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.
Lofty global bond prices partly reflect expectations of a wave of Japanese buying prompted by Bank of Japan (BoJ) suppression of domestic yields. The Japanese, however, may never arrive.
Japanese investors remained net sellers of foreign bonds and notes in the week before last, as they have been in 11 of the last 12 weeks – see first chart.
The suggestion is that they are about to pile into overseas bonds to escape lower domestic yields and a weakening yen. The real trade-weighted yen, however, is near the bottom of its historical range, having fallen by more than 20% over the last 10 months – second chart. Risk-averse Japanese investors are unlikely to judge it a good time to raise their foreign currency exposure.
The yield pick-up for accepting such exposure, moreover, has declined. JGB yields of all maturities are higher now than at end-March, before the 4 April BoJ announcement of expanded QE. The five-year benchmark yield has climbed from 0.13% to 0.24%, delivering a 0.57% capital loss (i.e. four years of yield). With five-year yields falling in the US (and elsewhere), the US / Japanese spread is almost back to the low reached in summer 2012, in turn suggesting that dollar / yen has overshot – third chart.
Global bond markets are at risk from a liquidation of speculative long positions opened in anticipation of the arrival of “greater fool” Japanese buyers.
Eurozone monetary developments remain mixed, with broad money soft but narrow money strengthening. (Real) narrow money has historically been a much better leading indicator of the economy so this mix is judged here to be positive, cautioning against consensus gloom*. Sluggish broad money, moreover, increases the probability of further ECB easing.
Broad money M3 fell by 0.1% in March, causing six-month growth to slip from 1.5% to 1.4%, or 2.8% annualised. Narrow money M1, by contrast, rose by 0.5%, pushing six-month expansion up from 3.1% to 3.6% – 7.3% annualised.
A geographical split is available for M1 (i.e. overnight) deposits, which comprise 83% of the aggregate. Eurozone-wide real M1 deposits (i.e. deflated by consumer prices) climbed 3.3% in the six months to March, or 6.7% annualised. This is the largest six-month increase since February 2010, when the Eurozone economy was expanding solidly – see chart. (M3, incidentally, was contracting in early 2010.)
Crucially, real M1 deposits are now growing respectably in the periphery (i.e. Italy, Spain, Greece, Ireland and Portugal) – 2.7% in the latest six months versus 3.6% in the core. Periphery / core divergence warned of the “crises” of recent years but the gap is now the smallest since 2009. The six-month change was positive in all five peripheral economies in March.
The core / periphery distinction, indeed, is no longer helpful: the six-month change was stronger in March in Italy and Spain than in the Netherlands, Belgium and France – the latter still negative. German growth remains much the strongest of the major economies – 5.6%, or 11.5% annualised.
*Narrow money is held mainly for transactions purposes whereas broad money is dominated by savings deposits. Households / firms are likely to increase their transaction balances ahead of a rise in spending. Broad money can be unchanged or even fall, for example if there is a simultaneous shift of savings out of banks into markets, to the extent that this transfer is reflected in a contraction of banks’ balance sheets.
GDP grew by 0.3% (0.31% before rounding) between the fourth and first quarters versus an above-consensus estimate here of a 0.2% gain – see Friday’s post. As expected, the rise was driven by solid expansion in the dominant services sector (+0.6%), which offset weakness in construction (-2.5%), with little contribution from industrial production (+0.2%).
The 0.3% GDP increase probably understates economic performance because 1) construction output is likely to have been affected by poor weather and 2) the recent pattern has been for initial estimates of the GDP change to be revised up. GDP would have risen by 0.48% if construction output had been stable last quarter, as suggested by a modest recovery in new orders in late 2012. The quarterly GDP change, meanwhile, has been revised up by 0.15% on average since the start of 2009 (i.e. comparing the initial estimate with the latest data vintage). Taking both considerations into account, “true” growth may have been 0.5% or more.
Today’s news should, thankfully, put to rest silly “triple dip” commentary – silly because the fourth-quarter GDP decline was entirely attributable to a reversal of the Olympics boost in the third quarter so clearly did not signal underlying economic contraction.
The focus now is on how much longer the “double dip” of the fourth quarter of 2011 and first quarter of 2012* survives in the official data. The quarterly GDP changes in the two quarters have so far been revised from an initially-reported -0.3% and -0.2% respectively to -0.1% and -0.1%. As previously explained, the double dip has already disappeared in onshore GDP data (i.e. excluding North Sea oil and gas production).
GDP last quarter was still 2.6% below the peak reached in the first quarter of 2008 but the onshore shortfall is significantly smaller, at 1.7%. The latest onshore GDP index estimate, of 104.5*, is 0.4% below the annual maximum of 104.9 reached in 2007. Moderate further growth in the remaining quarters of 2013, in other words, would result in a new annual high this year.
The sectoral detail in today’s report highlights a continuing depression in the (tiny) agricultural sector – output fell by 3.7% last quarter to stand 14.2% below a peak reached in the second quarter of 2008. Upward pressure on food prices may persist.
*GDP also fell in the second quarter of 2012 but this was attributable to an additional bank holiday.
**Based on 2009 = 100.