Simple “monetarist” rules for switching between global equities and cash continue to favour equities at present. A fall in G7 real narrow money growth, however, could trigger a “sell” signal during the first half of 2017.

Global equities have returned 6.6% in US dollar terms so far in 2016 (i.e. as of 6 December), or 7.6% assuming currency hedging. US dollar cash (i.e. three-month Eurodollar deposits) has returned just 0.8%.

Two “monetarist” rules suggested maintaining exposure to equities during 2016. The first rule holds equities if the annual growth rate of G7 real narrow money exceeds annual growth of industrial output. Global equities (unhedged) returned 10.0% per annum (pa) more than cash on average between 1970 and 2015 when the differential was positive*. They underperformed cash by 4.7% pa when real money growth was below industrial output growth. A negative differential, in other words, is associated with a significantly higher probability of equity underperformance, including outright weakness – see first chart.

One rationale for this finding is that faster growth of real money than economic output may indicate that a portion of current money holdings will be used to purchase financial securities, including equities, suggesting upward pressure on prices unless the supply of securities expands commensurately.

An alternative rationale is that faster real money growth indicates a future acceleration of output, with positive implications for equity earnings.

G7 real narrow money grew by 8.3% in the year to October while industrial output is estimated to have been unchanged, so this rule remains in favour of equities.

The second, simpler rule holds equities if G7 annual real narrow money growth is above its long-run average of 3% (after rounding**). Global equities returned 10.6% per annum (pa) more than cash on average between 1970 and 2015 when real money growth was above 3%. They underperformed cash by 6.2% pa when real money growth was below 3% – second chart.

Again, above-average real money growth may indicate either future purchases of equities or improving economic / earnings prospects.

With current G7 annual real narrow money growth above the 3% switching level, this rule also remains in favour of equities.

The third chart compares the performance of these switching rules with the return on equities relative to cash (i.e. buy and hold). Global equities outperformed US dollar cash by 3.1% pa on average over 1970-2015. The first switching rule, based on the real money / output growth differential, beat cash by 5.4% pa over this period, implying an excess return of 2.2 percentage points (pp, after rounding). The second rule outperformed by 6.0% pa, implying a 2.8 pp excess return.

The first rule was superior to the second rule during the first half of the period, capturing a greater proportion of equity market upside while offering similar protection against drawdowns. These characteristics changed during the second half of the period. The first rule, in particular, suffered a larger drawdown during the 2000-02 bear market***.

Both rules failed to switch into cash before the October 1987 equity market crash. The real money / output growth differential turned negative in October 1987 but the reporting lag implies that this would not have been known until December. Real money growth itself, meanwhile, fell below 3% only in December 1987.

Real money, however, was slowing sharply in spring / summer 1987, warning of rising risks and possible future “sell” signals. Annual growth fell from a peak of 9.9% in January to 5.9% by July – monetary data for July would have been available by end-August. This suggests supplementing the two rules with an additional defensive condition: switch into cash if G7 annual real narrow money growth falls by more than 3 pp within six months.

This modification “deals with” the 1987 “miss” and slightly improves the performance of the second rule at other times, with little impact on the first rule – fourth chart.

The additional defensive condition could conceivably trigger a “sell” signal in early 2017. G7 annual real narrow money growth has yet to decline – October’s reading of 8.3% was the strongest since August 2015. Six-month growth, however, peaked in August, with the monthly increase falling to only 0.2% in September and October – see fifth chart. The recent slowdown partly reflects faster consumer price inflation, which may be sustained by rising commodity prices.

Assume, for illustration, that real narrow money continues to increase by only 0.2% per month. Annual growth would fall to 4.7% by April, meeting the condition of a greater-than-3 pp decline within six months. Allowing for a one-month reporting lag, the rules would switch into cash at end-May.

This, to emphasise, is an illustration, not a forecast. Monthly narrow money growth could rebound in late 2016 / early 2017. Current data do not suggest an imminent risk to equities from a changing monetary environment.

*All performance figures quoted allow for reporting lags but are based on revised rather than original monetary / economic data.
**G7 real narrow money rose by 3.3% pa on average over 1970-2015.
***Both rules switched back into equities prematurely. The period was unusual because valuations were still high when the monetary signals turned positive. This suggests modifying the rules to include a maximum valuation condition for a “buy” signal.