Thoughts on US / Chinese yield curve signals

Posted on Friday, December 7, 2018 at 08:54AM by Registered CommenterSimon Ward | Comments5 Comments

Monetary trends and cycle analysis have been suggesting a cautious view of global economic and equity market prospects. An argument for remaining neutrally-positioned or overweight in equities and other risk assets at present runs as follows.

Major equity market declines historically were associated with US / global recessions. The US Treasury curve (10s-2s) inverted well before every recession since the mid 1950s but has yet to do so. The term premium, moreover, is unusually low, meaning that the flatness of the curve exaggerates monetary tightness. The curve, in other words, needs to become significantly negatively sloped to indicate a recession. Once this occurs, investors will have time to derisk portfolios before markets weaken.

This argument is dangerous for several reasons.

First, equity markets usually decline before / during economic slowdowns as well as recessions. Slowdown-related falls can often be severe, e.g. the 1966-67 US economic slowdown was associated with a 22% peak-to-trough decline in the S&P 500. Investors should dial down risk ahead of slowdowns as well as recessions, to the extent that either can be anticipated.

Secondly, the focus on the US yield curve may be misguided. The current global slowdown originated in China / Asia and has spilled over to Europe. The Chinese yield curve inverted in mid-2017 – see first chart.  It is possible that this will prove to have been the recession warning signal in this cycle, with the US curve lagging.

The last Asian-driven global economic slowdown was in 1997-98. It did not develop into a recession partly because of US / G7 monetary policy easing and partly because the region was a smaller part of the global economy. Asia ex Japan now accounts for 37% of world GDP at purchasing power parity, up from 19% in 1997, according to the IMF.

Thirdly, monetary trends argue against the view that the yield curve signal has been distorted by a low term premium. The slope of the G7 curve has been closely correlated historically with the six-month rate of change of G7 real narrow money – second chart. The two measures are giving an identical message at present – both suggest restrictive monetary conditions. If the term premium had introduced a distortion, one would expect real money growth to be diverging positively from the curve (assuming, reasonably, that the premium has little impact on money trends).

Fourthly, the argument that investors have time to adjust their portfolios after a yield curve inversion may be correct in principle but the relevant curve now may be China’s. The MSCI All Country World Index peaked in January 2018, eight months after the Chinese inversion.

The normalisation of the Chinese curve since mid-2017 suggests that China / Asia will lead a global economic recovery but Chinese money trends currently remain weak, arguing that any revival is unlikely until the second half of 2019 at the earliest.

Global economic prospects still dimming

Posted on Tuesday, December 4, 2018 at 12:36PM by Registered CommenterSimon Ward | CommentsPost a Comment

The baseline view here is that the current global economic downswing will extend into the first half of 2019, and probably beyond mid-year. Incoming news is consistent with this scenario.

Near-complete monetary data for October confirm that G7 plus emerging E7 real narrow money growth fell to a new low  – see first chart. This suggests that six-month industrial output momentum is unlikely to reach a trough until around July 2019 at the earliest, based on the historical average nine-month lead time at turning points.

As an aside, G7 plus E7 real narrow money growth may have crossed back below industrial output growth in October, with partial data indicating a rebound in the latter – an October estimate is included in the chart. If confirmed, the first of the two equities / cash switching rules described in a previous post will move from equities to cash at end-December*.

Non-monetary leading indicators are signalling a near-term further economic slowdown. The OECD will release October data for its composite leading indicators on 10 December but most of the component information is already available, allowing an independent calculation. The G7 indicator is estimated to have fallen further in October, reflecting declines in all countries bar Japan (where weather-related disruption to activity and a subsequent recovery may have distorted recent readings) – second chart**. The indicators are designed to predict the direction of detrended GDP, i.e. a decline signals below-trend growth.

Previous posts argued that a downswing in the global stockbuilding cycle would act as a drag on growth in late 2018 and 2019. The cycle has averaged about 3.5 years, measured from trough to trough, and the last low is judged to have occurred in early 2016, implying that the next one could be reached in the second half of 2019. Global manufacturing PMI survey results for November support the view that the cycle is at or past a peak, with the finished goods stocks index close to the series high and diverging from weak new orders – third chart.

Stockbuilding cycle downswings in 2011-12 and 2015-16 were associated with significant global economic slowdowns. The current downswing may coincide next year with a downswing in the longer-term business investment cycle, which last troughed in 2009 and is scheduled to reach another low by 2020 at the latest. The risk of the current economic slowdown developing into a recession, in other words, is greater than in 2012 and 2016.

Global narrow money trends would need to weaken further for a recession to be adopted as the central case here. The six-month change in G7 plus E7 real narrow money turned negative ahead of the 2008-09 recession – first chart. It fell to 0.4% (not annualised) ahead of the milder 2001 recession. The October reading was 1.0%. A reasonable judgement is that a recession call would be warranted by a further fall to 0.5%.

As previously discussed, the recent collapse in the oil price will provide near-term support to real money growth by cutting headline inflation. The six-month change in G7 plus E7 consumer prices could fall by about 0.5 of a percentage point if commodity prices, as measured by the energy-heavy GSCI, are stable at current levels – fourth chart.  Six-month nominal narrow money expansion, therefore, might need to fall by a further 1 percentage point to push real growth down to 0.5%.

*The second rule, based on whether G7 annual real narrow money is above or below 3%, remains in cash currently. Its recommendation at end-December will depend on November monetary / inflation data to be released over the course of this month. Both rules were in cash during October.
**Of the G7 country indicators, only Canada’s includes a monetary aggregate.

Euroland / UK money trends signalling sluggish outlook

Posted on Thursday, November 29, 2018 at 02:37PM by Registered CommenterSimon Ward | CommentsPost a Comment

Euroland / UK money trends have stabilised in recent months, suggesting that economic prospects remain weak but have not deteriorated further.

Euroland GDP rose by 0.2% in the third quarter and PMI survey compiler IHS Markit claims that November flash results released last week are consistent with a fourth-quarter increase of 0.3%. Second-half growth, therefore, may have averaged 0.25% per quarter, below the ECB staff’s September central forecast of 0.4%.

Slower economic growth was signalled by a weakening of monetary trends in late 2017 / early 2018. Six-month growth rates of real narrow and broad money, however, have recovered slightly since March / April, with little change in October – see first chart. Allowing for the usual nine-month lead, a reasonable expectation is that GDP will grow by 0.3% per quarter in the first half of 2019. The previous ECB staff projection was for quarterly growth of 0.5% but this is likely to be scaled back to 0.4% or less in the December update.

UK real narrow and broad money growth also bottomed in early 2018, recovering into mid-year before slipping back more recently – second chart. Levels are lower than in Euroland. GDP growth of 0.6% in the third quarter was anomalously high and a downshift to 0.3% per quarter or less is plausible over coming quarters.

While six-month growth rates of real money have stabilised, annual growth of nominal narrow money continues to subside in both Euroland and the UK, signalling a likely future slowdown in nominal GDP – third and fourth charts. This prospect suggests that monetary policies should be on hold or shifting to an easing bias. With economic growth undershooting its forecast significantly, and headline inflation about to fall sharply following unexpected oil price weakness, there are strong grounds for the ECB to suspend its previous plan to halt QE at end-2018.

The 2008-09 and 2011-12 Euroland recessions were preceded by a significant divergence of narrow money trends across countries. Reassuringly, no such divergence is yet apparent – fifth chart. Italian real narrow money growth, while below average, has held up better than expected following the rise in yield spreads. The most notable recent development has been a further slowdown in Germany, where real money growth is on a par with Italian – economic prospects may be similarly weak in the two countries.

Chinese money trends still cautionary

Posted on Wednesday, November 21, 2018 at 01:03PM by Registered CommenterSimon Ward | CommentsPost a Comment

Chinese money and credit numbers for October were disappointing, signalling that policy easing has yet to gain traction and may need to be stepped up.

A post last month noted a modest recovery in six-month growth of narrow money and broad credit in September but argued that a further rise would be necessary to warrant shifting away from a negative view of economic prospects. Growth, instead, slipped back in October – see first chart.

Real-terms money / credit expansion fell to a new low in October as six-month consumer price inflation rose further – second chart. The inflation spike, however, has been driven by food and energy prices, which are now reversing lower – third and fourth charts.

Economic activity is receiving support from a pick-up in infrastructure spending but public sector fixed asset investment is not yet growing strongly – fifth chart. Private investment has remained robust but may lose momentum in response to slowing profits and as housing construction cools - sixth and seventh charts.

The number of downgrades to company earnings forecasts by equity analysts has risen sharply in November, consistent with a further loss of economic momentum - eighth chart.

A cautious / negative view of economic prospects will be retained here pending a significant rebound in real narrow money growth. This remains possible: the failure of nominal money trends to recover to date is not inconsistent with historical experience of the policy transmission lag, while further easing is in the pipeline and inflation developments, as noted, should be supportive.

Global monetary update: further weakness

Posted on Friday, November 16, 2018 at 10:56AM by Registered CommenterSimon Ward | CommentsPost a Comment

Global real narrow money trends appear to have weakened further in October, suggesting that nine-month-ahead economic prospects are still deteriorating.

Six-month growth of real narrow money in the G7 economies and seven large emerging economies is estimated to have fallen again in October, moving below the previous low reached in February, based on monetary data covering two-thirds of the aggregate and near-complete inflation readings – see first chart.  If confirmed, the implication is that six-month industrial output momentum is unlikely to bottom before mid-2019.

Real narrow money growth has fallen below the lows reached in 2011 and 2014, suggesting that the current global economic downswing will be at least as significant as the 2011-12 and 2015-16 slowdowns, associated respectively with the Eurozone crisis / recession and China’s near-hard landing.

Annual growth of G7 plus E7 nominal narrow money has more than halved since 2016 and is approaching the low reached in 2008 – second chart. Annual nominal GDP expansion probably peaked in the second quarter of 2018, with a sustained decline in prospect. This slowdown is likely to squeeze profits and snuff out a recent pick-up in wage pressures. Central bankers worrying about inflationary risks are facing the wrong way.

In contrast to 2008, six-month real money momentum is still comfortably positive because consumer price inflation is significantly lower now than then. A recent pick-up in six-month inflation has contributed to the further fall in real money growth – third chart. This pick-up, however, should unwind as a result of falls in oil and other commodity prices, assuming these are not reversed – fourth chart. Commodity price weakness should be reflected in a sharp decline in prices paid indices in purchasing managers’ surveys – fifth chart.

The further fall in G7 plus E7 six-month real narrow money growth has been driven by the E7 component – sixth chart. A previous post discussed an alarming deterioration in trends across the Far East ex. China / Japan and weakness has now spread to Latin America, with six-month changes in real M1 in Brazil and Mexico turning negative – seventh chart.

Equity analysts are cutting earnings forecasts for EM companies at a faster pace, consistent with a significant economic downturn – eighth chart. The sharp fall in the oil price is similarly suggestive of weakening Asian / EM demand.