Rather than “flatlining”, the British economy has been regaining momentum since late 2011. This trend is obscured in official GDP statistics by various special factors – North Sea production weakness, an extra bank holiday and the Olympics. Adjusting for their effects, the quarterly change in output has risen from -0.1% in the fourth quarter of 2011 to 0.0%, 0.1%, 0.2%, 0.2% and 0.3% in the first quarter of 2013 – a clear upward trend.
Recent numbers, moreover, probably understate economic improvement because official first estimates of growth tend to be revised up during recovery periods. Quarterly GDP changes since the start of 2009 have already been revised by an average of +0.15%. So the current estimate of a 0.3% increase in underlying output in the first quarter of 2013 may reflect “true” expansion of about 0.5%.
The recent growth revival is no surprise to economists of a “monetarist” persuasion. The Friedmanite rule is that the real or inflation-adjusted money supply leads demand and activity by about six months. Economic weakness in 2011 was foreshadowed by a contraction from mid-2010 in real broad money, as measured by non-financial M4, comprising physical cash and sterling deposits held by households and non-financial firms. The six-month change in real money, however, turned positive in late 2011 and rose further in early 2012, signalling a stronger economy from the second half.
Why has real money growth revived? Part of the story is a slowdown in inflation after a 2011 spike driven by a combination of higher VAT, strong global commodity prices and the lagged impact of exchange rate weakness.
Nominal money trends, however, have also improved, despite continued weakness in bank lending. This may partly reflect the Bank of England’s QE programme but, interestingly, the recovery began before gilt purchases were restarted in October 2011. QE may have had a much smaller impact than the Bank claims: its operations may have substituted for gilt purchases by banks, which were under strong pressure to raise their liquidity ratios – such buying has similar monetary effects. QE has boosted banks’ reserves, allowing them to meet liquidity targets without expanding their gilt holdings.
A less-discussed reason for faster money growth is the effort by banks to restructure their liabilities to reduce reliance on non-deposit and overseas funding. The repayment of such funding can lead to an expansion of domestic deposits included in the money supply. An example would be an overseas investor using funds returned by a UK bank to buy a UK corporate bond at issue – a fall in banks’ overseas liabilities would then be matched by a rise in corporate deposits. The ongoing shift in bank funding sources may partly explain why money growth has remained solid despite the suspension of QE in November 2012.
Real non-financial M4 rose at an annualised rate of 2.1% in the six months to March. The composition of growth is encouraging, with strength focused on cash and instant-access deposits – these components, which constitute narrow money M1, are more likely to be related to future spending. Real non-financial M1 increased by 5.4% annualised in the latest six months.
Sectorally, corporate money holdings are expanding faster than those of households. Corporate liquidity has a closer relationship with the economic cycle – similar increases historically have presaged stronger investment and hiring, with a resulting rise in wage incomes lifting consumer spending.
Some commentators claim that companies are holding more money because of a lack of profitable investment opportunities and as a precaution against cash flow problems, given the difficulty of accessing bank credit. It is certainly plausible that the desired ratio of bank deposits to borrowing has risen as a result of the recession and more restrictive credit conditions. The actual ratio, however, has climbed by more than two-fifths in the four years since the economy bottomed, reaching a new high in data extending back to 1998 – this is unlikely to be fully explained by rising precautionary liquidity demand.
There is, moreover, no sign of any breakdown in the relationship between corporate money growth and the economy. The “soft patch” in 2011 was preceded by a contraction of real corporate liquidity. Recent economic improvement has occurred on schedule following a liquidity revival in 2012. Six-month growth in real corporate M4 holdings was 5.7% annualised in March and reached 7.9% in January – the highest since 2007.
Monetarist optimism on economic prospects contrasts with “creditist” pessimism, based on the idea that a pick-up in bank lending is a precondition of stronger growth. This notion, however, is at odds with historical evidence that, while money leads the economic cycle, credit is a coincident or lagging indicator. In the US, the Conference Board includes bank business loans and consumer credit in its lagging economic index.
This lagging relationship suggests that bank lending will revive as growth continues to strengthen during 2013. There are already hopeful signs, such as a rise in unused sterling credit facilities in the six months to March – the first such increase since 2007. A credit pick-up, in turn, would provide additional support for monetary expansion.
The monetary foundations for a sustainable economic recovery are in place. The Bank of England should avoid further policy experimentation and focus on achieving its inflation target while allowing banks to operate in a stable regulatory environment.
The global economy has strengthened in early 2013 – the six-month change in G7 plus emerging E7 industrial output rose from -0.2% in September 2012 to an estimated 2.4% in March (not annualised). This pick-up was predicted by faster global real narrow money expansion between spring and autumn 2012 – monetary trends lead activity by about six months, according to the “monetarist” rule.
The forecast here has been that global growth would moderate but remain respectable from spring 2013, reflecting a minor slowdown in real money expansion in late 2012 / early 2013. The six-month change in G7 plus E7 real money, however, edged higher again in March and is solid by historical standards – see first chart. The global economy, therefore, is unlikely to slow much over the summer. Incoming news, indeed, may beat current conservative expectations.
Global real money expansion is lower than last autumn only because of a slowdown in the US – trends elsewhere have improved. As previously discussed, the US narrow money numbers may have been affected by the removal of unlimited insurance on demand deposits at the end of 2012, prompting a shift into interest-bearing deposits or repos. Lower US real money growth, in other words, may not signal a material deterioration in economic prospects.
The suggestion that US economic expansion will remain respectable is supported by the latest Fed survey of senior bank loan officers. The net percentage of banks tightening standards on business loans usually surges ahead of significant economic weakness but fell further in April, to the bottom of the historical range – second chart. (Note that the net percentage is plotted inverted. The Fed survey was suspended between 1984 and 1990, explaining the data break.)
Today’s stronger services purchasing managers’ survey for April is further evidence in favour of the “monetarist” forecast here of solid UK economic growth in 2013, reflecting the lagged impact of faster real money supply expansion.
Monetarist optimism contrasts with “creditist” pessimism, based on the idea that a pick-up in bank lending is a precondition of a stronger economy. This notion, however, is at odds with historical evidence that, while money leads the economic cycle, credit is a coincident or lagging indicator. In the US, the Conference Board includes bank business loans and consumer credit in its lagging economic index.
This lagging relationship suggests that bank lending will revive as growth continues to strengthen during 2013. There are already hopeful signs, such as a rise in sterling unused credit facilities in the six months to March, the first such increase since 2007 – see chart. A credit pick-up, in turn, would provide additional support for monetary expansion.
The authorities, of course, will claim that a recovery in bank credit reflects the success of the funding for lending scheme and will try to argue that this recovery is driving a stronger economy, rather than vice versa.
The monetary foundations for a sustainable economic recovery have been laid. The Bank of England should avoid further policy experimentation and focus on achieving its inflation target while allowing banks to operate in a stable regulatory environment.
Emerging equities have continued to underperform developed markets so far in 2013 but relative monetary trends and valuations suggest an imminent turnaround.
The first chart shows the ratio of MSCI’s emerging equity markets index to its developed markets index – a rise in the line indicates that emerging equities are outperforming and vice versa. This ratio is compared with real (i.e. inflation-adjusted) money supply growth in the Group of Seven (G7) major countries and seven large emerging economies – the “E7”*.
Monetary strength signals favourable economic prospects and liquidity support for markets. The chart shows a relationship between the relative performance of emerging equities and the gap between E7 and G7 real money growth. The index ratio peaked in late 2010 as the gap narrowed sharply, turning negative in early 2011. The glory days of emerging equities in 2009-10 and before the financial crisis, by contrast, occurred against the backdrop of relative monetary buoyancy.
An update in February suggested remaining cautious on emerging markets because E7 real money growth, while improving, had not yet crossed above G7 expansion. Emerging equities have since underperformed by a further 7% but the awaited cross-over has now occurred, based on March money supply data. Monetary trends have strengthened in most of the E7 countries and there have been similar or larger gains in smaller emerging economies not included in the aggregate.
Emerging markets, meanwhile, appear inexpensive: the price to earnings ratio based on forecast earnings over the next 12 months is 10.1 versus 13.2 for developed markets, according to I/B/E/S – second chart. The 23% discount is the largest since 2006.
*The E7 is defined here as BRIC (Brazil, Russia, India, China) plus Korea, Mexico and Taiwan.
Better monetary trends from mid 2011 signalled the recent recovery in UK “underlying” economic growth. March monetary statistics suggest that this recovery will extend over the remainder of 2013.
Last week's post on the first-quarter GDP estimate contained a chart showing the quarterly change in “underlying” output, i.e. gross value added* excluding oil and gas production and adjusted for extra bank holidays and the Olympics. This quarterly change has risen from a low of -0.1% in the fourth quarter of 2011 to 0.0%, 0.1%, 0.2%, 0.2% and 0.3% in the first quarter of 2013. Far from “flatlining”, the economy has been gradually gaining momentum since late 2011.
The chart below shows the change in actual and underlying output over two rather than one quarters, comparing this with the six-month change in the real “Divisia”** money supply, including and excluding money holdings of financial institutions. Economic weakness in 2011 was foreshadowed by a contraction in the real money supply starting in mid 2010. The six-month change in real non-financial Divisia, however, turned positive in late 2011 and rose steadily during 2012, signalling an accelerating economic revival from mid 2012, allowing for the typical half-year lead of money to activity.
Six-month real Divisia growth has stabilised since late 2012 but at a level historically associated with solid output expansion. The message is that economic momentum will continue to build through late 2013 (at least). The view here remains that 2013 will be the best year for the economy since 2006.
*Gross value added = gross domestic product excluding indirect taxes and subsidies.
**The Divisia measure combines the components of the M4 broad money supply using liquidity weights based on interest rates.