Global monetary conditions remain supportive for markets but a further rally in equities could be delayed by rising issuance. Gains also depend importantly on central banks continuing to support money supply growth until private credit expansion revives.
Monetary conditions tightened last year because moderate growth in the G7 broad money supply was insufficient to accommodate higher inflation and a rise in the precautionary demand for money due to the financial crisis. This tightening was evidenced by a contraction in real narrow money M1 – a better measure of cash held for transactions purposes and often more closely related to economic activity and flows into markets.
Conditions began to improve in late 2008 as Federal Reserve asset purchases boosted US broad money, a sharp drop in commodity prices pulled inflation lower and falling economic activity reduced money demand. The emergence of "excess" liquidity was reflected in a strong acceleration in G7 M1 and laid the foundations for both the spring rally in equities and the current incipient economic recovery.
Broad money has slowed again since early 2009, with the impact of "quantitative easing" offset by weak private credit trends. Improving market and economic conditions, however, are likely to have reduced the precautionary demand for money (i.e. the fall in velocity during 2008 may now be reversing). Consistent with liquidity remaining favourable for markets and economies, M1 is continuing to expand faster than broad money.
This positive assessment is subject to two qualifications. First, cash inflows to equity markets could be absorbed by issuance rather than reflected in higher prices. A proxy for the global volume of shares outstanding rose by 1.1% during the second quarter – the biggest gain since the second quarter of 2002. This was influenced by post-stress-test capital-raising by US banks but non-financial companies and banks elsewhere are likely to step up issuance if market conditions allow.
Secondly, monetary conditions could deteriorate if central banks step back from QE efforts before private credit expansion recovers. The Fed's asset purchase plans imply a further significant boost during the second half of 2009 but prospects for the equivalent UK scheme are uncertain, while the ECB's alternative approach of supplying liquidity to banks has yet to yield results. With inflation risks viewed as minimal, however, policy-makers are likely to be open to further "unconventional" actions should credit weakness persist.
