A case can be made that the market impact of “shocks” depends on the state of the economy when they hit. The failure of Bear Stearns in March 2008, for example, may have triggered a negative spiral of events partly because it occurred just after the US economy had entered a recession (in January). Similarly, the severity of the 2011-12 Eurozone crisis may have reflected its interaction with a global economic slowdown, due partly to a downturn in the 3-5 year US Kitchin stockbuilding cycle.
Global economic growth has been weak but stable in early 2016 and the view here – based on monetary trends and leading indicators – is that it will strengthen during the second half. As in 2011-12, a downswing in the US Kitchin cycle has contributed to recent softness but this may be coming to an end: the ratio of business inventories to sales fell in April for the first time for 13 months and local peaks in the ratio usually occur around troughs in economic momentum.
The above view suggests that the negative impact of a Brexit vote on global markets would be smaller than many fear. It is questionable, moreover, whether such a vote would represent a “shock” as normally understood – markets are prepared for the possibility (it is a “known unknown” in Rumsfeld-speak) and there would be no change to economic / financial arrangements for a sustained period.
The UK fallout, of course, would be greater but a similar argument applies: recent data indicate that the economy has gained, not lost, momentum going into the vote and monetary trends continue to give a positive signal for prospects, suggesting that the immediate negative impact would be containable. As previously discussed, the Treasury “forecast” that a recession would ensue is circular: it assumes, arbitrarily, that economic uncertainty would rise by an amount historically associated with recessions.
Sterling would no doubt fall sharply in the wake of a Brexit vote but would it remain permanently lower? The trade deficit in goods and services was a modest 2.0% of GDP in 2015, unchanged from 2012, arguing against exchange rate overvaluation. The wider current account deficit – 5.2% of GDP last year – mostly reflects a shortfall on investment income but this has been more than offset by a capital gain on the external assets / liabilities position; the current account adjusted for this capital gain has recently been in surplus.
Divergent US / Chinese narrow money trends last autumn suggested that the US economy would slow in early 2016 while Chinese growth would rebound, both contrary to consensus expectations at the time – see post from September. The US leg of this forecast has played out but Chinese activity has remained lacklustre. Chinese monetary trends are still viewed here as giving a positive signal for economic prospects, with the lack of a significant pick-up to date reflecting the normal variability of the lag between money changes and activity.
Most Chinese economic series have shown stability or modest improvement in recent months. The two manufacturing purchasing managers’ indices* remain below 50 but were higher over March-May than between July 2015 and February. Annual industrial output growth has moved sideways – 6.0% in May versus 5.9% in December. Annual retail sales growth has declined from 11.1% in December to a still-solid 10.0% in May, or 9.7% in volume terms. New residential construction is rising year-on-year after falling for most of 2015 – see first chart.
Total fixed asset investment, however, has disappointed, despite a surge in state-sponsored spending. Annual growth in private investment has continued to slow sharply, to just 1.0% in May (value terms) – second chart. This probably reflects a lagged response to profits weakness in 2015.
The official money measures are giving conflicting messages. Annual growth of M1 rose further to 23.7% in May, the highest since 2010, but M2 growth fell back to 11.8%, an 11-month low – third chart.
The official measures are regarded here as flawed. Chinese M1, contrary to global convention, includes only corporate demand deposits, excluding household holdings. M2, meanwhile, has been distorted in recent years by large swings in growth of financial deposits, which are of little significance for economic prospects. The preferred aggregates here are an expanded M1 measure incorporating household as well as corporate demand deposits – “true” M1 – and M2 excluding financial deposits. Annual growth of the two measures has risen significantly over the past year, i.e. they are giving a consistent positive directional signal for economic momentum – fourth chart.
Some commentators have suggested that the relationship between narrow money and the economy has weakened or broken down. One prominent research group argued late last year that corporate demand deposits had been boosted by the local government debt swap programme; local governments, it was claimed, had passed the proceeds of bond sales to their related corporate entities, temporarily swelling the demand deposits of these entities pending their repayment of bank debt.
This “explanation” was regarded sceptically here, because detailed data showed that demand deposits of non-government-related corporations and households were also rising strongly. The failure of narrow money growth to subside in 2016 has cast further doubt on the story.
Another suggestion is that narrow money buoyancy reflects a rise in risk aversion and liquidity preference due to last year’s sharp fall in the stock market and more recent fears of a large devaluation of the exchange rate, i.e. it does not carry the usual implication of a rise in spending intentions. Stock prices, however, have stabilised since early 2016 while capital outflows have slowed significantly – any rise in narrow money demand due to increased risk aversion, therefore, should have reversed.
The view here is that the lack of a significant pick-up in economic growth to date reflects the normal variability of the lag in the relationship between money changes and activity. A study of G7 data over the past 50 years showed that turning points in narrow money preceded those in industrial output by nine months on average but with a plus / minus one standard deviation range of five to 13 months. Chinese narrow money growth started to surge in July 2015; the lack of a significant activity response by May 2016, 10 months later, is well within the bounds of historical experience.
The view that an economic pick-up is imminent is supported by a strengthening of several series that usually respond to monetary changes with a shorter lag than activity data. The annual rates of change of house prices and profits, for example, have risen since late 2015 – fifth chart. The pick-up in such “intermediate” variables is evidence that the monetary transmission mechanism is working normally. The recovery in profits, and continued corporate narrow money strength, suggest that the annual change in private investment is at or near a low.
The OECDs composite Chinese leading indicator – which excludes monetary variables – provides further corroborating evidence of an improving outlook. The “ratio-to-trend” version of the indicator rose in March / April after a sustained fall between late 2013 and early 2016, implying a recovery in economic growth from below- to above-trend – sixth chart.
*National Bureau of Statistics and Markit / Caixin.
A post in March suggested that the UK economy was reaccelerating, contrary to mounting consensus gloom at the time. An upbeat view seemed justified by a rise in real narrow and broad money expansion in late 2015 / early 2016 and was judged to be consistent with incoming economic data – excepting the widely-watched but historically-unreliable purchasing managers’ surveys.
The notion that economic growth has picked up is gaining credence, following recent upside surprises in a range of series including industrial / construction output, retail sales and the labour force survey unemployment measure. According to the FT, “The data have boosted hopes that economic growth will come in far stronger than expected in the second quarter.”
Services turnover for April released today continues the pattern. The turnover survey is an important input to the services output index, which accounts for 79% of the output-based measure of GDP. Real turnover* is estimated here to have risen strongly in April – see chart.
A post last week noted that a 0.2% rise in services output in April would imply that GDP for the month was 0.4% above its first-quarter average, given previously-reported strength in industrial / construction output (ignoring any revisions to prior data). A 1.9% increase in retail sales volume in April, however, will contribute +0.2 of percentage point to services output and the turnover result suggests an additional boost from other industries. A 0.4% monthly rise would lift GDP to 0.6% above its first-quarter level.
The strength in some April series may partly reflect the early timing of Easter this year, implying a possible reversal in May / June. A Brexit vote could abort the recent pick-up if it leads to corporate retrenchment – corporate narrow money trends, discussed in Tuesday’s post, should be informative about any such effect. A win for Remain, however, would probably be followed by a significant upgrade to consensus growth expectations.
*Total ex. wholesale trade turnover, deflated by services producer prices, seasonally adjusted.
US corporate financing needs fell modestly in the first quarter, a development consistent with the view here – based on monetary trends – that the economy will regain momentum during the second half of 2016.
The Fed’s quarterly financial accounts show that the “financing gap” of non-financial corporations – defined as the difference between their capital spending and domestic retained earnings – was 0.5% of GDP in the first quarter, down from 1.0% in the fourth quarter of 2015 and a peak of 1.2% in the second quarter of last year.
The financing gap is an inverse long leading indicator of the economy, probably because unanticipated changes in financing needs cause companies to alter spending and employment plans. The seven US recessions over the past 50 years were preceded by a rise in the financing gap to more than 1.5% of GDP – see first chart.
The fall in the financing gap in the first quarter was mainly due to a further reduction in capital spending (i.e. fixed investment plus stockbuilding). In addition, however, domestic profits recovered slightly after significant weakness during the second half of 2015 – second chart*.
The profits recovery may continue in the current quarter. The energy sector accounted for more than half of the fall during the second half of 2015 and the spot WTI oil price has averaged $46 a barrel so far in the second quarter versus $33 in the first. Productivity performance appears to have improved, relieving upward pressure on unit labour costs: the Atlanta Fed’s “nowcast” for GDP growth in the second quarter is currently 2.8%, implying a 0.7% non-annualised gain, while aggregate hours worked by private non-farm employees rose by only 0.1% April / May compared with the first-quarter average.
Foreign profits, meanwhile, will benefit from a positive translation effect from the weaker US dollar: the Fed’s trade-weighted index against other major currencies has averaged 89.5 so far in the second quarter versus 93.2 in the first, a 4.0% decline. (Foreign profits, however, enter the financing gap calculation only to the extent that they are repatriated.)
While corporate financing needs for operational purposes have declined, companies borrowed heavily to finance share buy-backs and cash takeovers in the first quarter. Equity buying net of issuance rose to 3.9% of GDP, the highest since the third quarter of 2011.
As expected given softer labour market news and the UK EU referendum, the Federal Open Market Committee (FOMC) was yesterday non-committal about the timing of another rate rise. The median expectation of the 17 meeting participants is still for two quarter-point increases by end-2016 but six now foresee a single rise versus one in March. The view here remains that the economy is on a firming trend and a move in September is plausible, unless the current “risk-off” phase in markets is sustained.
*”Economic” profits incorporate inventory valuation and capital consumption adjustments to reported profits.
Previous posts expressed optimism about UK economic prospects based partly on solid money / credit trends. GDP is currently estimated to have risen by 0.4% in the first quarter and April data for industrial / construction output and retail sales suggest a respectable start to the current quarter – see Friday’s post.
Six-month growth of real narrow money, as measured by non-financial M1, was stable in April at its highest level since December 2013. This stability, however, conceals a further pick-up in household real M1 expansion offset by a sharp slowdown in holdings of private non-financial corporations (PNFCs) – see chart.
Corporate narrow money numbers are volatile and the April weakness may prove temporary. It may, however, indicate that firms are reining back expansion plans, perhaps because of EU referendum uncertainty. Corporate money sometimes leads household / aggregate trends, e.g. before the 2008-09 recession. Household M1 buoyancy suggests solid consumer spending / GDP growth over the summer / autumn but confirmation of a corporate money slowdown would raise doubts about economic prospects for late 2016 / early 2017.