Equity markets weakened during the third quarter amid investor concerns about the impact of expected Federal Reserve policy tightening and slower growth in China and other emerging economies. Our monetary analysis suggests that the Chinese economy will regain momentum in late 2015 / early 2016, while US growth will remain moderate, allowing the Fed to proceed cautiously with rate rises. Such a scenario would probably be favourable for markets.
The equity swoon was not, in our view, due to any negative shift in current liquidity conditions. Global real (i.e. inflation-adjusted) money growth is solid by historical standards and well above economic output expansion, implying “excess” liquidity – see first chart*. Central bank policies, meanwhile, remain expansionary, with QE programmes proceeding in Japan and the Eurozone, and China and India cutting official rates and reserve requirements last quarter.
Rather than tighter liquidity, we attribute market weakness to a rise in investor risk aversion due to Fed / EM concerns and a series of negative “shocks”, including another Greek “crisis” in July, a change in China’s exchange rate policy in August and the Volkswagen emissions cheating scandal in September. Investors are now overly pessimistic about economic and earnings prospects, in our view.
China is key to the outlook. Industrial output growth slowed sharply in early 2015 and remained below-par over the summer. This weakness had been signalled by a contraction of our preferred real money measure in late 2014 – second chart**. This measure, however, has rebounded since early 2015, indicating that People’s Bank of China (PBOC) policy easing has more than offset a liquidity drain from foreign exchange intervention to support the renminbi. Fiscal policy is also turning expansionary, having been unintentionally harsh in early 2015. Economic news, therefore, should improve in late 2015 / early 2016.
Pessimists counter that the slump in Chinese stock prices will depress consumption, while exports will remain weak unless the exchange rate is allowed to fall significantly. Stocks, however, are not widely owned and consumer confidence has risen over the summer, partly reflecting a reviving housing market. Chinese exports, meanwhile, are outperforming, arguing against claims that the currency is overvalued: a 5.5% fall in US dollar terms in the year to August compares with a double-digit decline in global trade. The change to the fixing mechanism in August appears to have been made in order to satisfy conditions for the renminbi to be added to the basket of currencies forming the IMF’s special drawing right (SDR), rather than to open the door to a large depreciation.
Consensus pessimism about China contrasts with optimism about US economic prospects and associated worries that the Fed will be forced to tighten monetary policy significantly. US real money growth, however, has fallen sharply since early 2015 and is now below the pace in other G7 countries, suggesting that economic expansion will slow in late 2015 / early 2016 – third chart. The Fed is still likely to raise interest rates in response to a gradually tightening labour market but the risk of a series of closely-spaced increases has receded.
Opposite US / Chinese money trends have contributed to a convergence of real money growth between the G7 and an “E7” grouping of seven large emerging economies – fourth chart. Historical evidence suggests that the sign of the E7 / G7 real money growth gap is relevant for assessing whether EM equities will outperform developed markets: for example, EM stocks outperformed when the gap was last significantly positive in 2010-11 but have lagged since it turned negative in 2011. An increase in EM exposure may be warranted if the current small positive gap is sustained or widens further.
Within developed markets, real money growth is strong in Sweden, Australia and the Eurozone and weak in Switzerland as well as the US, with Canada, the UK and Japan mid-range – fifth chart. Economic and equity market prospects may be better in the former group. Within the Eurozone, real money growth is notably robust in France and is slightly higher in the “core” than the “periphery”***.
In emerging markets, real money growth is strong in Korea and Mexico, and solid in China, Taiwan and India; the pace of contraction has slowed sharply in Russia but remains alarming in Brazil, probably reflecting very high real interest rates – sixth chart. Favourable monetary trends in most EM economies support the view that consensus pessimism is overblown.
*”Global” = G7 developed countries and seven large emerging economies (“E7”). Narrow money = currency in circulation plus demand deposits and close substitutes. Broad money = narrow money plus time deposits, notice accounts, repos and bank securities. Precise definitions vary by country. Narrow money has been more reliable than broad money for forecasting purposes historically and is consequently emphasised in the analysis here.
**True M1 = currency in circulation plus demand deposits of corporations, government organisations and households.
***”Core” = Germany, France, Netherlands, Belgium, Austria, Luxembourg; “periphery” = Italy, Spain, Ireland, Portugal, Greece.
A remarkable feature of the past decade has been the stability of global “core” inflation. Headline inflation has fluctuated significantly as a result of commodity price swings but the annual increase in G7 consumer prices excluding food and energy has been confined within a narrow range of 0.7% to 2.0%, averaging 1.5% – see chart. The latest reading, for August, was 1.5%.
Supporters of current central bank orthodoxy might cite this stability as evidence of the success of inflation-targeting. The aim of policy, however, has been to maintain steady, low inflation by ensuring smooth economic growth in line with potential, avoiding booms and busts. The reality, of course, has been far removed from this ideal. Inflation has been stable despite central bankers’ failure to limit economic and financial volatility.
The observed stability contradicts the dominant “Phillips curve” understanding of the inflation process, to which central bankers continue to appeal to justify their policy decisions. This asserts that inflation trends higher when the “output gap” – the deviation of GDP from its potential level – is positive, and lower when it is negative. While there are huge measurement uncertainties, few would dispute that the output gap was significantly positive at the peak of the credit bubble in 2007 and heavily negative at the bottom of the “great recession” in 2009. Yet G7 core inflation was stable in 2007-08 and fell only modestly in 2009-10, recovering in 2011 when the gap was still, presumably, negative.
An alternative monetarist view is that inflation follows swings in money growth with a long lag. This is true of large and sustained changes in money growth, such as occurred in the 1960s / 1970s (up) and 1980s / 1990s (down). G7 money growth, however, has shown no clear trend since the 1990s and there has been limited pass-through of short-term fluctuations to core inflation.
The stability of core inflation, and trend money growth, suggests little risk of “deflation”. With inflation “anchored”, central banks should give greater weight to financial stability and medium-term growth objectives in setting policy. This argues for raising interest rates to encourage saving and deter financial speculation and capital misallocation.
Investors are concerned about weakness in the global economy and China in particular. Monetary trends are giving a reassuring message, suggesting that economic growth will revive into early 2016 before slowing again later next year.
The monetary measure used for forecasting here is the six-month change in global real narrow money, with “global” defined as the G7 plus seven large emerging economies (the “E7”)*. Statistical testing shows that this leads the six-month change in industrial output by nine months on average. Turning points in industrial output growth, meanwhile, usually coincide with those in GDP growth.
The six-month change in real narrow money turned negative before the six global recessions since the 1960s.
Real narrow money growth has moderated from a peak in February but rose slightly in August and remains solid by historical standards – see first chart. Its strength in early 2015 suggests that global activity news will improve near term but the uplift in growth may prove temporary, based on the more recent monetary slowdown.
Real broad money is giving a similar message to narrow money, though has an inferior historical record as a forecasting indicator of the economy.
The six-month change in industrial output appears to have remained negative in August, based on available data, but may have bottomed in June – first chart. If the monetary forecast is correct, it should soon return to positive territory.
Real narrow money is very far from contracting, suggesting a low risk of a recession. However, the low level of interest rates may be boosting the “trend” growth rate of narrow money, implying that a significant slowdown would be a sufficient signal for a recession. To attempt to gauge this possibility, a forecasting indicator was constructed allowing for divergent trends of real narrow money and industrial output growth, and also applying the average nine-month lead. A second indicator was calculated additionally incorporating the slope of the G7 yield curve, which – like real narrow money – has a good record of signalling recessions. These adjusted real money growth indicators are giving a reassuring message – second chart.
The relative stability of global real narrow money growth conceals some significant changes at the country level. As discussed in a previous post, real narrow money has slowed sharply in the US over the last six months while rebounding strongly in China. These and other changes have resulted in E7 growth moving above the G7 level for the first time since June 2013 – third chart.
Is this a positive signal for emerging market equities? As noted in another recent post, a “simplistic strategy that would have worked well would have been to invest in emerging markets when E7 six-month real money growth was above 4% and had not fallen by more than 2 percentage points over the prior six months but revert to developed markets if either of these conditions was no longer met”. August E7 growth was an estimated 3.0%**.
*The G7 only was used in analysis before 2005. Narrow money = currency in circulation plus demand deposits and close substitutes; precise definition varies by country. Real = deflated by consumer prices, seasonally adjusted. “E7” defined here as BRIC plus Korea, Mexico and Taiwan.
**August data available for all countries except Korea.
Broad liquidity holdings of UK households and non-financial firms are growing at the fastest pace since the 2008-09 recession, supporting optimism about economic prospects and strengthening the case for an early interest rate rise.
The Bank of England’s preferred broad money aggregate, M4 excluding money holdings of “intermediate other financial corporations” (M4ex), rose by an annual 3.9% in August, in line with the average since the start of 2014 – see first chart. Its growth, however, has been depressed by two factors unlikely to be of economic significance. First, money holdings of financial corporations have fallen by 4.3% over the past year, cutting M4ex growth by an arithmetical 0.6 percentage points. This reflects a decline in bank deposits held by fund managers* and securities dealers, and has little implication for spending in the economy.**
This suggests focusing on M4 holdings of households and non-financial firms, or “non-financial M4”, rather than M4ex. Annual growth of non-financial M4 was 5.3% in August, the fastest since July 2013 – first chart.
Secondly, the annual rise in household M4 has been lowered by large-scale switching into National Savings products. The 12-month inflow to NS was a record £21.8 billion in August, mainly reflecting heavy buying of high-interest pensioner bonds on offer from January until one week after the May general election. Such bonds, and other NS products, would be included in M4 if issued by a bank rather than the government. This argues for adding together non-financial M4 and outstanding NS when judging the broad liquidity position of households and non-financial firms. This expanded measure grew by an annual 6.3% in August, the fastest since June 2008 and well above an average of 3.7% over 2010-14 – first chart.
The positive message from broad liquidity is reinforced by still-solid narrow money trends. Non-financial M1, comprising notes / coin and sight deposits of households and non-financial firms, grew by an annual 7.6% in August – second chart.
Bank credit expansion is lagging money growth – the usual cyclical pattern – but is firming, with forward-looking indicators positive. M4 lending to households and non-financial firms rose by an annual 1.9% in August, the fastest since May 2009 – second chart. Mortgage approvals totalled £19.6 billion in August, the highest since April 2008. Excluding remortgages, approvals were £12.9 billion, almost matching a peak of £13.0 billion in January 2014 associated with a rush to beat new tougher mortgage rules. Meanwhile, sterling unused credit facilities – another leading indicator – grew by an annual 4.1% in August, with a notable pick-up in recent months***.
*Insurance companies / pension funds, investment / unit trusts and other fund managers.
**The fall may also be of limited significance for asset prices, since it may have been offset by a rise in financial institutions’ holdings of other liquid assets: the outstanding stock of DMO repos and Treasury bills increased substantially in the year to August.
***16.1% annualised rise over latest three months.
A pick-up in Eurozone narrow money (M1) growth from spring 2014 signalled that economic expansion would strengthen while deflationary risks were receding. Recently-revised national accounts data confirm this scenario. GDP grew at an annualised rate of 1.7% between the third quarter of 2014 and the second quarter of 2015, up from 0.7% in the prior three quarters. Domestic inflation, as measured by the annual increase in the GDP deflator, bottomed at 0.7% in the second quarter of 2014, rising to 1.2% a year later.
Note that the monetary pick-up was under way well before the ECB began to discuss QE in late 2014. Rather than QE, interest rate cuts in June and September played a key role, with their impact possibly magnified by the ECB supplying long-term liquidity tied to lowered official rates via its TLTRO programme.
Monetary trends continue to give a positive message for economic prospects, although August changes were softer than in recent months. M1 rose by 0.3% on the month while the broader M3 measure was unchanged. Both aggregates, however, had increased sharply in July and six-month growth rates remain solid, at 5.3% and 2.2% respectively, or 10.9% / 4.4% annualised – see first chart.
Previous posts on UK and Japanese experience argued that QE had little impact on monetary growth, because it triggered offsetting changes in private sector behaviour – in particular, sales (or reduced buying) of government securities by banks and an increase in net non-bank capital outflows (i.e. some liquidity flowed overseas). The evidence to date suggests that the current ECB programme is proving similarly ineffectual: six-month M3 growth of 2.2% in August compares with 2.6% in February, just before QE started. The M3 counterparts analysis confirms a drag from capital outflows: the impact of changes in banks’ net external asset position on six-month M3 growth has moved from +0.1 percentage points (pp) in February to -0.6 pp in August – second chart. In addition, banks sold €51 billion of government securities in the six months to August versus purchases of €41 billion in the prior six months.
Respectable economic growth, reviving inflation and still-positive monetary trends argue against further policy easing. If it were required, there is little reason to believe that additional QE would be effective.