct, equity markets would weaken by the third quarter of 2019, with cyclical sectors underperforming further. US and emerging market stocks, however, would stop outperforming / underperforming, the US dollar would be little changed, while the recent rise in US Treasury yields would reverse and corporate credit spreads would increase significantly.

*Brazil, Russia, India, China, Korea, Mexico and Taiwan.
**Narrow money = currency in circulation plus demand deposits and close substitutes. Broad money = narrow money plus time deposits, notice accounts, repos and bank securities. Precise definitions vary by country. Narrow money has been more reliable than broad money for forecasting purposes historically and is consequently emphasised in the analysis here.
***Non-financial = held by households and non-financial businesses.

Why have Treasury yields risen?

Posted on Tuesday, October 9, 2018 at 09:29AM by Registered CommenterSimon Ward | CommentsPost a Comment

The long-standing forecast here has been for global economic momentum – as measured by the six-month rate of change of industrial output in the G7 economies and seven large emerging economies – to fall into late 2018 and remain weak in early 2019. Incoming news is consistent with this forecast. The global PMI manufacturing new orders index, for example, was reported last week to have declined further in September, with export orders now in contraction territory – see first chart.

The OECD yesterday released August data for its country composite leading indicators, allowing an update of the global (G7 plus E7) leading indicator tracked here. The six-month rate of change of this measure fell again, consistent with a further economic slowdown into late 2018 – the indicator typically leads by four to five months. The one-month change, however, has stabilised recently, suggesting that downward pressure is starting to ease, although confirmation is required – second chart.

Why, then, did US Treasury yields break higher last week? Yields typically fall during global economic slowdowns. Are Treasuries looking through current weakness and sniffing another pick-up in growth from early 2019, with associated inflationary risks?

Such a pick-up, on the view here, is unlikely without a prior rise in global real narrow money expansion, which remained soft through August. With monetary policies tightening or on hold in most economies, it is not obvious why money trends should strengthen.

The exception, of course, is China, where recent easing steps – including an addition large cut in bank reserve requirements announced over the weekend – raise the possibility of a monetary rebound. September money data due shortly will be important but the suspicion here is that the authorities are “behind the curve” – see previous post. Reserve injections, moreover, may serve mainly to boost capital outflows.

Equity market behaviour appears inconsistent with the notion that Treasury yields are being pushed higher by rising economic optimism. Yield increases in 2012-2013 and 2016-early 2018 were accompanied by rising equity markets and outperformance of cyclical sectors. Now, equities are struggling and cyclical sectors fell further relative to defensive sectors last week – third chart.

The yield rise may reflect the weight of official Treasury supply rather than reduced demand due to stronger economic / inflation expectations. The outstanding stock of marketable Treasury securities rose by $1,078 billion in the 12 months to September, with the portion held outside the Fed up by $1,230 billion – fourth chart. The former increase is significantly higher than the federal deficit – $890 billion in the 12 months to August, the latest available month – because the Treasury issued additional debt to fund an increase in its cash balance at the Fed.

Supply to non-official holders is also being boosted by currency intervention by foreign monetary authorities attempting to contain dollar strength. Chinese official reserves fell by $23 billion last month, with most of this decline likely to reflect intervention rather than valuation changes.

Rises in Treasury yields accompanied by underperformance of cyclical equity market sectors also occurred briefly in 2006, 2007 and 2008 – third chart. On the first occasion, yields fell back and cyclicals rallied; in the latter two cases, both yields and the cyclicals / defensives ratio declined.

Until global money trends suggest an end to the current slowdown / weak growth phase, the rise in Treasury yields will be interpreted here as an additional reason for caution about equity market prospects.

UK money trends: recovery not yet convincing

Posted on Monday, October 1, 2018 at 04:44PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK monetary trends are less negative than in early 2018 but still suggest a lacklustre economic outlook. The August rate hike, moreover, could serve to abort the monetary recovery.

Six-month rates of change of real (inflation-adjusted) narrow and broad money – as measured by non-financial M1 and non-financial M4 – bottomed in February-March and recovered into July. This suggested that economic prospects were starting to improve before the August rate hike. August monetary numbers released today show a small set-back in real money momentum – see first chart. This set-back was driven by a rebound in six-month consumer price inflation in August, which offset a further improvement in nominal money trends.

Monetary data for September / October will be important for clarifying economic / equity market prospects. A further recovery in six-month real money momentum would suggest stronger economic growth in the first half of 2019 than currently expected by a gloomy consensus – assuming no cliff-edge Brexit. This could warrant adding to UK equity exposure, following further significant underperformance during the first nine months of 2018. As of August, six-month real narrow money growth was still below levels in Japan and Euroland but the gap has narrowed – second chart.

The risk, of course, is that monetary trends weaken in response to the August rate hike, as they did following the prior November increase.

The third chart shows a sectoral decomposition of real narrow money momentum between households and private non-financial corporations (PNFCs). The corporate component, surprisingly, recovered further in August, suggesting improving prospects for business spending. It is possible that Brexit uncertainty is boosting corporations’ precautionary demand for money, although such demand normally affects broad rather than narrow money trends.

Euroland money trends still cautionary

Posted on Thursday, September 27, 2018 at 02:21PM by Registered CommenterSimon Ward | CommentsPost a Comment

Euroland monetary trends have stabilised since the spring but continue to suggest a weak economic outlook – GDP may rise at a 1.0-1.5% annualised pace through early 2019 versus ECB / consensus expectations of about 1.75%. Slower growth may feed through to a stabilisation or slight rise in unemployment, complicating the ECB’s exit strategy.

Headline annual growth rates of M1 and M3 fell to 6.4% and 3.5% respectively in August, the lowest since 2014. Weakness partly reflected a decline in financial institutions’ deposits, probably connected with slowing QE: annual growth of non-financial M1 and non-financial M3 has held up slightly better recently, though is well down from 2016-17 – see first chart.

The forecasting approach here emphasises six-month growth rates of real (i.e. inflation-adjusted) non-financial M1 and non-financial M3. These reached lows in April-May and have since moved sideways. Allowing for a typical nine-month lead, this suggests that two-quarter GDP growth will ease further into January-February 2019, stabilising thereafter – second chart.

Two-quarter GDP growth is currently estimated at 0.77%, or 1.55% at an annualised rate, in the second quarter of 2018. Money trends argue against the ECB / consensus view that growth will bounce back, to about 1.75% annualised, in the second half of 2018 / early 2019.

Potential GDP expansion is estimated by the EU Commission, IMF and OECD to be 1.4-1.6% in 2018. Assuming that actual growth falls below this range in late 2018 / early 2019, the unemployment rate would be expected to stabilise or rise slightly. The September EU Commission consumer survey hints that the falling trend is approaching an end, with the net percentage of respondents expecting a rise in unemployment over the next year at an 18-month high – third chart.

A fall in stockbuilding could contribute to a further GDP slowdown during the second half. On current estimates, stockbuilding rose to 0.55% of GDP in the second quarter of 2018, the highest since 2011 – fourth chart. Stockbuilding accounted for two-thirds of the GDP rise of 0.77% between the fourth quarter of 2017 and second quarter of 2018, i.e. GDP excluding inventories grew by only 0.27% over the two quarters.

As the chart shows, the stockbuilding share of GDP is inversely correlated with the net percentage of firms reporting above-normal stocks of finished goods in the EU Commission industrial survey, with the latter leading slightly. This relationship supports the forecast of a second-half GDP drag.

The fifth chart shows a separation of real non-financial M1 deposits into household and non-financial corporate (NFC) components. Corporate real deposit growth recovered in August but, excluding July, was the lowest since 2012. Weakness is consistent with the view here that a profits squeeze is under way and will feed through to slower business investment and hiring. Household real deposit growth has been more resilient, suggesting better prospects for consumer spending, for now.

Growth of real non-financial M1 deposits is now similar across the big four economies – sixth chart. Growth is weakest in Italy and has stabilised in France and Spain, though is well down from a year ago. German growth continues to move sideways. In no case is a rebound in economic momentum suggested.

US corporate money slowing - business investment to disappoint?

Posted on Friday, September 21, 2018 at 02:50PM by Registered CommenterSimon Ward | CommentsPost a Comment

US second-quarter financial accounts released yesterday provide additional information about recent monetary trends. Business money trends have weakened significantly despite tax cuts and foreign profits repatriation, supporting the forecast of an economic slowdown through early 2019.

The monetary forecasting approach employed here places particular emphasis on the narrow non-financial M1 measure, comprising holdings of currency and checkable deposits by households and non-financial businesses. The headline M1 aggregate also includes holdings of insurance companies, pension / retirement funds, money market funds, government-sponsored enterprises, finance companies, REITs, brokers / dealers and foreign non-banks (excluding official institutions). These holdings account for more than 30% of M1 (dominated by the foreign component, mainly currency) but are unlikely to be of relevance for assessing near-term prospects for spending on goods and services.

Most major countries provide a monthly sectoral breakdown of monetary data. In the US, unfortunately, non-financial M1 is available only quarterly with a reporting lag of over two months.

The first chart compares two-quarter / six-month changes in GDP, real M1 and real non-financial M1. Fluctuations in real narrow money momentum have generally led swings in GDP growth in recent years, with non-financial M1 outperforming M1.

Both real money measures lost momentum during 2017 but there was a divergence in early 2018, with headline M1 remaining weak but non-financial M1 rebounding. This rebound was consistent with the expected impact of tax cuts and has been reflected in recent / current strong economic data.

The financial accounts show that M1 was dragged down around end-2017 by falls in money holdings of money market funds, GSEs and REITs.

The divergence between the two measures, however, closed in the second quarter, with the two-quarter change in real non-financial M1 falling back sharply. Both real M1 and real non-financial M1 barely grew between December and June. Two-quarter GDP growth is likely to have peaked in the second quarter and may fall significantly into early 2019.

The weakness in non-financial M1 has been driven by the business component: real M1 holdings of non-financial businesses contracted by 5.3% between December and June – second chart. Corporations, which account for nearly 80% of non-financial business M1, were responsible for the decline, with holdings of unincorporated businesses rising.

Business broad as well as narrow money trends have weakened. M3 holdings of non-financial businesses rose by only 0.2% in nominal terms in the year to end-June, while M1 contracted by 2.8% – third chart.

Why hasn’t business liquidity benefited from post-tax profits strength and foreign earnings repatriation? The financial accounts show that non-financial corporations repatriated $52 billion of foreign profits in the second quarter after $173 billion in the first quarter. This inflow, however, was used to finance increased share buy-backs and cash take-overs: net retirement of equities rose to $101 billion in the first quarter and $210 billion in the second quarter – fourth chart. Corporations have also slowed bond issuance this year.

The distribution of money by corporations casts doubt on hopes of an internally-financed boom in business investment. The corporate flow has supported money growth of households but pass-through to consumer spending may be small.

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