Solid equity market performance during the first quarter reflected a recovery in global economic growth coupled with a supportive liquidity backdrop. Markets may be choppier into mid-year as economic momentum moderates but the liquidity indicators monitored here remain favourable, suggesting limited downside.

The revival in global growth following significant weakness in mid-2012 was foreshadowed by faster real narrow money supply expansion from last spring – real monetary trends lead the economy by about six months, according to the “monetarist” forecasting rule. Six-month global real narrow money growth, however, peaked in October 2012 and has continued to slow in early 2013 – see first chart. Allowing for the half-year lead, this suggests that economic momentum will start to fade again in mid-2013.

Global real money growth slowed in a similar fashion in early 2011 and early 2012 and equity markets subsequently corrected lower on both occasions. The 2011 decline, however, was more severe, with the MSCI World index falling by 23% in US dollar terms from peak to trough versus 13% in 2012, despite more significant economic weakness in the latter year. The likely explanation is that the liquidity backdrop was unfavourable in 2011 but supportive in 2012 – the gap between global real money growth and industrial output expansion was significantly negative for several months in early 2011 but remained mostly positive in early 2012.

Any coming equity market set-back may resemble the mild 2012 correction. First, global real money expansion remains respectable by historical standards – it is not, in other words, signalling major economic weakness. Secondly, the real money / industrial output growth gap has yet to close as it did in 2011 and 2012. Thirdly, the Federal Reserve and Bank of Japan (BoJ) are committed to further substantial liquidity injections – the market decline of 2011 may also have been influenced by the ending of US QE2 in June of that year.

The latter point is illustrated by the second chart, showing commercial banks’ holdings of cash at the Fed, BoJ and ECB along with projections based on announced US and Japanese QE plans. Combined reserves fell during the first quarter as Eurozone banks repaid borrowings from the ECB but US / Japanese liquidity injections should now dominate, resulting a new record being reached by mid-year.

Some analysts speculate that equities will receive additional “structural” support from a “great rotation” out of bonds but, even if true, this is probably of limited relevance for the near-term outlook. Retail buying of equities has picked up in early 2013 but inflows to bond funds have remained solid – any “rotation”, in other words, has been out of cash. Equity market outperformance reduces pension fund deficits and may, perversely, encourage more buying of bonds as liability matching becomes feasible.

Japan, Switzerland and the US were the best-performing markets in currency-adjusted terms during the first quarter, while the Eurozone periphery was again weak, along with emerging markets. This was similar to the ranking of real money growth at the start of the year – the US and Switzerland were then at the top, with the periphery at the bottom and emerging markets below the average. Japan’s outperformance partly reflected expectations of additional monetary policy easing in early April under the newly-installed BoJ leadership.

A key monetary development recently has been a sharp fall in US real narrow money growth – third chart. With Fed policy remaining expansionary, this was unexpected: it may partly reflect the removal of unlimited insurance of demand deposits at the start of the year but could also indicate a reining back of spending plans, perhaps in response to fiscal tightening. The size of the move argues against downplaying it – US economic performance may disappoint during the second half, with US equities underperforming.

Another notable change is that real money has resumed growth recently in the Eurozone periphery, led by Italy, although the rate of expansion is below the global average. The latest number predates the imposition of losses on Cypriot bank depositors, which could trigger renewed capital outflows, although this is not yet suggested by weekly ECB balance sheet data. Assuming no relapse, monetary trends suggest raising equity exposure while remaining underweight.

UK real money growth has also improved absolutely and relatively, despite the suspension of QE last November. Corporate liquidity is particularly strong – fourth chart. Institutional selling of UK equities, meanwhile, has abated: domestic institutions in aggregate were net buyers in the fourth quarter for the first time since 2010. These developments appear to support a higher UK weighting.

Japanese equities have been impressed by “shock and awe” BoJ easing but this has yet to be reflected in a pick-up in real money growth, which is in the middle of the global pack. The rally to date has been led by foreign buying – not usually a good sign – and some caution may be warranted pending either a relative correction or confirmation of monetary improvement.

Elsewhere, monetary trends remain favourable in Switzerland and Germany, with the latter dragging up the Eurozone core despite weakness in France and a slowdown in the Netherlands. Combined real money growth in the “E7” large emerging countries, meanwhile, is improving relative to the G7 as the latter slows, warranting consideration of an increased weighting, particularly following recent underperformance.