A "monetarist" perspective on current equity markets

Posted on Tuesday, April 10, 2018 at 12:07PM by Registered CommenterSimon Ward | Comments2 Comments

Our last quarterly commentary noted that global narrow money trends had weakened significantly during the second half of 2017, suggesting that the economy would lose momentum in 2018 while the liquidity backdrop for markets was no longer favourable. Money trends softened further in early 2018, adding to our concerns. It is possible that US and Chinese money data will rebound over coming months, reflecting, respectively, the lagged impact of tax cuts and policy easing. A defensive investment stance, however, is recommended until such a recovery is confirmed.

Our key forecasting indicator is the six-month growth rate of real (i.e. inflation-adjusted) narrow money* in the G7 advanced economies and seven large emerging economies (the “E7”). Real money growth has led turning points in economic growth by nine months on average historically. The indicator peaked most recently in June 2017, falling significantly later in the year. This suggested that global economic momentum would slow from a peak to be reached around March 2018 – see first chart.

Recent economic news appears consistent with global growth passing a peak. The Markit Economics / J P Morgan global composite purchasing managers’ index, for example, is widely followed as a coincident indicator of economic activity and fell sharply from a 41-month high in February to a 16-month low in March.

Monetary trends, meanwhile, have weakened further in early 2018, with G7 plus E7 six-month real narrow money growth falling to a nine-year low in February. Real broad money has also continued to decelerate. The emerging economic slowdown, therefore, could extend into late 2018, allowing for the usual lead.

Weak money trends also imply less liquidity support for equity prices. Significantly, G7 plus E7 six-month real narrow money growth crossed below industrial output growth in December 2017, with the shortfall increasing in January / February. Global equities have underperformed US dollar cash by 7.2% per annum on average historically (i.e. over 1970-2017) when real money growth has been lower than output growth. The February / March set-back in markets is consistent with this experience.

Why could this prognosis be too gloomy? Economic optimists expect US tax cuts and higher federal spending to boost US / global growth later in 2018 and in 2019. Our view is that a significant positive impact should be signalled in advance by monetary reacceleration. We examined money trends around three previous large tax cuts and found a pattern of money growth rebounding two to four months after legislation was enacted. Recent behaviour has been consistent with the historical pattern, which suggests a rise in money growth in the second and third quarters – second chart. Such a recovery would imply better economic prospects for late 2018 / early 2019.

Another upside risk is an early easing of Chinese monetary policy. A clampdown on speculative credit and shadow banking activity since late 2016 has been reflected in much weaker money trends, an economic slowdown and falls in house and producer price inflation. The authorities, on our assessment, are likely to need to relax restrictions to prevent GDP growth undershooting the 6.5% target. A recent decline in interbank interest rates may be an early sign of policy shift.

A rebound in US / Chinese money trends over the next three to six months would not alter the forecast here of a loss of global economic momentum through late 2018 but would suggest a reacceleration into 2019. A monetary rebound, coupled with near-term economic weakness, could conceivably result in global real money growth moving back above output growth later in 2018, reversing the current negative signal for equity markets.

Downside risks, however, are also present. Federal Reserve balance sheet contraction could offset any boost to monetary trends from tax cuts. Major central banks appear overly optimistic about economic prospects and may be slow to offer policy support as momentum cools. A late-cycle pick-up in labour cost inflation remains possible. Rising trade tensions, meanwhile, threaten to undermine business confidence and investment plans.

The recent global monetary slowdown has been remarkably synchronised across economies. Real narrow money trends remain particularly weak in Australia and Canada, with the UK joining the rear carriage following the November 2017 interest rate hike – third chart. These three equity markets underperformed in the first quarter. The UK Monetary Policy Committee is worried about rising labour cost pressures but monetary weakness argues for delaying a further rise in rates.

At the opposite end of the range, real narrow money growth remains respectable by historical standards in Japan and Euroland but has nonetheless fallen significantly since mid-2017. In contrast to the US and China, moreover, there are no strong grounds for expecting a monetary rebound. The recent success in Italian elections of parties advocating fiscal loosening is likely to strengthen the ECB’s resolve to wind down QE by end-2018.

Country-level monetary trends, therefore, are not currently giving strong signals for regional / country selection. The main strategy suggestion from our analysis is to reduce exposure to cyclical equity market sectors in favour of defensive sectors. This follows from the forecast of a near-term global economic slowdown and is also directly implied by the low level of global real narrow money growth – fourth chart.

Emerging equity markets often underperform developed markets during global economic downswings but the sign of the gap between E7 and G7 real narrow money growth is also relevant for assessing relative return prospects, according to our analysis of historical data. While both E7 and G7 trends have weakened, the gap is currently positive, suggesting maintaining exposure to emerging markets despite a less favourable cyclical economic backdrop – fifth chart.

*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. Real = inflation-adjusted.

Is China starting to ease?

Posted on Wednesday, April 4, 2018 at 12:43PM by Registered CommenterSimon Ward | CommentsPost a Comment

Previous posts (e.g. here) suggested that weaker economic growth and a cooling of inflationary pressures would prompt the Chinese authorities to take steps to ease monetary conditions in mid-2018. A recent fall in interbank rates could be an early indication that a policy shift is under way.

Significant policy tightening since late 2016 has been achieved mainly via regulatory / macroprudential measures, rather that Western-style changes in central bank money market intervention rates. The PBoC seven-day reverse repo rate, which sets the floor for short-term market rates, rose by only 25 basis points (bp) between end-September 2016 and end-December 2017. The regulatory clampdown, however, restricted access to and boosted the cost of term market funding. Three-month SHIBOR climbed 210 bp over the same period. Restrictive policy, that is, has operated to a significant extent through the wider three-month SHIBOR / seven-day reverse repo rate spread.

A recent fall in the spread, therefore, may be meaningful. The PBoC raised the seven-day reverse repo rate by a further 5 bp on 22 March following the latest FOMC quarter-point hike, contributing to a consensus view that policy remains on a tightening tack. Three-month SHIBOR, however, has, fallen by 30 bp since 21 March, reducing the spread to the lowest since July – see first chart.

Recent economic news, admittedly, has been mixed and not obviously a trigger for a policy shift towards easing. The authorities, however, may be concerned about a continued slowdown in credit and monetary aggregates: three-month annualised growth of total social financing, seasonally adjusted by Datastream, fell to a new low of 7.1% in February – second chart. Producer price pressures, meanwhile, have cooled, with input price balances in the March NBS and Markit manufacturing  PMI surveys at nine-month lows. Rising trade tensions with the US may also be shifting policy-makers’ bias towards precautionary easing.

Policy easing, if confirmed, would be expected, as usual, to be reflected swiftly in a revival in money trends, in turn suggesting improving economic prospects for late 2018 / early 2019. If accompanied by a stabilisation or recovery in US money trends, which – as previously discussed – would be consistent with experience after previous large tax cuts, this would temper concern here that an expected global economic slowdown over the remainder of 2018 will extend and deepen in 2019.

UK monetary alarm bells ringing louder

Posted on Thursday, March 29, 2018 at 02:12PM by Registered CommenterSimon Ward | CommentsPost a Comment

UK monetary trends continued to weaken in February, suggesting deteriorating economic prospects and arguing for the MPC to hold off on plans to raise interest rates.

The preferred narrow and broad money aggregates here are non-financial M1 and M4, comprising money holdings of households and private non-financial corporations (PNFCs). Annual growth rates of the two measures fell further to 5.0% and 3.5% respectively in February, the lowest since 2012 and down from peaks of 10.1% and 6.8% in September 2016 – see first chart. The monetary slowdown has been reflected in a decline in annual growth of nominal GDP, to 3.1% in the fourth quarter of 2017. Such a rate of increase, if sustained, would suggest an undershoot of the 2% inflation target over the medium term, assuming trend real economic expansion of around 1.5%.

Discussion of UK monetary trends normally focuses on the Bank of England’s M4ex measure, which includes broad money holdings of non-intermediate other financial corporations (OFCs) as well as those of households and PNFCs. Annual growth of M4ex fell to 4.5% in February but is in line with its average over 2013-17, giving a more favourable impression of economic prospects than the non-financial measures. M4ex, however, continues to be inflated by rapid expansion of non-intermediate OFC money holdings, which rose by 10.2% in the latest 12 months and are up by a quarter since February 2016. Such holdings appear to contain little information about near-term spending prospects but have been correlated recently with current (not future) share price movements: market weakness, therefore, suggests a fall in their growth rate – second chart.

Returning to the non-financial money measures, shorter-term trends have weakened significantly further since the November interest rate increase, signalling a likely further fall in annual growth rates. Non-financial M1 rose at an annualised rate of 1.6% in the three months to February, with non-financial M4 growing by 1.1% – third chart.

The fourth chart shows the six-month rate of change of real (i.e. deflated by consumer prices) non-financial M1 and household / PNFC components. Aggregate growth fell to just 0.1% in February, with household real M1 in contraction and the PNFC component continuing to slow, consistent with deteriorating prospects for both consumer spending and business investment. These trends, coupled with global monetary weakness discussed in previous posts, suggest that Bank of England and Office for Budget Responsibility forecasts of GDP growth during 2018 (i.e. in the year to the fourth quarter) of 1.8% and 1.4% respectively will be undershot, possibly significantly.

Euroland economic prospects still deteriorating

Posted on Tuesday, March 27, 2018 at 12:47PM by Registered CommenterSimon Ward | CommentsPost a Comment

Euroland monetary trends and the OECD’s composite leading indicator continue to soften, suggesting that a recent economic slowdown will extend through late 2018, at least.

Annual growth rates of the headline M1 and M3 money measures fell to 8.4% and 4.2% respectively in February, extending a decline from peaks in September 2017 of 9.8% and 5.2% respectively. The preferred narrow and broad aggregates here are non-financial M1 and M3*, reflecting their superior historical forecasting performance. These measures have slowed more significantly, with annual growth down to 7.8% for non-financial M1 and 3.9% for non-financial M3 in February, the lowest since 2014-15 – see first chart.

Shorter-term trends suggest that annual growth rates will subside further. Non-financial M1 rose at an annualised rate of 6.3% in the three months to February, with non-financial M3 growing by only 2.4% – second chart.

The third chart shows six-month growth of real (i.e. deflated by consumer prices) non-financial M1 and household / corporate components. Aggregate growth is back around its level in late 2012 through early 2014, following which GDP grew at an annualised rate of 1.0-1.5% – well below current consensus and ECB forecasts. Corporate holdings have slowed particularly sharply in recent months and exhibited a stronger correlation with future GDP than household holdings historically, according to ECB research.

The ECB publishes a country breakdown of overnight deposits, which account for more than 80% of M1. Six-month growth of real deposits has fallen steeply in France and Spain since August-September 2017, converging with sluggish German expansion – fourth chart. Recent weaker French business surveys are consistent with the monetary slowdown and suggest that President Macron’s economic honeymoon period has ended. Italian real deposit growth, surprisingly, held up through February but increased policy risk following this month’s election could lower confidence / spending intentions and encourage capital flight, thereby weakening monetary trends.

The OECD’s Euroland composite leading index, which typically lags monetary trends by several months (and excludes money measures), confirms softer economic prospects. The normalised version of the index is estimated to have declined again in February, with a further reduction projected for March – fifth chart**. The normalised index is designed to predict GDP relative to trend, so the shift from rising to falling suggests that recent strong growth will give way to below-trend expansion.

*Non-financial = covering holdings of households and non-financial corporations (NFCs), i.e. excluding financial sector money.
**The OECD is scheduled to release a February reading on 10 April but most of the component information is available, allowing an independent calculation.

Is the UK MPC about to make another policy mistake?

Posted on Wednesday, March 21, 2018 at 12:58PM by Registered CommenterSimon Ward | CommentsPost a Comment

Today’s UK labour market release is likely to cement MPC plans to hike rates again in May. Monetary trends suggest that the Committee should hold off.

Annual growth of average weekly earnings, smoothed by a three-month moving average, rose to 2.8% in January from an upwardly-revised 2.7% in December. Growth of regular earnings – excluding bonuses – was lower at 2.6%, though moved up to 2.8% on a single-month basis in January. Pay trends appear slightly stronger than the MPC expected at the time of the February Inflation Report, which suggested that regular earnings growth would average around 2.75% during the first half of 2018.

MPC hawks will also take note of a rebound in aggregate hours worked in the three months to January after a surprise drop in the prior three months, suggesting that a pick-up in growth of productivity (i.e. output per hour) in the second half of 2017 was temporary. The unemployment rate, meanwhile, returned to its recent low of 4.3% in the three months to January.

Why, then, should the MPC delay hiking again? Current labour market conditions are a lagged reflection of above-trend economic growth in 2016-17, which was signalled by strong monetary trends through late 2016. A subsequent significant monetary slowdown argues that economic prospects have deteriorated, implying that labour market strength will ebb and medium-term inflation risks are receding.

Annual growth rates of non-financial narrow (M1) and broad (M4) money fell to 5.3% and 3.7% respectively in January, the lowest since 2012 – see first chart. Trends appear to have weakened further since the November rate hike, with monthly growth of the two aggregates averaging only 0.1% in December / January.

The case for the MPC holding off, it should be emphasised, is unconnected to yesterday’s news that consumer price inflation dropped to 2.7% in February from 3.0% in January. Inflation is expected here to remain around its February level through late 2018. The overshoot, however, is a consequence of past policy laxity relative to monetary and economic conditions – belated remedial action risks compounding the error.

As previously discussed, weaker monetary trends have already been reflected in a slowdown in nominal GDP, annual growth of which subsided to 3.2% in the fourth quarter, compared with a peak of 5.2% in the fourth quarter of 2016. Today’s public finances release suggests that this slowdown is feeding through to government receipts, casting doubt on Chancellor Hammond’s optimism about fiscal headroom in last week’s Spring Statement – second chart.

Softer receipts hint that labour market strength may be peaking, as does a fall in outstanding vacancies in the three months to February – the first decline since June 2017.

Today’s CBI industrial trends survey for March, meanwhile, was weak, with the output expectations balance down further and the balance reporting more-than-adequate finished goods stock levels surging – third chart.