High inflation resulted in poor equity market performance in 2022 despite economic / earnings growth. Inflation relief in 2023 may limit further market weakness despite a global recession.

Absent shocks, economic momentum usually reflects real money trends six to 12 months earlier. Global six-month real narrow money momentum turned negative in March 2022, reaching a low in June before recovering slightly into November – see chart 1. This suggests that economic weakness will intensify in early 2023, with no monetary signal yet of a subsequent meaningful rebound. 

Chart 1

Real money contraction is fastest in the housing bubble / bust economies of New Zealand, Sweden and Canada, although the UK, Eurozone and US are only slightly behind – chart 2. China and Japan are positive outliers, suggesting less unfavourable prospects.

Chart 2

Hopes are high that China’s covid policy U-turn will lead to a V-shaped economic recovery, as occurred in G7 economies post reopenings. Strong G7 rebounds, however, followed a surge in money growth. Chinese real narrow money expansion is still modest by historical standards and a rise in money rates in late 2002 may indicate less expansionary PBoC policy, possibly reflecting concern about inflationary effects of rapid reopening. 

Still-negative global real narrow money momentum indicates that a Chinese economic pick-up won’t offset recessions elsewhere. Forecasts of China-driven strength in commodity prices, therefore, are suspect. Additional weakness is more likely, based on an accelerating downswing in the global stockbuilding cycle, a key driver of commodity prices historically – chart 3. 

Chart 3

The 2021-22 inflation surge was a consequence of central banks applying record monetary stimulus in 2020 as the stockbuilding cycle was tracing out an extreme low. Monetary fuel supercharged the usual cyclical rise in commodity prices. 

The monetary backdrop, like the status of the stockbuilding cycle, is now the opposite of 2020. G7 annual broad money growth crashed to 2.0% in November, below a pre-pandemic (i.e. 2015-19) average of 4.5% and down from a February 2021 peak of 17.3% – chart 4. The monetarist understanding of a roughly two-year lead implies an inflation crash from early 2023. 

Chart 4

The latest trends, indeed, suggest rising medium-term deflation risk. G7 broad money contracted marginally in the three months to November. Bank loan growth to the private sector had been providing support but is now slowing as higher rates curb mortgage demand and corporate borrowing needs moderate with the stockbuilding downswing. 

The weak economic outlook is, according to the monetarist view, of limited relevance for assessing equity market prospects, which will hinge instead on “excess” money developments.

Two global excess money proxies are followed here: the gap between six-month real narrow money and industrial output momentum; and the deviation of 12-month real money momentum from a long-term moving average. The first indicator turned negative in December 2021 (allowing for data reporting lags), with the second following in February 2022. Historically (i.e. over 1970-2021), global equities underperformed cash by 8.9% pa on average when both were negative. The underperformance between end-February and end-December 2022 was larger, at 14.9% pa. 

As noted earlier, six-month real narrow money momentum has recovered slightly from a June low. Industrial output momentum, meanwhile, is estimated to have turned negative at end-2022, with further weakness likely. A cross-over, therefore, appears imminent and may even have occurred in December – chart 5. Allowing for the data reporting lag, a December cross-over would imply a shift in sign of the first indicator from positive to negative from end-February. 

Chart 5

The second indicator – the deviation of 12-month real money momentum from a moving average – is heavily negative and unlikely to turn positive before mid-2023 at the earliest. 

The expected combination of positive and negative readings of the first and second indicators respectively was historically associated with equities underperforming cash by an average 4.5% pa, suggesting retaining a cautious investment stance.

The combination could result in significant sector / style rotation: tech, quality and growth outperformed on average with value and energy underperforming. Non-energy defensive sectors would be expected to continue to outperform non-tech cyclicals. EM equities outperformed developed markets on average.

The suggestion of a reversal of growth underperformance in 2022 is consistent with indications that Treasury yields will decline during 2023 – surging yields contributed to the derating of growth stocks last year.

Equity markets are bullish or bearish depending on whether excess money is positive or negative. Bond markets, by contrast, are sensitive to the rate of change of excess money, rather than its sign. Changes in US real Treasury yields have been inversely correlated with changes in the first excess money measure historically, i.e. yields have fallen when the measure has risen, even while still negative – chart 6. The current / expected improvement in the measure, therefore, suggests an extension of the recent yield decline.

Chart 6

Treasury yields, in addition, usually move down into a low around the same time as the stockbuilding cycle trough – chart 7. Based on the average cycle length of 3 1/3 years, the next low could occur in Q3 or Q4.

Chart 7

A fall in Treasury yields requires a Fed policy “pivot” but this could be imminent. Chart 8 shows the estimated probability of the Fed tightening policy in a particular month based on the latest data on core inflation, unemployment and supply bottlenecks. The probability estimate fell from 100% in October to 80% in December and currently stands at 75% for the FOMC meeting on 31 January / 1 February, consistent with market speculation of a step down from a 50 to 25 bp hike.

Chart 8

Based on the FOMC’s December median projections, the probability of tightening is forecast to fall below 50% in Q2 and below 10% in Q3. This outlook is consistent with the Fed shifting to an easing bias in Q2 and starting to cut rates in Q3.

Recent Bank of England signals have been deemed to be less hawkish than those of the Fed and ECB, contributing to a view that UK policy tightening is less likely to prove excessive, in the sense of causing greater economic damage than necessary to return inflation to target. 

Monetary trends do not support this hope. 

It should be remembered that the Bank embarked on rate hikes and QT before the Fed and has raised rates by 340bp versus the ECB’s 250 bp. 

“Shadow” rate estimates attempt to incorporate the impact of unconventional monetary policy measures. The Wu-Xia shadow rate for the UK has risen by 1250 bp from its 2021 low versus increases of 650 bp and 980 bp respectively in the US and Eurozone – see chart 1. 

Chart 1

UK real narrow money (i.e. non-financial M1 deflated by consumer prices) contracted by more than comparable US / Eurozone measures in the six months to November – chart 2. The decline is historically extreme and suggests a severe recession – chart 3. 

Chart 2

Chart 3

UK nominal broad money (non-financial M4) grew by just 1.3% at an annualised rate in the six months to November – chart 4. The comparable Eurozone measure rose at a 5.0% pace. US broad money contracted but is correcting a much larger increase in 2020-21. 

Chart 4

Real broad money holdings of UK households have retraced almost all of the pandemic-related surge, falling to the lowest level since May 2020 – chart 5. Far from “excess” money balances supporting spending, a real money squeeze is now likely to magnify consumption weakness. 

Chart 5

Bank of England communications may be becoming less hawkish but the damage has been done. Officials ignored the monetary signal that a 2021-22 inflation spike would reverse with modest policy restraint. The economic consequences of overkill are likely to be at least as bad as in the US / Eurozone.

Gas price relief and Chinese reopening have tempered pessimism about Eurozone economic prospects, contributing to a Q4 rally in equities. Monetary trends, by contrast, suggest a worsening outlook due to the ECB’s scorched earth policy tightening. 

The preferred narrow money measure here – non-financial M1 – contracted for a third straight month in November. The three-month annualised rate of decline of 5.3% compares with a maximum fall of 1.7% during the GFC – see chart 1. 

Chart 1

Narrow money weakness is being driven by households and firms switching out of overnight deposits into time deposits and notice accounts – a normal pre-recessionary development. Broad money, in addition, is slowing – non-financial M3 rose by only 0.2% in November, pulling three-month annualised growth down to 3.4%, the slowest since 2018. 

The headline M1 and M3 measures are displaying greater weakness, reflecting a fall in money holdings of non-bank financial corporations.

Broad money growth had been supported by solid expansion of bank loans to the private sector but, as expected and signalled by the ECB’s lending survey, momentum is now fading – chart 2. Slumping credit demand and forthcoming QT suggest that broad money will follow narrow into contraction. 

Chart 2

Corporate loan demand had been boosted by inventory financing but stockbuilding reached a record share of GDP in Q3 – chart 3 – and is probably now being cut back sharply, contributing to a move into recession. Consistent with this story, short-term loans to corporations contracted in both October and November. 

Chart 3

A sharp fall in inflation will support real money trends but has yet to arrive. The six-month rate of contraction of real non-financial M1 reached another new record in November – chart 4. 

Chart 4

Monetary tightening in 2007-08 and 2010-11 was associated with a divergence of money trends across countries, reflecting and contributing to financial fragmentation. This is occurring again, with weakness focused on Italy. 

Italian real narrow money deposits contracted by 9.7%, or an annualised 18.4%, in the six months to November, with the larger decline than elsewhere due to both greater nominal weakness and higher CPI inflation – chart 5.

Chart 5

In nominal terms, total bank deposits in Italy were unchanged in the year to November – chart 6. Italian banks’ assets grew modestly over this period. The banks funded this expansion by increasing their net borrowing from Banca d’Italia, which in turn accessed additional funding from the Eurosystem, resulting in a further widening of Italy's TARGET2 deficit. This reached a record €715 billion in September following a surge in Italian BTP yields, falling back in October / November – chart 7. Another rise in yields since early December may have been associated with deposit outflows from the banking system and renewed upward pressure on the TARGET2 shortfall. 

Chart 6

Chart 7

US non-farm payrolls have risen by an average of 337,000 per month in the eight months since the Fed started hiking rates in March. The household survey measure of employment was essentially flat over this period.

The gap between the eight-month changes in the two series is at a record high, excluding April-May 2020 when data were distorted by the pandemic*. (This comparison, however, uses revised data for the two series.) 

The payrolls numbers have informed the FOMC’s judgement that “job gains have been robust”, in turn influencing the magnitude of the rise in rates this year. 

The payrolls survey covers about 670,000 worksites, while the household survey has a sample size of about 60,000. Sampling error, therefore, is larger for the household survey – the standard error of the monthly change in the household survey employment measure is more than four times that of the monthly payrolls change, according to the BLS. 

The payrolls survey, therefore, is conventionally regarded as the more reliable gauge of short-term employment movements. 

A focus on monthly sampling error, however, ignores sometimes large revisions to the payrolls data due to annual benchmarking against unemployment insurance tax records. There is no comparable annual revision to historical household survey data. 

The annual payrolls revisions have averaged close to zero over the long run but there have been clusters of negative revisions around recessions – see chart 1. 

Chart 1

Benchmark revisions occur with a long lag. The BLS in August issued a preliminary estimate of a 462,000 upward revision to the March 2022 level of payrolls. This will be incorporated in monthly historical data up to March 2022 in February 2023. 

Benchmark revisions to recent monthly data, therefore, will occur in February 2024 under current BLS practice. 

Research by the Philadelphia Fed suggests that these revisions will be negative and potentially very large. The researchers have attempted to replicate the annual BLS benchmarking procedure using quarterly UI records. They estimate that the currently-reported level of payrolls in June 2022 of 151.9 million will be revised down by 843,000, or 0.55% – chart 2. 

Chart 2

This would imply that payrolls grew by only 3,500 per month on average between March and June compared with the currently-reported 349,000. 

Chart 3 compares three-month growth rates of the official payrolls series, the household survey employment measure and the Philadelphia Fed benchmarked payrolls series. The May / June readings of the latter two are equal.

Chart 3

The official payrolls measure has risen by an average of 329,000 per month in the five months since June. Monthly gains in the household survey employment measure averaged 72,000 over this period. 

A benchmarked payrolls estimate for September won't be available until March but timely data on withheld income and employment taxes – including UI taxes – suggest that the official payrolls series has continued to overstate gains. The daily tax data are noisy but year-on-year growth of a moving average has fallen sharply since June, widening an undershoot of the normal relationship with aggregate private sector earnings growth from the payrolls survey – chart 4. 

Chart 4

*The payrolls series measures jobs while the household survey measures people. The wide gap partly reflects a rise in the number of people with multiple jobs. A BLS research series is available that attempts to convert household survey employment data to a payrolls concept, including by adding multiple jobs. This series rose by an average of 103,000 per month in the eight months to November. The difference with payrolls growth is also a record excluding 2020 data.

The BoJ’s decision to widen the fluctuation band of the 10-year JGB yield around the zero target follows an apparent withdrawal of monetary policy support by the PBoC in recent weeks. 

Three-month SHIBOR has risen by 75 bp since late September and is now only 15 bp below its start-of-year level – see chart 1. Upward pressure has been partly market-driven but the PBoC has chosen not to accommodate increased demand for liquidity. 

Chart 1

The PBoC’s Q3 monetary policy report, issued in November, expressed concern about medium-term inflation risks, stressing the importance of avoiding excessive monetary growth. An apparent hawkish shift may have been reinforced by the shock abandonment of the zero covid policy, which officials may view as likely to boost near-term price pressures via a faster demand recovery and / or an increase in supply bottlenecks. 

The Japanese / Chinese policy moves are worrying because monetary trends in the two economies have been providing a modest offset to significant US / European weakness – chart 2. That support could now fade. 

Chart 2

A rise in Japanese six-month narrow money growth in November was accompanied by a further pick-up in bank lending, consistent with stronger credit demand expectations in the BoJ’s Q3 loan officer survey – chart 3. The hope is that firmer bank loan growth / money creation will survive a modest policy adjustment. 

Chart 3

Global six-month real narrow money momentum is estimated to have risen for a fifth month in November but remains negative – chart 3. Allowing for the usual lag, the suggestion is that global manufacturing PMI new orders will bottom by next spring but remain in recessionary territory into Q3. 

Chart 4

The recovery in real money momentum continues to be driven by a slowdown in six-month CPI inflation, with nominal money growth languishing – chart 5. The inflation decline will extend but overly hawkish central banks risk pushing nominal money momentum to new lows. 

Chart 5

UK payrolled employment rose solidly again in November, while pay growth numbers for October surprised to the upside. It has been suggested that this news reinforces the case for a Bank rate hike of at least 50 bp this week. 

Employment is a lagging economic indicator. There is ample coincident evidence that a recession is under way. Annual broad money growth – as measured by non-financial M4 – is down to 3.4%, a level suggesting a medium-term inflation undershoot. The view here is that any rate rise this week will be a mistake. 

The monthly payrolled employment measure has a short history but it correlates closely with the quarterly (and less timely) Workforce employee jobs series. In the 2008-09 recession, the latter measure peaked two quarters after GDP.

Labour market indicators that lead employment / unemployment include the stock of vacancies and average hours worked. These indicators are usually roughly coincident with GDP.

The headline vacancies series is a three-month moving average but non-seasonally-adjusted single-month numbers are available and can be adjusted using a standard procedure. The resulting series peaked in April, one month before GDP, and fell again in November – see chart 1. The recent pace of decline is comparable with the 2008-09 recession.

Chart 1

The weak November vacancies number suggests that GDP contracted significantly last month after October’s catch-up from reduced September activity due to the Queen’s funeral.

Average weekly hours tell a similar story. The series, which is available only as a three-month moving average, peaked in March and fell again in October, reaching its lowest level – excluding the pandemic recession – since 2012.

Should the MPC react to strong pay numbers? The monetarist view is that pay pressures are an effect rather than a cause of high inflation and will moderate as the dramatic slowdown in money growth since 2021 feeds through to slower price rises.

The latest upside surprise, in any case, reflects a belated catch-up in public sector pay; six-month growth of private sector regular pay is high but moving sideways – chart 2. A public sector pay pick-up may be bad news for real government spending and / or the public finances but will have little effect on the pricing behaviour of private sector suppliers of goods and services – especially against a backdrop of deepening recession and a loosening labour market.

Chart 2