Monetary / leading indicator signals still negative

Posted on Tuesday, September 4, 2018 at 10:33AM by Registered CommenterSimon Ward | CommentsPost a Comment

Near-complete July monetary data confirm an estimate in a previous post that six-month growth of real (i.e. inflation-adjusted) narrow money growth in the G7 economies and seven large emerging economies fell to its lowest level since February – see first chart. The “big picture” is that real money growth declined significantly between June 2017 and February 2018 and has since moved sideways, remaining below its range over September 2008-November 2017. Allowing for a typical nine-month lead, this suggests that six-month industrial output growth will fall further into late 2018 and stay weak into early 2019.

The OECD’s composite leading indicators continue to confirm the downbeat message from narrow money trends. The OECD is scheduled to release a July update of its indicators on 10 September but most of the component information is already available, allowing an independent calculation. The G7 indicator is estimated to have fallen further in July, with a decline signalling future below-trend GDP growth – second chart. Weakness remains broad-based geographically; the July data, in particular, should confirm that the US indicator is now in a downtrend – third chart.

There were notable falls in six-month real narrow money growth in July in the US, Euroland, Canada, Switzerland and Sweden – fourth and fifth charts. The UK bucked the trend but the recent recovery may not survive the unwise August rate hike. Australia remains at the bottom of the range among developed economies, suggesting downward pressure on interest rates. Also of interest is a sharp contraction in Hong Kong domestic-currency real M1 reflecting recent pressure on the currency peg – sixth chart.

It has been suggested that trends in broad money, unlikely narrow money, signal a “Goldilocks” scenario of moderate global economic growth with subdued inflation. Six-month growth of G7 plus E7 real broad money, however, also eased in July and is below its average in recent years – first chart. Broad money, in any case, has been an unreliable indicator – it did not signal the 2008-09 recession in advance and wrongly suggested a “double-dip” in 2010-11. Real broad money growth did pick-up in 2015-16 ahead of the 2016-17 economic “boomlet” but this partly reflected a slowdown in inflation, while narrow money accelerated much more impressively.

It is possible that broad money growth is being supported currently by an incipient rise in risk aversion in financial markets and an associated increase in the precautionary demand for money, which is more likely to be in broad form (i.e. time deposits, notice accounts, bank bonds etc.) – such an effect may also help to explain why broad money trends remained solid in the initial stages of the 2008-09 financial crisis and recession.

The July monetary data confirm that annual growth of G7 real narrow money moved further below 3% and has now also fallen by more than 3 percentage points over six months. The second of the equities-cash switching rules described in a previous post, therefore, remained in cash at end-August.

The first rule is based on the difference between G7 plus E7 six-month real narrow money growth and industrial output growth, which remained positive in June – the latest available month of full industrial output data. Accordingly, this rule stayed in equities at end-August. Partial data for July, however, suggest that output growth recovered slightly; with real narrow money growth falling, the gap between the two may have closed, in which case the first rule would switch to cash at end-September.

Are UK monetary clouds lifting?

Posted on Thursday, August 30, 2018 at 12:15PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK monetary growth recovered further in July but could fall back in the wake of this month’s rate hike. August data should be awaited before upgrading economic expectations.

Six-month growth of real (i.e. inflation-adjusted) narrow money, as measured by non-financial M1, rose to its highest level since November 2017 in July, though remains below its range over the prior five years (i.e. back to August 2012). Real broad money – non-financial M4 – has also reaccelerated, following significant weakness earlier in 2018 – first chart.

The rise in six-month real narrow money momentum in July contrasts with falls in the US and Euroland. UK growth remains lower than in Euroland but the gap is the smallest since October 2016 – second chart.

“Local” UK shares – as measured by the FTSE local UK index, which includes companies generating 70% or more of sales from the UK / Europe, the Middle East and Africa – have underperformed other markets significantly in currency-adjusted terms so far in 2018, undershooting even emerging markets – third chart. Improving absolute and relative monetary trends suggest that the case for underweighting UK shares is weakening.

The caveat, of course, is the unfortunate August rate hike, which risks aborting the monetary recovery. Six-month growth of narrow and broad money fell sharply immediately after the November rate increase.

The recovery in real money growth, in addition, has been partly due to a slowdown in six-month consumer price inflation – fourth chart. This could reverse in the wake of recent sterling weakness – the effective exchange rate fell by 2.6% between April and July.

A cautious view of UK economic / market prospects, therefore, will be maintained here, at least pending August monetary data released at end-September.

Sectoral data show that the recent rise in six-month real narrow money growth has reflected increases in both the household sector and private non-financial corporate (PNFC) components – fifth chart. The latter improvement, in particular, is surprising, suggesting that businesses are not yet scaling back expansion plans in response to the supposed increased risk of a “no deal” Brexit.

Euroland money trends suggesting sub-consensus GDP growth

Posted on Wednesday, August 29, 2018 at 09:23AM by Registered CommenterSimon Ward | CommentsPost a Comment

Euro area July money numbers were disappointing, suggesting that GDP growth will stick at its recent slower pace – contrary to consensus hopes that first-half weakening represented a temporary “soft patch”.

As usual, the focus here is on non-financial monetary aggregates, comprising holdings of households and non-financial corporations (NFCs)*. Six-month growth rates of real (i.e. inflation-adjusted) non-financial M1 and non-financial M3 fell in July and are back near lows reached in April and May respectively – see first chart.

Both real money growth measures declined significantly between June 2017 and April / May, correctly signalling the “surprise” weakening of GDP expansion in the first half of 2018. The sideways move since April / May suggests that economic growth will continue at around its recent pace through the first quarter of 2019 – GDP may rise at a 1.25-1.5% annualised rate, below ECB and consensus forecasts of 1.75-2.0%.

The fall in six-month real non-financial M1 growth in July reflected notably weaker expansion of non-financial corporate deposits – second chart. This may signal a scaling-back of business expansion plans in response to uncertainties around US trade policy, Brexit, the ending of QE and Italy / EU relations.

Curbed business expansion would be expected to feed back into consumer spending via reduced hiring and slower expansion of worker incomes. Corporate real M1 holdings display a stronger correlation with future GDP expansion than household holdings, according to ECB research.

The third chart shows six-month growth rates of real non-financial M1 deposits in the "big four” economies. The Euro area slowdown over the past year has been driven by France and Spain, suggesting a greater loss of economic momentum in those two countries – already evident in French GDP data for the first half.

Italian real deposit growth has been volatile but weakened sharply in July. Monetary trends led the Italian / German yield spread around the 2011-13 recession but have lagged the spread recently; with the latter widening further, the monetary slowdown may be sustained – fourth chart.

*The headline M1 / M3 aggregates also include financial sector money holdings, which are more volatile and display a lower correlation with future GDP expansion, according to ECB research.

Business investment: as good as it gets?

Posted on Wednesday, August 22, 2018 at 02:54PM by Registered CommenterSimon Ward | Comments2 Comments

Optimists expect strong growth of business investment to relieve capacity strains and allow the global economic upswing to continue for several more years. The view here, by contrast, is that investment strength may be peaking ahead of weakness in 2019-20.

Economists in the first half of the twentieth century were familiar with a 7-11 year cycle in business investment (the Juglar cycle, after nineteenth-century French economist Clément Juglar), along with shorter- and longer-term cycles in inventories and housing construction respectively. The long post-WW2 economic expansion contributed to the idea of distinct cycles in different parts of the economy falling out of fashion in favour of a vaguer concept of an irregular business cycle that could be tamed by wise policy-makers.

A 7-11 year fluctuation in business investment, however, is clearly visible in post-war US / G7 data, with troughs in the cycle plausibly occurring in 1949, 1958, 1968, 1975, 1983, 1993, 2002 and 2009 – see first chart. Another trough, therefore, is scheduled by 2020 at the latest, implying that the cycle will be in a downswing in 2019.

The investment cycle is closely related to the profits cycle, with the latter usually leading by several quarters – second chart. The profits measure in the chart is a national-accounts version of EBITDA and usually moves ahead of cash flow numbers associated with stock market indices such as MSCI World – these numbers are usually presented as four-quarter moving totals. Nominal profits were converted to real terms using the GDP deflator. G7 real profits growth is running below investment growth and eased into the first quarter, despite a rise in the US. Second-quarter figures will be important for assessing whether the investment cycle is already peaking.

The relative weakness of profits trends in Japan and Europe suggests that an investment slowdown should begin there. Japanese and German capital goods orders, indeed, have been surprisingly weak recently, contrasting with a continued rise in US core orders – third chart.

As well as a stronger profits trend, US business investment has been boosted by the boom in oil and gas exploration – mining investment contributed one-quarter of non-residential fixed investment growth of 9.4% annualised between the fourth quarter of 2017 and second quarter of 2018. A recent stalling of the rig count and oil prices, however, suggests that this segment will lose momentum – fourth chart.

A further reason for expecting US business investment strength to cool is the lagged relationship with residential investment, which has slowed significantly since early 2016 – fifth chart. This empirical regularity may reflect housing responding more quickly than business investment to changes in monetary conditions; an alternative explanation is that housing swings affect general economic activity, resulting in an accelerator effect on business investment. For whatever reason, the relationship has been surprisingly reliable historically.

Softening prospects for business investment would be expected to be associated with weaker corporate narrow money trends. No monthly sectoral breakdown of US monetary data is available but the six-month rate of change of real corporate narrow money is lower than a year ago in Japan, Euroland, the UK and China, although there are hints of a bottoming out recently – sixth chart*.

*NFC = non-financial corporation; PNFC = private NFC; NFE = non-financial enterprise.

Equities / cash switching rules: an update

Posted on Friday, August 17, 2018 at 09:34AM by Registered CommenterSimon Ward | Comments2 Comments

Various posts in recent years discussed two rules for switching between global equities and US dollar cash based on monetary signals. One or other of the rules has recommended cash since end-January, suggesting that a cautious investment strategy remains warranted.

The simple idea underlying the rules is that “high” (to be defined) global money growth is likely to be associated with rising demand for equities and other financial assets, with corresponding upward pressure on prices. Conversely, low or falling money growth may signal selling and downward pressure.

The first rule generates positive or negative signals by comparing six-month rates of change of real narrow money and industrial output*. A positive differential suggests that money holdings are rising faster than needed to support economic expansion, implying a surplus to be invested in markets.

This rule uses G7 plus E7 data from 2000 and G7-only for earlier years. The switch-over date reflects a judgement that E7 monetary trends were of limited significance for global markets before the 2000s.

The second rule recommends equities unless G7 annual real narrow money growth falls below 3% – its average from 1970 until the 2008-09 recession / crisis – or falls by 3 percentage points within six months. The latter condition was added in light of experience in 1987, when real money growth was falling fast but crossed below 3% only after the October crash.

Since the formulation of the rules was informed by historical evidence, their backtested performance is impressive by construction – see first chart. The additional return that would have been generated by following the rules over the last 48 years is identical, although their signals disagreed in 23% of months.

Both rules recommended equities between end-August 2011 and end-January 2018.

Six-month growth of G7 plus E7 real narrow money moved below that of industrial output in November / December 2017 – second chart. Allowing for the reporting lag, this resulted in the first rule switching into cash at end-January.

The second rule, however, remained in equities, since G7 annual real money growth was still at 5.8% in December 2017 and had fallen by only 1.2 percentage points from six months earlier – third chart.

The two rules have now reversed their recommendations. G7 annual real money growth crossed beneath the 3% threshold in May / June and is likely to have fallen further in July, based on US / Japanese monetary data. The July reading may also be down more than 3 percentage points from six months earlier. The second rule, therefore, switched to cash at end-July.

By contrast, the global economic slowdown and a stabilisation of monetary trends since early 2018 resulted in the gap between six-month growth of G7 plus E7 real narrow money and industrial output turning positive in May / June, causing the first rule to switch back into equities at end-July.

As noted in yesterday’s post, G7 plus E7 six-month real narrow money growth appears to have fallen in July, so this positive signal could prove short-lived. Using G7-only data, the growth gap has remained negative.

The historical backtest results, unsurprisingly, were most impressive when the two rules agreed. Dual positive signals were associated with an average excess return on equities relative to cash of 16.3% per annum (pa); equities underperformed cash by 10.3% pa on average when both rules were negative. Mixed signals, as currently, were associated with an average excess return of 1.6% pa. Even if unneeded, the opportunity cost of a defensive strategy may prove modest.

*A positive signal also requires the six-month change in real narrow money to be above zero.