Forecasting indicators were giving a more positive message for the global economy and markets at the start of the second quarter. The MSCI World index returned 5.1% in US dollar terms over the quarter, up from 1.4% in the prior three months. The indicators continue to suggest solid near-term economic prospects and a supportive liquidity environment for markets. The main concerns for investors are unappealing valuations, a likely inflation rise as the economy strengthens and increased geopolitical conflict.
The economic forecasting approach here is based on the “monetarist” rule that the real, or inflation-adjusted, money supply leads demand and output by about six months. This rule suggested that global* economic growth would slow between late 2013 and spring 2014 in lagged response to a fall in real narrow** money supply expansion between May and November last year. This forecast proved correct: the six-month change in global industrial output peaked in November 2013, falling to an 11-month low in May – see first chart.
Real money expansion, however, rebounded sharply between November and February and has remained solid more recently. Economic growth, therefore, probably bottomed in May and will recover over the summer. This prospect has been confirmed by short-term leading indicators such as the purchasing managers’ surveys – the US and Chinese surveys, in particular, strengthened significantly in May and June. Growth could peak at the end of the third quarter but will likely stay respectable in late 2014, based on the latest monetary data.
The assessment of the liquidity environment for equity markets is informed by the gap between global real money growth and output expansion – a positive differential suggests that there is “excess” liquidity available to inflate asset prices and has been associated historically with stocks outperforming cash substantially. The gap is at a similar level to three months ago – first chart – though may narrow if economic growth strengthens as expected.
The economic slowdown since late 2013 has been reflected in the pattern of asset market returns, with government bond yields falling and “cyclical” equities underperforming “non-cyclicals”***. A summer growth rebound may reverse these trends; the ratio of cyclical equity prices to non-cyclicals stabilised in June and usually mirrors shifts in the G7 purchasing managers’ survey – second chart.
The assessment has been that there is less slack in the global economy than central banks assume, so stronger growth is likely to be associated with a rise in inflation. The six-month change in global consumer prices has firmed modestly since early 2014, driven by trends in the US and Japan. Equities would be at risk if faster inflation resulted in a sharp reversal of bond yields. Steep yield curves and conservative investor positioning, however, may limit any near-term bond market weakness.
Country-level monetary trends are informative about local economic and market prospects. Real money growth is currently strong in the US, moderate on average across the E7 emerging markets and below-par in the rest of the G7 developed economies – third chart. This pattern is consistent with year-to-date equity market performance – the US outperformed emerging markets, which in turn beat non-US developed market equities, according to MSCI indices.
Why has US real money growth strengthened despite Fed “tapering”? The narrow money measure followed here reflects the changing liquidity demand of households and companies and is only indirectly affected by Fed policy. The recent pick-up is evidence of rising economic confidence and spending intentions. Put differently, the progression towards monetary policy normalisation has not yet damaged economic and market prospects.
Real money growth is sluggish on average across other developed economies but this conceals significant variation – fourth chart. UK strength suggests that the economy will continue to outperform. UK equities have been slightly disappointing year to date, beating Japan but only keeping pace with Eurozone markets, while lagging the US. This is partly explained by rising issuance: the stock of shares outstanding rose by more in the UK than other major markets during the second quarter.
Real money trends have been weakest in Japan, with the six-month change turning negative in April. The latter mainly reflects a temporary inflation boost from the recent sales tax hike but, in addition, nominal money growth has slowed, despite QE. The monetary impact of the Bank of Japan’s (BoJ) bond-buying has been largely offset by sales by banks, while associated reserves creation has yet to stimulate bank lending.
Japanese equities are unappealing based on current monetary trends but lacklustre economic expansion could prompt further policy stimulus, suggesting limiting an underweight position. An extreme possibility is that the BoJ will switch its QE buying from bonds to equities in an effort to gain more traction. More likely, the authorities will achieve the same effect by the back door by forcing public pension funds to raise their domestic equity weighting financed by selling bonds to the BoJ.
The European Central Bank (ECB) eased policy further last quarter, cutting the main refinancing rate to 0.15% in June while moving the deposit rate – the lower bound of the corridor for the overnight rate – to -0.1% and offering banks additional longer-term funding on favourable terms. These changes may have little impact on real money growth, which has slipped since end-2013 and suggests unexciting economic and market prospects.
Eurozone inflation is well below target but this reflects monetary / economic weakness 1-2 years ago and euro strength. “Core” inflation – excluding food and energy – has stabilised since late 2013 and may revive gradually as economic recovery continues and the euro drag abates. This scenario suggests low odds of the ECB launching QE.
As noted, emerging E7 real money growth is now higher than in the G7 ex. the US, though remains moderate by historical standards. There is substantial country variation, with monetary trends strong in Mexico and India, and weak in Brazil and Russia. Chinese real money growth is mid-range but has risen since late 2013, consistent with other evidence that the economy is about to regain momentum.
*”Global” = G7 developed plus E7 emerging economies. E7 defined here as BRIC plus Mexico, Korea and Taiwan.
**Narrow money refers to forms of liquidity held by households and firms, excluding banks, that can be used in immediate settlement of transactions. Country definitions vary but include, at a minimum, currency and demand deposits while excluding time deposits and notice accounts. Narrow money should be distinguished from the monetary base, comprising currency and bank reserves with the central bank.
***”Cyclicals” = the top eight MSCI World level 2 industries ranked by correlation with the economic cycle; “non-cyclicals” = the bottom eight industries.
UK monetary trends remain expansionary, suggesting no slowdown in economic growth and rising medium-term inflation risks.
The preferred narrow and broad monetary aggregates here are non-financial M1 and M4, i.e. comprising holdings of households and non-financial firms. Non-financial M1 grew by 10.3% annualised in the six months to May, while M4 was up by 4.5%.
Demand and output follow the real or inflation-adusted money supply by about six months, according to the Friedmanite rule. Six-month growth in real non-financial M1 surged in 2012, predicting last year’s pick-up in the economy – see chart. It has stabilised since early 2013 at a strong level by historical standards. Recent GDP expansion of 3% plus annualised should be sustained at least through end-2014.
Real non-financial M4 growth is also tracking sideways, albeit at a significantly lower level. Real bank lending, meanwhile, is finally reviving – credit, unlike money, tends to lag rather than lead the economic cycle.
Low deposit interest rates have cut the demand to hold broad money while encouraging a shift from time deposits to sight deposits and cash, which comprise M1. The M4 numbers, in other words, understate monetary laxity while M1 may exaggerate it.
This demand change has been reflected in the velocity of circulation of non-financial M4, which has risen by about 0.5% per annum (pa) since the financial crisis, having fallen by more than 3% pa over the prior decade. Non-financial M4 growth of 4.5% now, therefore, is the equivalent – in terms of nominal GDP generation – of about 8% before the crisis. Put differently, current M4 growth and a velocity rise of 0.5% pa imply nominal GDP expansion of 5% pa – too high to meet the 2% inflation target over the medium term.
Previous posts have assessed house price valuation using the national rental yield, defined as the sum of actual and imputed owner-occupier rents in the national accounts divided by the value of the housing stock. This measure has signalled house price undervaluation in recent years, contrary to the consensus view. This remained true in the first quarter: the yield stood at 4.48% versus an average since 1965 of 4.26%, suggesting that the average house price is 5% cheap relative to rents – see first chart.
The Office for National Statistics (ONS), however, revised its rents data earlier this year and plans to make further methodological changes in the 2014 and 2015 Blue Books. The 2014 revision, to be published at end-September, should lower recorded rental growth over 2010-11, resulting in a reduction in the rental yield from 2010 onward. The revised yield series should still indicate house price undervaluation over 2011-13 but on a much smaller scale. Current prices will probably be slightly above fair value on the new basis.
The ONS historically has based its estimates of rental inflation on a survey of household living costs. It plans to switch to a new methodology using data from the Valuation Office Agency (VOA), an arm of HMRC, in the 2015 Blue Book. The VOA is already used as a source for the actual and imputed rent components of the CPIH consumer prices index. Pending the 2015 revision, the ONS is aligning estimates of rental inflation since 2010 with the CPIH components. This change is being implemented in stages, with the final stage occurring in September.
The estimated impact of the September 2014 revision on the historical rental yield path is shown in the second chart. On the new basis, the yield may peak at 4.34% in the first quarter of 2012 versus a long-run average of 4.24%, implying house price undervaluation of 2% at that date – down from 9% on the previous basis.
The revised rental yield is estimated to have fallen to 4.13% by the first quarter of 2014, suggesting 3% overvaluation. This compares with peak overvaluation of 27% in the third quarter of 2007. So prices are now slightly expensive but still far from bubble territory.
The ONS changes may be questioned. The living cost survey data, showing faster rental inflation, could be combined with the VOA information, rather than discarded. Sceptics will note that ONS methodological “improvements” rarely raise inflation estimates. The changes will affect the GDP deflator and current-price GDP, so may have a small influence on the monetary policy debate.
A statistical model of voting intentions continues to suggest that the Conservatives will fail to achieve an overall majority at the 2015 election despite an improving economy.
The model is designed to predict the poll differential between the main government and opposition parties based on economic factors. It was estimated on ICM-Guardian poll data extending back to 1984. The poll differential depends positively on average earnings growth and house price inflation, and negatively on the unemployment rate, retail price inflation and interest rates (Bank rate). More details are available in a previous post.
The Conservatives were 1 percentage point (pp) behind Labour in the June ICM-Guardian poll. The model estimates a 5 pp shortfall based on current economic readings. The 4 pp difference is within the historical margin of error of the model. Other recent polls have been less favourable for the Tories: the average calculated by the UK Polling Report website shows them lagging by 3 pp.
The model estimate of the Conservative / Labour differential has risen from a low of -10 pp last year as the economy has improved. The continued shortfall is attributable to low average earnings growth. According to the model, a big rise in earnings growth would be needed to generate a Tory lead of 6 pp, which is probably the minimum required for the party to achieve a Commons majority*. This is possible but would bring forward Bank rate hikes, with an offsetting poll effect.
The chart, an update from the previous post, shows three possible scenarios. The first is based on the latest MPC economic forecast in the May Inflation Report. In this forecast, average earnings growth rises to 2.75-3% by May 2015, the unemployment rate drops to about 6%, inflation is stable and Bank rate increases by 25 bp early next year. The model predicts a tiny Conservative lead by election time, consistent with Labour obtaining most seats in a hung parliament.
The second scenario is intended to be a “best case” for the Tories. Earnings growth rises to 4% while unemployment drops to 5.5-5.75%, but lower-than-expected inflation results in the MPC keeping Bank rate on hold. The Conservative lead reaches 6 pp by May 2015 – just sufficient to deliver a seat majority.
The MPC’s guidance, however, implies that it would raise Bank rate earlier in this scenario because of a faster erosion of slack. The third scenario uses the same economic assumptions but incorporates 0.25 pp rate hikes in November, February and May (just after election day). These hikes cap the Tory lead at 3-4 pp, suggesting similar numbers of seats for the two parties. Such an outcome might force a repeat election later next year or in 2016.
Non-economic influences could be of greater importance in the coming election, with additional uncertainty injected by the Scottish and promised EU referenda. A stronger economy should continue to aid the Conservatives but is unlikely to be sufficient to deliver victory.
*Each 1 pp rise in earnings growth boosts the Conservative / Labour differential by 4 pp, according to the model. See the previous post for a discussion of the relationship between voting intentions and seat allocations.
Investors are positively inclined towards the dollar. A net 58% of global fund managers believe that the US currency is undervalued, the second highest reading in more than 10 years, according to Merrill Lynch. US futures market investors, excluding “commercials”, are moderately long the dollar against other developed market currencies, based on the weekly commitment of traders report*.
Dollar bulls expect the currency to be boosted by a continued rise in US / foreign interest rate differentials as the US economy grows strongly over the remainder of 2014. Monetary trends support optimism about US economic prospects: six-month real narrow money expansion rose to a 17-month high in May and is stronger than in most other developed economies.
The bullish argument, however, ignores recent deterioration in the capital account of the balance of payments. The current account deficit has been stable but the balance of direct and portfolio investment flows has moved from a significant surplus in 2012 to a small deficit in the latest 12 months – see chart. The “basic balance”** deficit, therefore, has risen to its highest since 2009.
The capital account has been weakened by a rise in portfolio investment outflows, partly reflecting the ebbing of the Eurozone crisis and optimism about “Abenomics” in Japan. Higher US portfolio investment overseas could be sustained as the global economy improves. The direct investment deficit, meanwhile, could widen as US corporations step up foreign take-over activity, partly for tax reasons.
A basic balance deficit requires an offsetting surplus on the short-term capital account. US economic strength and a rise in US / foreign interest rate differentials may attract a larger inflow of short-term capital but there is no guarantee that this will be sufficient to outweigh the wider basic balance deficit, resulting in upward pressure on the dollar. Bulls may continue to be disappointed.
*The net long position against six other developed market currencies was equivalent to 15% of open interest as of last Tuesday.
**Basic balance = current account plus long-term capital flows (conventionally defined as direct / portfolio flows).