Monetary trends suggest that the global economy will grow at a respectable pace during the first half of 2011. The liquidity backdrop for markets remains unfavourable currently but may improve early next year.
The forecasting approach here places weight on the Friedmanite rule that movements in the real (i.e. inflation-adjusted) money supply lead the economy by about six months. Consistent with this rule, a slowdown in G7 industrial output growth from an annual 10% in May to about 5% currently was presaged by a fall in real narrow money expansion from 14% in August 2009 to 4% by early this year – see first chart.
Real money growth, however, has stabilised at 4% since early 2010 – above its long-term average and historically consistent with solid output expansion. As the chart shows, the five global recessions over the last 50 years were preceded by a contraction in real narrow money.
The liquidity backdrop for markets depends less on the level of real money growth than whether it is higher or lower than output expansion – a positive differential may imply that there is "excess" money available to drive up asset prices. Empirical evidence supports this approach: on average, world equities have outperformed cash by a substantial margin when the gap has been positive while underperforming at other times – see earlier post.
Real money growth fell beneath output expansion in early 2010 and remains lower currently, warranting a cautious stance on equities, which have trod water since the spring. The annual output rise, however, should slow further over coming months, partly reflecting base effects, suggesting that the gap will turn positive by early 2011 if real money expansion is stable – second chart. Near-term weakness in equity markets, therefore, could present a buying opportunity.
