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A "monetarist" perspective on current equity markets

Posted on Tuesday, July 2, 2019 at 09:40AM by Registered CommenterSimon Ward | CommentsPost a Comment

The forecasting approach used here signalled the 2018-19 global economic slowdown and suggests that the downswing is entering its final stage. Early indications are that 2020 will be a recovery year for the global economy, although this requires confirmation from a further rise in monetary growth. A bottoming of economic momentum may be associated with an increase in market volatility and a reversal of several recent trends.

A key basis for the forecast that the global economy would lose momentum in 2018-19 was a significant fall in global six-month real narrow money growth between July 2017 and October-November 2018. Allowing for an average nine-month lead, this suggested that the six-month rate of change of industrial output would peak in early 2018 and fall through the third quarter of 2019. This forecast continues to play out, with the six-month output change turning negative in April 2019, the latest available month – see first chart. The Markit / J P Morgan global manufacturing PMI, meanwhile, fell to a seven-year low in June.

Real narrow money growth has recovered since late 2018 but, as of May, remained weak by post-GFC standards. Monetary trends, that is, are consistent with global economic momentum reaching a low in the third quarter of 2019 but have yet to suggest a meaningful rebound. The judgement here is that six-month real money growth needs to rise to 3% (not annualised) during the second half of 2019 to confirm that 2020 will be a recovery year for the global economy. The 3% level was exceeded before all previous economic reaccelerations since the 2008-09 recession.

The forecasting approach does not attempt to predict monetary trends but there are reasons to be hopeful. Six-month nominal money growth reached a 16-month high in May and may be boosted by recent bond yield declines and central bank policy easing. Real money growth has been suppressed by a rise in six-month consumer price inflation but this is likely to fall back, assuming stable commodity prices.

The forecast that the global economy would weaken in 2018-19 also rested on an assessment that the 3-5 year stockbuilding (inventory) cycle and the 7-11 year business investment cycle were about to enter downswings that would continue into the second half of 2019 and possibly beyond. Recent business survey evidence confirms weakness in the two cycles but readings have yet to reach extremes suggestive of lows. The current working assumption here is that the stockbuilding cycle will bottom in the third quarter of 2019 with the business investment cycle following one or two quarters later.

Economic weakness is now feeding through to labour markets and a rise in global unemployment is expected over the next 12 months even if an economic recovery begins in early 2020. Together with soft headline and core inflation, this will trigger belated and probably excessive monetary policy easing, laying the foundation for another bout of strong economic growth, possibly in late 2020 or 2021.

The stockbuilding and business investment cycles are “nested” within longer-term housing and inflation cycles. The current constellation of the cycles was last replicated in 1966-67, suggesting that economic developments will play out somewhat similarly. The US Treasury yield curve inverted in 1966 and the economy slowed sharply into 1967, while avoiding a recession. US weakness followed recessions in Japan and Germany – a mirror, perhaps, of China’s leading role in the current global downswing.

The US slowdown resulted in a rise in the unemployment rate from a low of 3.6% in 1966 to a high of 4.0% in 1967, prompting the Federal Reserve to ease policy – prime rate fell by 50 basis points, with money market rates dropping by significantly more. This policy shift triggered a bear steepening of the Treasury curve and contributed to a rebound in growth and inflation into 1968. Other major economies were also strong in 1968 – a possible template for late 2020 / early 2021.

Recent market behaviour is consistent with the cyclical position. As discussed in previous commentaries, returns are correlated with the stockbuilding cycle, with the 18 months leading into a trough usually associated with “risk-off” market moves, which reverse in the following 18 months. The first two columns in the table show average returns on various instruments or long / short pairs around the last seven cycle troughs. The final column shows returns so far in the current downswing, on the provisional assumption that the cycle will reach bottom in the third quarter of 2019.

Recent performance has in most respects displayed the expected defensive pattern, with Treasury yields falling, credit spreads widening, US and quality stocks outperforming, emerging market equities underperforming, commodity prices weakening and the US dollar strengthening. The suggestion is that investors should prepare for a reversal of these trends in late 2019, assuming that incoming data confirm a third-quarter stockbuilding cycle trough and global real money growth continues to recover.

A notable discrepancy in the recent returns pattern is the resilience of equities in aggregate – the MSCI World index showed the expected weakness in late 2018 but this year’s rebound has pushed it above the level at the suggested start of the current “risk-off” phase. This raises the possibility of another sharp sell-off as the stockbuilding cycle moves into its low.

Index resilience, however, may partly reflect an unusual contraction in the global share float, with buy-backs and cash take-overs boosted by US tax reform and low corporate borrowing costs. The second chart shows an index of the number of shares outstanding derived by dividing the market cap of the MSCI World index by its price. The share float rose during the previous seven stockbuilding cycle “risk-off” phases but has fallen so far in the current downswing.

The implication may be that equity market weakness has been deferred until a rise in borrowing costs or other development curtails share-buying. Equities, that is, could underperform the historical average as interest rates rebound in the early stages of the next stockbuilding cycle upswing.

Previous commentaries described equities / cash switching models based on the concept of “excess” money. Excess money exists when monetary growth exceeds the level needed to support economic expansion. An excess is associated with additional demand for financial assets and upward pressure on prices.

Excess money cannot be measured directly. Two proxy indicators are monitored here – the global real money / industrial output growth gap and the deviation of real money growth from its long-run average. Between 1970 and 2017, global equities outperformed cash by 16.3% per annum (pa) when both indicators were positive but underperformed by 10.1% pa when they were negative.

The indicators were both consistently positive over 2012-17 but have been mixed or both negative in most months in 2018-19. Currently, the real money / industrial output growth gap is positive but this mainly reflects economicweakness, with real money growth still below its long-run average. Historically, a mixed signal has been associated with positive but weak relative equity returns, i.e. the opportunity cost of defensive positioning under such circumstances has been modest, on average.

The third chart shows monetary developments in individual major economies. US real narrow money contracted in mid-2018 and has yet to stage a convincing recovery. The economy has slowed – the income-based measure of GDP rose by only 0.8% at an annualised rate in the fourth and first quarters combined – and weakness is likely to extend through late 2019, at least.

China led the global downswing – its Treasury yield curve (10-year versus 1-year) inverted in June 2017, 21 months ahead of the US. The PBoC relaxed monetary policy from mid-2018 and real narrow money growth has recovered but remains weak by historical standards. As expected, recent economic data have disappointed consensus hopes of an early recovery and further easing is in train. This suggests better monetary news during the second half, which would confirm a 2020 economic rebound.

Real narrow money growth has risen and is relatively strong in Euroland and Japan. This questions the necessity of further monetary policy easing, which is, nevertheless, likely to be forthcoming. Both economies could surprise positively next year if global activity recovers as expected – conditional on no negative shock from trade wars and / or Brexit.

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