Japanese equities have underperformed the US and emerging markets in common currency terms so far in 2016, while faring slightly better than UK and continental European stocks. Monetary trends and demand / supply considerations suggest that relative performance will improve.
GDP rose by just 0.05% in the second quarter but this may represent payback for a 0.5% first-quarter gain, which may have been flattered by a statistical leap-year effect. Two-quarter growth moved up to 0.55%, or 1.1% at an annualised rate, the fastest since the second quarter of 2015. Monetary trends are signalling a further rise, with six-month growth of real narrow money M1 surging since the Bank of Japan (BoJ) introduced a negative rate on the top tier of bank reserves in February, and real M2 / M3 expansion also firming – see first chart.
Faster growth of M1 than broader aggregates normally signals that companies and consumers are shifting their monetary savings into more liquid form ahead of boosting their spending. A similar divergence occurred in the Eurozone after the ECB cut the deposit rate to negative in June 2014 and was followed by significantly stronger domestic demand and GDP growth in 2015. (As an aside, a recent claim that the current wide gap between M1 and M2 growth in China is evidence of a “liquidity trap” and has negative economic implications has no basis in monetary theory and is not supported by international historical evidence.)
Six-month growth of real narrow money is now higher in Japan than in most other developed economies, suggesting greater potential for a positive economic surprise, which could boost relative equity market performance – second chart.
The demand / supply backdrop, meanwhile, appears favourable. The BoJ has been buying at a weekly average rate of ¥69 billion over the latest three months but last month’s decision to raise the annual target for equity ETF purchases from ¥3.3 trillion to ¥6.0 trillion implies a step-up to ¥115 billion – third chart. ¥6.0 trillion is equivalent to 1.9% of the market capitalisation of the TOPIX index (free float basis).
Business corporations, meanwhile, have been buying shares at a weekly rate of ¥51 billion over the latest three months, while issuance averaged only ¥19 billion a week in the three months to July.
There is additional “structural” demand from the Government Pension Investment Fund (GPIF) and other public schemes. The GPIF’s weighting in domestic equities stood at 23.35% at end-December, the latest available date, versus its target range of 25% plus or minus 9 percentage points. Public pension funds in aggregate bought equities at a weekly rate of ¥74 billion in the first quarter, according to the BoJ’s flow of funds accounts.
The combination of BoJ QE demand, corporate float shrinkage and public fund buying suggests upward pressure on prices unless foreign investors or individuals dump shares. Foreigners, however, have reduced exposure significantly since May 2015 and may be underweight, in aggregate, relative to benchmarks. They may be forced to buy if the market starts to outperform.
Individuals tend to accommodate swings in foreign demand but they may be reluctant to sell at current prices owing to a lack of appealing alternatives, with government bond yields negative but rising, and foreign investments at risk from further yen strength.
The suggestion is that higher prices will be required to balance the net demands of the various sectors.
Global economic growth continues to strengthen, consistent with a forecast based on narrow money trends, which remain positive.
Global economic momentum is measured here by the two-quarter / six-month change in GDP or industrial output in the G7 major economies and seven large emerging economies (the “E7”*). The G7 plus E7 grouping dominates the global economy, accounting for two-thirds of GDP measured at “purchasing power parity” and nearly three-quarters in current US dollars**. Measuring changes over two quarters / six months is judged to optimise the trade-off between timely signals and noise.
Two-quarter growth in G7 plus E7 GDP is estimated to have risen from 1.1% in the first quarter to 1.2% in the second, or 2.4% at an annualised rate. Six-month industrial output growth, meanwhile, jumped to 1.1% in June, or 2.2% annualised, the fastest since February 2015 – see first chart.
GDP and industrial output changes are closely correlated, with June six-month output growth consistent with annualised GDP expansion of about 2.75%. GDP momentum, therefore, was probably still firming as the second quarter ended.
The US and China have released July industrial output data; six-month growth rose further in both cases. Additional positive signals are a further pick-up in six-month expansion of world steel output in July and a sharp increase in the equity analysts’ earnings revisions ratios for developed and emerging markets in July / August – second and third charts.
A summer revival in economic growth had been predicted by a rise in six-month G7 plus E7 real narrow money expansion from a low in August 2015 – real money turning points lead those in industrial output by nine months on average, according to a study of G7 data since the 1960s. Six-month growth of real narrow money continued to increase during the first half of 2016, reaching 5.2% in June, or 10.7% annualised, the fastest since 2009. It appears to have remained strong in July, judging from data for countries covering two-thirds of the G7 plus E7 aggregate – fourth chart. The suggestion is that the current cyclical upswing will extend through spring 2017, at least.
The forecasting approach here seeks confirmation for monetary signals from the OECD’s composite leading indicators, which combine a range of non-monetary forward-looking data. The OECD, bizarrely, suspended publication of its entire suite of indicators in response to the UK's Brexit vote – the most recent numbers are for April with data for May, June and July due to be released in early September. The OECD’s calculation method has been replicated to estimate its G7 “normalised” leading indicator, designed to signal whether future economic growth will be above-or below-trend. The indicator appears to have bottomed in April, edging higher in May and June, with early data suggesting a further increase in July – fifth chart. It is not possible to replicate the OECD’s E7 calculations (because the organisation does not release historical data on components) but the behaviour of the G7 indicator is consistent with an economic upswing.
The forecast of significantly stronger global economic growth questions current consensus narratives about “secular stagnation”, low / negative “natural” levels of interest rates and the need for fiscal stimulus. A positive growth surprise could be the catalyst for a narrowing of the current wide gap between government bond yields and the level suggested by actual economic performance – sixth chart.
*Defined here as BRIC plus Mexico, Korea and Taiwan.
**Averages of PPP and current US dollar GDP weights are used to calculate the G7 plus E7 aggregates.
The suggestion in a previous post that a recovery in US business investment will contribute to significantly stronger second-half GDP growth is supported by July industrial output data.
Equipment spending accounts for 46% of business investment (i.e. private non-residential fixed investment). Six-month growth of industrial output of business equipment rose to 2.0% in July, the fastest since 2014. Output and investment numbers are, unsurprisingly, closely correlated – see first chart.
Structures investment accounts for a further 21% of the business total and has been even weaker than equipment spending, mainly reflecting a collapse in mining exploration. The industrial output component covering oil and gas well drilling, however, bottomed in May, edging higher in June and July. The recovery in the oil price, meanwhile, suggests a significant rebound in both output and investment over the remainder of 2016 – second chart.
Spending on “intellectual property products”, mainly software and R&D, accounts for the remaining 33% of business investment; it continues to grow strongly.
Business investment fell by 1.4% during the first half (i.e. between the fourth quarter of 2015 and the second quarter of 2016), subtracting 0.18 percentage points (pp) from GDP growth, or 0.36 pp at an annualised rate. A reasonable base case is that this decline will be fully reversed during the second half, implying that business investment alone could contribute 0.72 pp to the change in annualised GDP growth between the first and second halves.
The change in inventories subtracted a further 0.79 pp from annualised GDP growth during the first half but is expected here to have a neutral impact at worst during the second half . Total business spending, therefore, may deliver a boost of more than 1.5 pp to second-half GDP expansion.
UK vacancies data covering July suggest that the economy has slowed sharply but is not contracting – contrary to the recessionary message from the high-profile but often unreliable purchasing managers’ surveys, which appear to have played a key role in the MPC’s decision to launch further policy easing.
The vacancies numbers are reported on a three-month moving average basis. The average fell from 744,000 in June to 741,000 in July, a decline of 0.4%. A previous post argued that vacancies would need to fall by 4% over three months to suggest that the economy is contracting, based on the historical relationship with gross value added (GVA). The decline between June and July is beneath the implied monthly threshold of 1.3%.
The chart shows fitted values of a regression of quarterly non-oil GVA growth on the three-month change in vacancies. The latest three-month change (i.e. a decline of 0.9% between April and July) suggests weak GVA expansion.
The Office for National Statistics makes available the monthly non-seasonally-adjusted data underlying the reported three-month moving average. This single-month series, adjusted for seasonal factors using the X-12 procedure, fell by 1.0% between June and July – also below the contraction threshold.
The July vacancies number tallies with the Reed job index, a measure of online listings, which edged lower last month but remains close to a May peak – see the previous post for more discussion and a chart. The Reed index is released two weeks before the official vacancies number, with an August reading due in early September.
Claimant-count unemployment, meanwhile, fell by 8,600 in July, the first decline since February, defying expectations of a sizeable rise. This series, while timely, usually lags economic activity and may have been distorted as an indicator recently as claimants have been moved from job-seeker's allowance to universal credit.
The July vacancies number is modestly reassuring but the assessment of the economic outlook here will depend on post-Brexit vote monetary trends, with July data scheduled for release on 30 August.
Chinese activity and money / credit data for July were mixed but are interpreted here as supporting a positive view of near-term prospects.
Annual industrial output growth edged lower in July but the six-month rate of increase rose to its strongest level since 2014, based on the World Bank’s seasonally-adjusted level series – see first chart. A rebound in steel output has contributed to the recent pick-up and may be a positive signal for prospects – steel output is a component of the OECD’s Chinese leading indicator.
The rise in six-month industrial output growth accords with the Markit / Caixin manufacturing purchasing managers’ index, which moved above the 50 level last month for the first time since February 2015.
Pessimistic commentary has focused on a further slowdown in fixed asset investment, with the private sector component contracting in the year to July – second chart. The working assumption here is that private investment has been adjusting to lower economic growth and a fall in profits in 2014-15. With profits now recovering, and non-financial enterprise deposits rising strongly, a turnaround may be imminent – third chart. The profits rebound partly reflects an easing of deflationary pressures, with producer prices rising in four of the last five months – fourth chart.
Annual growth in housing sales and starts peaked in March but has remained positive, recovering slightly in July – fifth chart.
Exports could provide a fillip during the second half. The average level of the renminbi against the PBoC’s currency basket so far in August is 7.5% lower than during the second half of 2015, while global demand appears to be firming. A recent recovery in container freight rates, as measured by the Shanghai shipping exchange’s composite containerised freight index, is a promising sign – sixth chart.
Narrow money growth remains buoyant: the annual rise in true M1, comprising currency in circulation and demand / temporary deposits of non-financial enterprises, government organisations and households, edged up to 21.8% in July, the highest since 2010 – seventh chart*. It has been argued that demand deposits have been boosted by side-effects of the local government debt swap programme and rapid expansion of wealth management products but such explanations cannot account for the extent and persistence of recent strength. Household as well as corporate deposits have grown robustly – up by an annual 15.0% in July.
Annual growth of the broader M2 measure fell to 10.2% in July, a fifteen-month low, but the recent decline is entirely explained by deposits of non-bank financial institutions – these surged in 2014-15 but are now contracting. Swings in such deposits are unlikely to be relevant for assessing immediate economic prospects. M2 excluding financial-sector deposits, by contrast, has accelerated over the past year: annual growth of 12.3% in June was the strongest since 2013, with July little changed at 12.1% – seventh chart.
The preferred aggregates here, therefore, suggest that annual nominal GDP growth will continue to recover during the second half, following a rise from 6.0% to 7.3% between the third quarter of 2015 and the second quarter of 2016 – eighth chart.
*The official M1 aggregate omits household deposits.