Despite the credit crisis, global monetary conditions have remained expansionary in recent months – G7 real broad money is currently rising at a 7% annual rate versus only 1% for industrial output. True, money supply numbers have been inflated by a rerouting of financial flows through the banking system but the money / output growth gap would still be positive even without this effect – see chart.

“Excess” liquidity is typically channelled narrowly into a fashionable investment theme – the late 1990s TMT bubble was a classic example – and commodities are currently the speculation of choice. The Goldman Sachs energy index soared 37% last quarter while non-oil prices climbed 7%. The Fed’s aggressive policy easing since last autumn has provided more fodder for the bulls: commodities are being bought as a hedge against a weaker dollar, while US rate cuts have fed through to looser monetary conditions in many emerging economies, sustaining strong growth and rising demand for raw materials.

In the early spring it looked as if equity markets would benefit from an influx of liquidity as risk aversion moderated from the extreme levels reached at the height of the credit crisis. However, a solid rally in April and early May aborted as commodity prices scaled new heights, fuelling renewed worries about economic prospects.

Commodity price appreciation coexisted with rising equity markets over 2003-2007 because costs were climbing gradually from historically low levels. However, the rate of ascent has accelerated sharply since the Fed began to cut rates and prices are now reaching levels that threaten to render a significant portion of the capital stock uneconomic. Meanwhile, large rises in headline inflation rates have prompted a tightening of global monetary policies, further increasing downside risks to growth and earnings. Pressures are strongest in emerging economies: official rates are rising in 22 of 46 investable countries monitored by New Star.

A fall in commodity prices – particularly energy – is therefore a prerequisite for a sustainable rally in equities, both to free up available liquidity and to stabilise the economic outlook. The key issue is whether prices are now at levels likely to result in an excess of supply over demand over the medium term. In the case of oil, they probably are – significant demand destruction is now occurring in developed economies (e.g., US petroleum consumption fell an annual 4% in the first quarter), while a recent lifting of subsidised prices should lead to greater conservation efforts in emerging countries. However, the timing of any reversal is uncertain.

The central case scenario of a recovery in equity markets during the second half as recent commodity price gains partially reverse depends on global liquidity conditions remaining benign. While G7 annual real money growth currently remains strong, nominal money trends have slowed in recent months and a further rise in headline inflation will squeeze the real measure. With industrial activity languishing, however, the money / output growth gap should remain positive, though smaller than in early 2008.