Recent Japanese economic news has mostly disappointed. Real consumer spending recovered by only 1.3% in May after an 8.1% drop in April. Core machinery orders plunged 17.4%, to a 15-month low. Export volumes were down 2.2%, still failing to benefit from a lower yen.
Monetary trends have been suggesting economic weakness. Six-month nominal growth of narrow and broad money has fallen sharply since end-2013, with the decline extending last month – see chart. The aggregates have contracted in real terms, reflecting the inflation impact of April's sales tax hike.
Annual growth in broad money M3, 2.4% in June, is back to the level prevailing before incoming Bank of Japan (BoJ) Governor Kuroda launched his mega-QE experiment in April 2013. On a monetarist interpretation, therefore, the experiment has flopped. As previously explained, the BoJ has, in effect, engaged in a JGBs / reserves swap with the banks, with no impact on the size of their balance sheets or the wider economy.
Current monetary trends suggest that economic news will continue to challenge optimists, although exports should benefit near term from stronger global activity. Stock market bulls, meanwhile, are pinning their hopes on the Government Pension Investment Fund (GPIF) raising its allocation to domestic equities, selling bonds to the BoJ to fund the switch. This would amount to QE shifting from JGBs to equities by the back door.
The GPIF, however, could delay the execution of any such policy change. Why should it assume the role of “greater fool” by buying equities at prices inflated by front-running by foreign hedge funds and other speculators? Its managers, whose heavy bond weighting has paid off, can afford to be patient, spreading purchases over years and timing them to take advantage of market weakness.
Global leading indicators followed here continue to signal a summer economic rebound but suggest that growth will level off or moderate later in 2014.
The indicators are designed to give advance warning of turning points in global industrial output momentum. Short- and longer-term measures are calculated, with average lead times of 2-3 and 4-5 months respectively in recent cycles.
The short-term leading indicator rose again in May while the longer-term measure fell marginally for a second month, following a sharp gain between December and March. The message is that six-month global industrial output growth will rebound from an expected May low but may level off or retreat slightly at the end of the current quarter – see first chart. Note that prior falls in the indicators correctly signalled recent output weakness.
The recent small decline in the longer leading indicator fits with a minor slowdown in six-month global real narrow money expansion since February – second chart. Real money trends typically lead output by about six months.
The level of global real money growth remains consistent with solid economic expansion. The current global reading, however, is reliant on US strength, with real money growth slowing in the rest of the G7 and moderate / trendless across the E7 large emerging economies – third chart. Near-term global economic prospects are positive but faster growth may not be sustained unless non-US monetary trends improve.
*Global = G7 developed and E7 emerging economies.
The MSCI frontier markets index has risen by 17.4% in US dollar terms year-to-date*, far outpacing gains of 6.2% and 6.0% respectively for MSCI’s developed and emerging markets indices. Is this a reflection of the fundamental attraction of these markets or more evidence that QE is driving excessive risk-taking?
The answer, probably, is neither. The strong performance of the frontier markets index this year has been due to outsized rises in the United Arab Emirates (UAE) and Qatar as fund managers bought the two markets ahead of their promotion to the MSCI emerging markets index at end-May. Stripping out the UAE and Qatar, frontier markets have risen by 6.0% year-to-date, matching gains in developed / emerging equities.
Anyone riding the UAE / Qatar buying wave needed to jump off before the transfer took place. The two markets have slumped by 17.6% and 14.9% respectively since end-May.
The MSCI frontier markets index currently trades on a 1.85 multiple of book value versus 1.53 for the emerging markets index. The 20.6% premium is close to the previous high (before this year) of 24.4% reached in January 2008. Frontier markets were on a significant discount to emerging markets between 2009 and 2012.
Monetary trends in the larger frontier countries do not suggest relative economic or market strength. The six-month change in real narrow money is modest or negative in six of the eight largest MSCI markets** – see chart.
Frontier markets are tiny – the market cap of the MSCI index is 2.7% of its emerging markets counterpart – so prices could be forced still higher if investors increase allocations in response to recent strong performance. The mammoth Norwegian sovereign wealth fund is, reportedly, raising exposure – or, more likely, has already done so.
*As of Friday’s close.
**The top eight markets account for 79% of the index.
The MPC is debating when to raise interest rates. No member, presumably, thinks that policy should be loosened. A backdoor easing, however, is taking place as banks continue to cut lending and deposit rates. An immediate rise in Bank rate is needed simply to offset this additional monetary stimulus.
The chart shows estimates of the average interest rates banks receive / pay on the outstanding stocks of household lending and deposits. The average lending rate has fallen by 0.24% since end-2012 while the deposit rate has been cut by 0.58%*. The lending / deposit rate spread, nevertheless, remains low by historical standards.
These averages are likely to fall further, since the interest rates on new business are below those on the outstanding stocks. New fixed-rate bonds, for example, now yield just 1.34% versus 2.38% on the yet-to-mature stock. Similarly, the interest rate on new fixed-rate mortgages is 3.23% versus 3.67% on outstanding loans**.
Monetary conditions at end-2012 were sufficiently loose to generate strong nominal and real GDP growth. The fall in lending / deposit rates since then represents an unwarranted further relaxation, requiring an MPC response. With the supply of funding expanding***, a half-point Bank rate hike might be needed to return average deposit / lending rates to end-2012 levels.
MPC officials have argued that it was necessary to maintain official rates at an emergency level because of an unusually large wedge between bank interest rates and Bank rate. With this wedge narrowing, a compensating adjustment in Bank rate is overdue.
*As of May. Averages estimated from Bank of England interest rate and volume data for different types of business.
**Bankstats table G1.4.
***Banks expect an increased supply of household deposits in the third quarter, partly due to the introduction of NISAs, according to the latest Bank of England bank liabilities survey.
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.