Is the stockbuilding cycle peaking?

Posted on Thursday, July 12, 2018 at 02:41PM by Registered CommenterSimon Ward | CommentsPost a Comment

The US ISM manufacturing new orders index – an important gauge of US / global industrial momentum – fell back between December 2017 and April 2018 but rebounded in May / June. This recovery has been cited as evidence in favour of the consensus view that the global economic slowdown since early 2018 represents a temporary “soft patch”. The judgement here, by contrast, is that the ISM new orders increase will prove to be a “head-fake” caused by rapid inventory accumulation as the three- to five-year stockbuilding cycle reaches a peak.

Conceptually, new orders from customers received by ISM firms can be divided into trend and transitory components, reflecting respectively final demand and customers’ efforts to adjust their inventories to a desired level. The transitory component, by definition, is high at the peak of the stockbuilding cycle. New orders subsequently move back to trend and then below it as the cycle downswing develops.

The ISM survey does not distinguish between these two sources of order flow. The transitory component, however, should be related to the customer inventories index, which measures whether stock levels are judged to be too high or too low. A low level of the index should be associated with high customer orders related to stockbuilding. A low index, that is, should imply strong transitory demand and a future decline in aggregate new orders as this fades.

The customer inventories index fell below 40 in May / June versus an average of 45.8 between its inception at the start of 1997 and end-2017 – see first chart. The index has been below 40 in 22 previous months historically. The average change in the new orders index over the subsequent six months was -3.6 points. Such a fall would more than offset the May / June rise.

The suggestion that ISM new orders index will resume a decline over coming months is supported by the Conference Board CEO confidence survey for the second quarter, conducted between mid-May and mid-June. Expectations for manufacturing business conditions in six months’ time correlate with and sometimes lead the ISM new orders index, and fell to a seven-quarter low – second chart.

Stockbuilding strength may have been exaggerated by firms boosting inventories of items at risk of tariff-related price increases or supply disruption. The ISM imports index rose sharply in June and is far above its long-term average. Front-loading of orders and production due to tariffs, that is, may have supported industrial activity at the likely expense of greater weakness later in 2018 as the stockbuilding cycle turns down.

A "monetarist" perspective on current equity markets

Posted on Friday, July 6, 2018 at 09:11AM by Registered CommenterSimon Ward | Comments2 Comments

Global monetary trends have stabilised but remain weak, suggesting slow economic growth and an unpromising backdrop for equities and other risk assets, warranting maintaining a cautious investment stance.

Our key forecasting indicator is the six-month growth rate of real (i.e. inflation-adjusted) narrow money in the G7 countries and seven large emerging economies (the “E7”)*. Real money growth peaked most recently in June 2017, falling to a nine-year low in February 2018. Allowing for the typical nine-month lead, this suggested that global economic growth would peak around March 2018 and fade into the second half of the year.

Shorter-term leading indicators began to confirm the monetary forecast in early 2018. The global manufacturing purchasing managers’ index, for example, peaked in December 2017, falling to an 11-month low in June. A slowdown is now also evident in G7 plus E7 industrial output data, with six-month growth declining sharply in May** – see first chart.

A further significant development in late 2017 was that six-month growth of G7 plus E7 real narrow money crossed beneath industrial output expansion. Since 1970, global equities, as measured by the MSCI World index in US dollar terms, have underperformed US dollar cash by 7.2% per annum on average when real money has lagged industrial output. Equities started the year strongly but MSCI World lost 4.3% between end-January and end-June, resulting in a first-half return of only 0.8%.

Monetary trends, thankfully, stabilised in the second quarter: G7 plus E7 real narrow money growth rebounded in March and held above the February low in April / May. It remains, however, weaker than over 2009-17. The suggestion is that global economic momentum will bottom out in late 2018 but without much of a rebound subsequently. Consensus growth forecasts, in our view, remain too high.

We do not rule out a more significant recovery in real money growth. China has started to ease monetary policy but the impact could be offset by tightening credit market conditions and capital outflows. The US tax cuts may still be filtering through to spending intentions and money demand but any boost may be outweighed by ongoing Fed policy tightening. Escalating trade tensions, meanwhile, may cause a downward revision to business investment plans, a development that would probably be associated with a fall in corporate money growth.

A cautious view of economic and investment prospects, therefore, will be maintained pending more convincing evidence of a change in monetary trends. A monetary relapse, of course, would argue for a further move towards defence.

Our caution is also informed by longer-term cycle analysis, although this plays a secondary role to monetary signals in our forecasting process. Commentators frequently refer to “the” business cycle but there are, in fact, several cycles of different lengths that interact to produce observed economic fluctuations. The three key cycles are the 3-5 year stockbuilding or inventory cycle, the 7-11 year business investment cycle and the 15-25 year housebuilding cycle. Cycle lengths are measured from peak to peak or trough to trough.

The housebuilding cycle bottomed in 2009 so another trough is not scheduled until the mid 2020s at the earliest. The business investment and stockbuilding cycles, however, bottomed most recently in 2009 and 2016 respectively. Downswings in the two cycles, therefore, are scheduled to occur in 2019-20. In the event that the downswings are synchronised, a recession will be likely. The last business investment / stockbuilding recession occurred in 2001. Such recessions are usually – though not always – less severe than those involving downswings in the housebuilding cycle.

The cycle analysis provides a longer-term framework for assessing monetary signals. The current message is that, if global money trends were to recover, the implied subsequent pick-up in economic growth would probably be modest and short-lived. The current position of the business investment and stockbuilding cycles, in other words, argues for downplaying a positive monetary signal while according strong significance to a negative one.

A 2019-20 global recession is not, it should be emphasised, the current central forecast here. Such a scenario would need to be confirmed by the six-month change in global real narrow money turning negative, as it has before every previous recession since the 1970s (at least).

Our analysis suggests that the pattern of market returns is strongly correlated with the stockbuilding cycle, whether or not this cycle is aligned with the other cycles.  Specifically, the 18 months following a trough in the stockbuilding cycle is usually a “risk-on” phase characterised by strong performance of equities, credit and commodities, with cyclical sectors outperforming defensives. These trends reverse in the 18-month lead-in to the next trough.

While the stockbuilding cycle can stretch to 5 years, the average historical length has been about 3.5 years. Based on the contribution of stockbuilding to annual G7 GDP growth, we judge that the cycle last bottomed in early 2016, implying that the next trough could occur in the second half of 2019 – second chart. If so, the 18-month negative window for markets may already have opened.

Recent equity market sectoral performance is consistent with an economic slowdown. The MSCI World cyclical sectors index rose strongly in early 2018 but fell by 2.9% between end-February and end-June, versus a 1.9% rise in the defensive sectors index over the same period. The weakness in the cyclical index has been driven by financials, materials and industrials, with information technology and consumer discretionary remaining strong until late in the second quarter – third chart. Energy, utilities and health care have been the best-performing defensive sectors.

Monetary trends show a similar pattern of stabilisation but no significant recovery across most major developed economies. The six-month rate of change of real narrow money is above-average in Japan and Euroland and weakest in Australia – fourth chart.

In Euroland, we are on the alert for a further slowdown in Italian real narrow money, reflecting a widening of yield spreads following the formation of an EU-sceptic populist government – fifth chart. The ECB’s plans to phase out bond purchases by end-2018 could act as a drag on area-wide money growth, although the central bank has also signalled that rates will be held at their current negative level through September 2019, at least.

UK monetary trends remain weak and are at risk from a mooted August rate increase. Money measures slowed sharply immediately after the November 2017 hike.

Monetary policy may offer greater support for money trends in Japan, although Bank of Japan bond purchases continue to run well below the expected ¥80 trillion per annum pace. Real money growth has been boosted recently by a slowdown in inflation, although this may prove temporary.

Emerging equity markets typically underperform developed markets during the downswing phase of the stockbuilding cycle. Relative monetary trends, however, are currently supportive, with E7 six-month real narrow money growth slightly above the G7 level – sixth chart. With currency weakness causing policy tightening and higher inflation in a number of EM economies, the sustainability of this positive divergence is in doubt.

*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. E7 defined here as Brazil, Russia, India, China, Korea, Mexico and Taiwan.
**The May fall was exaggerated by a fire at a US auto parts plant and a truckers’ strike in Brazil.


UK data mixed, money trends still soft

Posted on Friday, June 29, 2018 at 12:47PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK monetary trends have stabilised but remain weak, suggesting continued sub-par economic expansion. The monetary slowdown has been reflected in a significant fall in nominal GDP growth, the current level of which is below that consistent with achievement of the 2% inflation target over the medium term. The view here remains that the MPC should wait for a rebound in money growth before considering a further rate hike.

Economic data released today were mixed. Quarterly GDP growth in the first quarter was revised up from 0.1% to 0.2% but the annual increase was unchanged at 1.2%, reflecting a downgrade to the third quarter of 2017.

Services output rose by 0.3% in April from March but overall GDP in April – taking into account industrial and construction data – appears to have been only 0.1% above the first-quarter level, implying a need for solid May / June data to meet the Bank of England staff projection of 0.4% quarterly growth in the second quarter.

Annual growth of nominal (i.e. current-price) GDP, meanwhile, declined further to 2.7% in the first quarter, compared with a recent peak of 4.9% in the fourth quarter of 2016. Unless potential output expansion has fallen below 1% per annum, such a growth rate, if sustained over the medium term, would imply an undershoot of the 2% inflation target.

The money measures tracked here rose respectably between April and May but their trends remain weak, arguing against an early rebound in real / nominal economic expansion.

Annual growth rates of non-financial M1 and non-financial M4 more than halved between September 2016 and April 2018 but recovered slightly in May. Three-month rates of expansion, moreover, crossed above the annual increases – see first chart.

The annual growth rates remain lower than for the comparable Euroland measures, suggesting continued relative economic weakness. Non-financial M1 rose by 4.9% in the UK in the year to May versus 7.6% in Euroland; non-financial M4 grew by 3.3% versus a 3.9% increase in Euroland non-financial M3. The difference, of course, is larger in real terms, with UK consumer price inflation at 2.4% in May versus 2.0% in Euroland in June.

Six-month rates of change of real non-financial M1 and non-financial M4, while recovering slightly, remain well below recent and longer-term historical averages – second chart. As previously discussed, real money trends held up through November 2017 but weakened sharply after the rate hike that month, which appears to have damaged confidence and spending intentions. A mooted August follow-up increase would probably abort the recent tentative monetary recovery, risking more significant economic weakness in 2019.

Euroland money data slightly better, trends still subdued

Posted on Wednesday, June 27, 2018 at 12:12PM by Registered CommenterSimon Ward | CommentsPost a Comment

Euroland monetary trends have stabilised, suggesting that economic growth will be sustained at its recent slower pace through late 2018. The ECB / consensus forecast that GDP will expand at a 1.75-2% annualised rate appears over-optimistic. Real narrow money growth has fallen in Italy but is only slightly lower than in the other major economies, although a further slowdown is likely.

Annual growth rates of Euroland non-financial M1 and non-financial M3 – the preferred aggregates here – fell significantly between March 2017 and March 2018 but recovered slightly in April / May. Three-month rates of expansion, moreover, have moved above the annual growth rates and are at their highest levels since October / November 2017 – see first chart.

The shorter-term reacceleration is less impressive in real terms because of a rebound in consumer price inflation. Nevertheless, six-month growth rates of real non-financial M1 / M3 have stabilised recently – second chart*.

The current six-month real growth rates are similar to those prevailing in mid-2013, following which GDP expanded at an annualised rate of 1.4% through end-2014. This seems a reasonable expectation for growth over coming quarters. The latest ECB staff projections of annual average GDP increases of 2.1% in 2018 and 1.9% in 2019, by contrast, imply sequential expansion of 1.75-2% annualised.

Narrow money trends remain similar across the “big four” economies but six-month growth of real non-financial M1 deposits is now weakest in Italy, with the recent rise in Italian yield spreads suggesting a further decline – third and fourth charts.

Corporate real M1 deposits, moreover, have slowed sharply recently in Italy and Spain, possibly reflecting a loss of business confidence and an associated reining back of expansion plans – fifth and sixth charts. The Euroland GDP slowdown to date has been driven by Germany and France but risks may now be shifting to the periphery – excluding Greece, where money measures are surging.

*Abbreviations: HH = household, NFC = non-financial corporation.

Why is US economic news holding up?

Posted on Thursday, June 21, 2018 at 12:58PM by Registered CommenterSimon Ward | CommentsPost a Comment

Global economic activity news has surprised negatively since March, with the Citigroup G10 composite index recently reaching its lowest level since 2012 – see first chart. This is consistent with the “monetarist” view that global economic momentum would peak in early 2018 and soften into the second half of the year.

Global data weakness, however, conceals continued, though moderating, positive surprises in the US offset by very negative news elsewhere – second chart. Yet real narrow money growth – as measured by the six-month rate of change of M1 deflated by consumer prices – has been no less weak in the US than in most other major economies.

Why has US news remained resilient despite an apparently negative monetary backdrop?

An obvious answer is that fiscal stimulus has insulated the US from monetary tightness and global economic weakness. A post in December, indeed, argued – contrary to the consensus view – that US tax cuts were well-timed from a cyclical perspective, albeit reckless in terms of longer-term fiscal health.

The view here, however, was – and still is – that an effective fiscal stimulus would be signalled by a pick-up in narrow money trends. As previously discussed, such a pick-up occurred following the tax reductions in 1964, 1978 and 1981 – the three largest cuts since World War Two before the current programme (which ranks third of the four).

The explanation for the puzzle may be that US money trends have been less negative than suggested by the headline M1 data. This view is supported by additional monetary details in the Fed’s financial (flow of funds) accounts for the first quarter of 2018, released two weeks ago.

The preferred narrow money measure here for forecasting purposes is non-financial M1, comprising holdings of households and non-financial businesses. Aggregate M1 includes checkable / overnight deposits of financial institutions, fluctuations in which often reflect portfolio allocation shifts, with no economic implications.

Non-financial M1 can be calculated monthly in the Eurozone and UK, while Japanese headline money measures are non-financial by construction. In the US, by contrast, non-financial M1 is available only on a quarterly basis with a significant lag from the Fed’s financial accounts.

The third chart shows the two-quarter / six-month changes in US GDP and real M1 / non-financial M1. Turning points in real money momentum have consistently led turning points in GDP momentum in recent years. As expected, non-financial M1 appears to have given slightly more reliable signals.

The six-month change in real non-financial M1 was weaker than that of real M1 in the second half of 2017 but rebounded sharply in the first quarter of 2018. The financial accounts show that M1 was held back by a fall in checkable deposits of financial institutions – in particular, money market funds and government sponsored enterprises (GSEs). Money funds moved funds out of banks and the repo market in order to buy Treasury bills, probably in response to attractive interest rates caused by a surge in supply, while GSEs increased their repo lending. These shifts are unlikely to carry any significance for economic prospects.

The recovery in real non-financial M1 momentum may help to explain recent US data resilience and suggests that economic growth will continue to hold up better than elsewhere near term. The judgement here, however, remains that US monetary trends are signalling a second-half slowdown, with data likely to surprise negatively relative to upbeat consensus expectations. This judgement reflects three additional considerations.

First, while the six-month change in real non-financial M1 was above that of real M1 in March, year-on-year growth rates were similar and near the bottom of the range in recent years – fourth chart.

Secondly, real M1 momentum – both six-month and year-on-year – has weakened since March. It seems likely that six-month real non-financial M1 growth has fallen back in the second quarter, although confirmation, unfortunately, will not be possible until the next financial accounts are released in early September.

Thirdly, the rebound in the six-month change in real non-financial M1 in the first quarter partly reflected a large quarterly rise in holdings of non-financial corporations, and this increase may have been connected with foreign earnings repatriation due to the tax changes. If so, it may represent a temporary rise in money demand as corporate balance sheets are reorganised, rather than signalling stronger business spending.

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