December monetary data released today suggest that the Japanese economy will disappoint in the spring, while Chinese news will improve at the margin.
Six-month growth of Chinese real M1 and M2 weakened last summer and autumn, signalling a likely industrial slowdown around end-2013 – December output will be released next week. Real money expansion, however, recovered in December, warranting less concern about economic prospects – see first chart. The risk, of course, is that the December improvement proves temporary; January / February data, unfortunately, will be difficult to interpret because of the Chinese New Year.
Japanese real money growth, by contrast, continued to slow in December, with an earlier drag from higher inflation now compounded by lower nominal expansion – second chart. Monetary trends, therefore, look set to reinforce rather than offset the economic impact of fiscal tightening this spring. As previously discussed, QE has had a disappointing monetary impact partly because increased selling of JGBs by banks initially offset higher Bank of Japan purchases, although these sales have slowed recently.
The latest monetary signals question the consensus view that Japanese equities will perform well this year, while China-related plays will continue to languish. According to the December Merrill Lynch survey, the percentage of global fund managers with a positive view of Japanese equities is more than one standard deviation above its long-run average; the popularity of emerging market equities and commodities, by contrast, is about two standard deviations below normal.
Annual consumer price inflation fell unexpectedly to 2.0% in December, ending a four-year overshoot of the Bank of England’s target*. The level of consumer prices, however, is 7.4% higher than if the Bank had achieved 2.0% inflation consistently since the end of 2003, when the current target was established.
The decline from 2.1% in November mainly reflected another significant drop in food inflation – down to 2.1% from a recent high of 5.0% in April. The food drag may be approaching an end: food producers’ price-raising plans rebounded in late 2013 – see first chart.
The focus here is on “core” inflation, i.e. excluding energy and unprocessed food and adjusted for the impact of changes in VAT and undergraduate student tuition fees. This fell to 1.8% in December, matching a low reached in October. Core inflation peaked at 2.9% in March 2012.
It is important to recognise that inflationary trends reflect monetary conditions about two years ago; they are of limited relevance for judging whether the MPC’s current policy stance is appropriate.
The money supply backdrop was very weak in 2011 but strengthened significantly in 2012-13. Annual growth of broad money, as measured by non-financial M4, rose from a 2011 low of 1.5% to a peak of 5.6% in April 2013. The narrow M1 measure improved more dramatically. Faster monetary expansion correctly signalled current economic strength and suggests that core inflationary pressures will revive during 2014.
Inflation expectations, moreover, remain elevated despite the recent headline decline. Current gilt yields imply retail price inflation of 3.3% in five years’ time, above an MPC-era average of 2.9% and inconsistent with the 2.0% CPI target – second chart. A household expectations measure derived from the EU Commission consumer survey is similarly high relative to history and has firmed recently – third chart.
The main risk to the pessimistic inflation view here is a further significant rise in the exchange rate, echoing a 1996-97 surge four years after sterling’s expulsion from the European exchange rate mechanism – fourth chart. The balance of payments position, however, is much weaker now than then: the current account was close to balance in 1997 versus a deficit of 3.8% of GDP in the first three quarters of 2013.
*The last month at or below 2.0% was November 2009 (1.9%).
Six-month growth in global* industrial output rose further to 2.6% in November, or 5.3% annualised – the fastest since October 2011. Monetary trends and global leading indicators continue to suggest that momentum is at or close to a peak.
The first chart shows short- and longer-term leading indicators, constructed by transforming and combining the OECD’s country leading indicators, a November update of which was released today. The longer indicator has led growth turning points by an average of five months in recent cycles and peaked in September, suggesting a February top in output expansion.
The short indicator typically leads by two or three months and moved sideways in November, consistent with output growth reaching a maximum in January or February.
Monetary trends suggest an earlier peak: global real narrow money expansion usually leads by about six months and has trended lower since May 2013 – second chart.
The decline to date in the longer leading indicator has been minor and the expectation here is that economic growth, while moderating, will remain solid in early 2014. A further slowdown in real money expansion, however, would raise concern about prospects for later in the year**.
*G7 developed countries and seven large emerging economies (“E7”).
**An early estimate of December global real money growth will be available later this week and will be reported here.
Commentators continue to speculate that the Eurozone will enter a deflationary scenario in which household and business expectations of falling prices cause spending to be deferred. Such worries are not supported by EU Commission December consumer and business surveys.
The first chart shows annual CPI inflation and an expectations indicator* derived from the consumer survey. The indicator has been stable recently at close to its historical average. The current level is consistent with the ECB’s target of “inflation rates below, but close to, 2%”.
Price-raising plans in business surveys covering industry, construction, services and retailing are similarly normal and little changed from a year ago.
The consumer inflation expectations indicator remains positive even in Italy and Spain – second chart.
Annual CPI inflation slipped back to 0.8% in December, though remains above October’s 0.7%. A previous post argued that weakness reflects disastrously restrictive monetary policy in 2011, when the ECB hiked rates despite money supply stagnation. The policy reversal under President Draghi succeeded in reviving the key M1 measure in 2012-13, with economic activity now responding and inflation likely to follow later in 2014 – assuming no further exchange rate strength. Current monetary trends suggest that deflation risks are receding even in the periphery – see post last week.
*The indicator is the sum of the net percentages of consumers reporting higher prices over the last 12 months and expecting a faster increase over the coming 12 months.
Global growth picked up during 2013, ending the year at a solid pace. This strength should carry over into early 2014 but momentum is likely to wane as the year progresses. The global economy may be entering the late stage of the cycle, characterised by rising capacity constraints, increased inflationary pressure and tightening liquidity.
Monetary trends predicted recent economic improvement. A year ago, global* real (i.e. inflation-adjusted) money supply growth was strong and higher than output expansion. This signalled that economic prospects were brightening and there was “excess” liquidity available to boost financial markets. Global industrial production grew by 5% annualised in the six months to November 2013, up from just 1% a year earlier. Equities, of course, have performed strongly.
Current monetary signals are less favourable. Global real money growth is still respectable but has declined since spring 2013. With economies strengthening, it has fallen beneath output expansion. This suggest that economic momentum is close to a peak, while markets no longer enjoy a liquidity tailwind.
Most forecasters and investors expect current strength to be sustained. The IMF recently signalled increased optimism, raising its 2014 growth projections for the US and Japan. According to Merrill Lynch, three-quarters of global fund managers judge the economy to be in the early or middle part of the cycle, implying that the upswing has several more years to run. This view is questionable on numerous grounds.
First, the cycle already looks mature by historical standards. Global industrial output has risen by 30% since February 2009 and is 12% above its prior peak – see first chart. The upswing has lasted 58 months versus an average duration of 78 months for the previous four trough-to-peak output rises. If the current cycle were to match the average, another recession would begin in 2015.
Secondly, stronger growth is running into supply-side constraints. In the US, the Institute for Supply Management business survey indicates that the economy-wide operating rate is above average – at odds with claims that there is still a large “negative output gap”. Firms globally are finding it difficult to recruit skilled labour: skill shortages are at their most acute since 2007, at the end of the last cycle, according to the world business survey conducted by Germany’s Ifo Institute – second chart.
Thirdly, there are signs that inflationary pressure is reviving in response to capacity tightening. Global inflation was broadly stable in 2013, with falls in strong currency areas – in particular, the Eurozone – offset by rises in Japan and elsewhere. Business price expectations in the Ifo world survey rose notably in late 2013, to their strongest since spring 2011 – third chart. Commodity prices have firmed recently.
Central banks are trying to extend the cycle by promising to defer official interest rate increases until after inflation rises. Liquidity conditions, however, tighten endogenously at the end of a cycle as stronger activity and price gains push up longer-term yields and cause the gap between real money and output expansion to close. This process is under way. Central banks usually lag market-driven liquidity tightening, often magnifying its effect at the wrong time. The current cycle is unlikely to be different.
Rather than loose policy, the best hope of extending the cycle is a surge in business investment that boosts supply capacity and defers higher inflation. Capital spending intentions have firmed but are not signalling a major shift towards expansion. Continued business reluctance to increase capacity, ironically, probably partly reflects additional uncertainty created by central banks’ “monetary activism”.
2013 was a better year for financial markets than main street. The reverse may be true in 2014, as forward-looking markets begin to anticipate more difficult economic conditions in 2015.
*”Global” figures quoted refer to the G7 major countries and seven large emerging economies (the “E7”).
An abridged version of this article appeared in today's City AM.