The monetary forecast of global recession in late 2022 / early 2023 appears to be playing out. The latest real money data hint at a bottoming out of economic momentum around end-Q1 2023 but there is no suggestion yet of a subsequent recovery. This message dovetails with cycle analysis, with the stockbuilding cycle now turning down and unlikely to enter another upswing until H2 2023 at the earliest. Global industrial output is expected to contract sharply over the next two quarters with labour market data turning decisively weaker. Below-average nominal money growth, meanwhile, continues to signal major inflation relief in 2023-24. The monetary backdrop has improved for high-quality bonds and may turn less hostile for equities by year-end. A possible strategy is to remain overweight defensive sectors but add to quality / growth exposure on confirmation of monetary improvement. Monetary trends are relatively favourable in China / Japan and Chinese “excess” money could shift from bonds to equities if pandemic policy eases.

Global six-month real narrow money momentum remains significantly negative but appears to have bottomed in June, edging higher in July / August. Assuming that a June low is confirmed, the suggestion is that global industrial output momentum will bottom around March, based on an average nine-month lead at historical turning points. The global manufacturing PMI new orders index might reach a low a month or two earlier – see chart 1. 

Chart 1

The base case here is that real money momentum will recover into year-end because of a sharp slowdown in six-month consumer price inflation, which could fall by 1-2 percentage points based on current commodity price levels. 

The risk is that an inflation slowdown will be offset by a further weakening of nominal money growth in response to policy tightening. This is not guaranteed and, if it occurs, may be on a smaller scale than the inflation slowdown. Episodes of rising risk aversion are usually associated with an increase in the precautionary demand for money, reflected in a pick-up in narrow aggregates. This “dash for cash” is a negative coincident influence on markets and the economy but a subsequent release of the monetary buffer can drive recovery. (This process may explain a recent rebound in Eurozone three-month narrow money growth.) 

The baseline monetary scenario would suggest a sharp global recession through Q1 2023 followed by a stabilisation in Q2 and some form of recovery in H2. Lagging indicators such as labour market data would continue to deteriorate during H2. This scenario probably represents a best case. 

Similar timings with downside risk are suggested by cycle analysis. The stockbuilding cycle, which averages 3 1/3 years measured between lows, is very likely to have peaked in Q2 – the contribution of stockbuilding to G7 annual GDP growth was the highest since 2010 (a cycle peak year) and in the top 5% of historical readings. A business survey inventories indicator calculated here, which is more timely than the GDP stockbuilding data and leads slightly, plunged in July / August, strongly suggesting that a downswing is beginning – chart 2. 

Chart 2

With the last cycle low in Q2 2020, the average cycle length of 3 1/3 years would suggest another trough in Q3 / Q4 2023. The previous cycle, however, was longer than average, raising the possibility of a compensating shorter cycle and an earlier low in Q2 2023. This would dovetail with the suggestion of the baseline monetary scenario of economic stabilisation in Q2 and a recovery later in 2023. 

As with the monetary analysis, however, the risk is of a later trough and recovery. The concern from a cycle perspective is that the long-term housing cycle may be peaking early. This cycle has averaged 18 years historically and last bottomed in 2009, suggesting another trough around 2027. Weakness is typically confined to the last few years of the cycle but this was not always the case. This year’s interest rate shock may have brought forward the peak, if not shortened the cycle. Housing permits / starts – a long leading indicator – have fallen sharply and further weakness would suggest that a major top is in – chart 3. 

Chart 3

The risk, therefore, is that housing weakness and its lagged effects on the rest of the economy will offset any recovery impetus later in 2023 from a turnaround in the stockbuilding cycle. A rapid reversal in interest rates may be necessary to avert this scenario. 

An unambiguous positive message from the monetary and cycle analysis is that inflation is likely to fall sharply in 2023 and return to target – or below – by 2024. G7 annual nominal broad money growth is below its pre-pandemic average, while the correlation of commodity prices with the stockbuilding cycle suggests further falls into a possible mid-2023 trough – charts 4 and 5. 

Chart 4

Chart 5

The weakness of nominal money trends argues that central banks have already overtightened policies but the timing and extent of a “pivot” will hinge on labour market data. The suggestion from consumer surveys is that a shift to weakness is imminent. The G7 indicator shown in chart 6 has moved up significantly from a December 2021 low and led unemployment by an average 6-7 months at previous major troughs. The recent unemployment rate low in July, therefore, may prove to be a significant turning point, with a rise of c.1 pp possible by H2 2023. 

Chart 6

The view of market prospects here is informed by two measures of global “excess” money shown in chart 7 – the differential between six-month changes in real narrow money and industrial output and the deviation of the 12-month change in real money from a long-term average. Both measures remain negative currently, a condition historically associated with significant underperformance of global equities relative to US dollar cash. 

Chart 7

The first measure, however, has recovered and – based on the above monetary / economic forecasts – may turn positive by year-end. A rise in this measure, even while still negative, has been associated with US Treasuries outperforming cash on average (a fall signalled underperformance).

The current large shortfall of 12-month real narrow money growth from its long-term average suggests that the second measure will remain negative until well into 2023. The possible combination of positive / negative readings for the first and second measures respectively has been associated with modest underperformance of equities on average, although this conceals significant variation. 

Sector / style performance under this combination has been significantly different from the “double negative” regime, with tech, quality and growth tending to outperform, along with non-energy defensive sectors. The best-performing individual sector was health care with financials the worst. Energy also underperformed. 

The Canadian, UK and Australian equity markets were the strongest year-to-date performers at end-Q3 – chart 8. In the case of the former two, however, sector weightings have been a key driver: both have higher-than-average exposure to financials and energy, with the UK also heavy in consumer staples – all outperforming sectors. 

Chart 8

Chart 9 shows the results of recalculating performance using common (MSCI World) sector weights. Canada drops to bottom and the UK is also revealed as an underperformer. 

Chart 9

The top performance of Australia is consistent with strong real money growth earlier in the year – chart 10. This support, however, has now fallen away. 

Chart 10

Real money trends are relatively favourable in China and, to a lesser extent, Japan. Chinese nominal money growth has picked up, partly reflecting money-financed fiscal expansion, while inflation momentum in both countries is weaker than elsewhere. With Chinese activity depressed by pandemic policy, “excess” money has been supporting government / corporate bonds and could flow into equities if and when economic conditions normalise. A large basic balance of payments surplus, meanwhile, has partially insulated the currency from unfavourable movements in interest rate differentials: the RMB index is currently around the middle of its YTD range and stronger than over 2016-late 2021.

Bank of England Chief Economist Huw Pill has suggested that fiscal policy easing in the mini-Budget and the reaction in markets warrant a “significant monetary policy response”. Why? 

UK monetary trends continue to weaken and are consistent with a medium-term return of inflation to target, if not below. 

Annual growth of non-financial M4 – the preferred broad aggregate here, comprising holdings of households and private non-financial firms – was unchanged at 3.7% in August, below an average of 4.4% over 2015-19. The three-month rate of expansion fell further to just 0.8% annualised – see chart 1. 

Chart 1

Should the Bank tighten to offset the inflationary impact of exchange rate weakness? The “monetarist” view is that currency movements can delay or speed up the transmission of monetary changes to prices but have no longer-term inflation impact as long as money growth is unaffected. 

The sterling effective rate index was down by 10% on a year before at last week's low point but the annual change reached -25% during the GFC and -19% after the Brexit referendum. The index hasn’t (yet) broken below its GFC low – chart 2. 

Chart 2

The greater concern here is that increased government borrowing will be financed significantly through the banking system, resulting in another boost to money growth. This could occur via voluntary purchases of gilts by commercial banks in response to higher yields or because the Bank is forced to offer sustained support to a dysfunctional market. 

Such a scenario, however, is possible rather than likely. Any monetary boost from deficit financing could be offset or outweighed by a further weakening of private sector credit trends as banks pass on higher funding costs and widen spreads. 

The Bank would have made better recent decisions if it had paid attention to monetary trends: it wouldn’t have expanded QE in November 2020, would have raised rates earlier in 2021 and wouldn’t have embarked on QT. Current monetary weakness argues against policy tightening. The Bank may judge it necessary to hike rates to bolster its credibility, and that of the wider UK policy-making framework. Bank officials, however, should avoid inflating market expectations and be prepared to reverse increases if markets calm and – as seems likely – money trends remain soft.

Revised numbers confirm that US GDP fell by 0.6% (1.1% annualised) between Q4 2021 and Q2 2022*. Hours worked in the private sector economy, meanwhile, climbed 1.1% (2.2% annualised) over the same period. What explains this disconnect and how long can it continue? 

The ”explanation” here is that economy-wide productivity was pushed far above trend by the pandemic but has been normalising this year. The reversion to trend appears complete, suggesting that labour market data will reflect output weakness going forward.

Output per hour in the business sector surged in the initial stages of the pandemic in Q2 / Q3 2000, opening up a gap of more than 4% with the prior trend – see chart 1.

Chart 1

Firms responded to economic contraction by laying off lower-productivity workers, boosting the average. Output returned to its pre-pandemic level in Q2 2021, requiring these jobs to be refilled. A fall in participation (due to age demographics) coupled with supply / demand mismatches slowed the rehiring process, resulting in output per hour remaining elevated until recently.

The deviation from trend had narrowed to below 1% as of Q2.

Another way of presenting the data is to compare actual hours worked in the business sector with the number implied by the current level of output, assuming that productivity had continued on its pre-pandemic path – chart 2.

Chart 2

A big deficit had opened up by Q2 2021 but strong employment growth and an output set-back have narrowed the gap. Monthly data through August suggest that hours worked rose solidly again in Q3 and may have converged with the output-warranted level.

With productivity back or close to trend, the GDP / employment divergence is likely ending.

The productivity trend implies that hours worked will fall if GDP rises by less than 0.2% (0.8% annualised) per quarter. Real narrow money has been contracting since January 2022, suggesting further GDP declines in Q4 / H1 2023. Labour market data may be poised for imminent deterioration.

*Gross domestic income – GDP measured from the income side – rose by 0.2% (0.4% annualised) over the same period.

Global six-month real narrow money momentum, the key economic leading indicator in the forecasting approach employed here, is estimated to have moved sideways in deep negative territory in August* – see chart 1. Allowing for an average nine-month lead, the suggestion is that an incipient global recession will extend through Q2 2023, at least. 

Chart 1

More specifically, global six-month industrial output momentum, which crossed below zero in July and is estimated to have weakened further in August, may continue to fall into April / May next year, with no monetary signal yet of a subsequent slowdown in the pace of contraction. 

The lack of recovery in real narrow momentum is disappointing since, as previously discussed, global six-month consumer price momentum pulled back in July / August. This slowdown, however, was offset by a further fall in nominal money expansion – chart 2. 

Chart 2

Nominal money weakness, encompassing broad as well as narrow aggregates, is evidence that monetary policies were already over-restrictive before the latest round of hair-shirt rate hikes. 

What does this monetary backdrop imply for markets? The two measures of global “excess” money calculated here, i.e. the differential 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, remained negative in August – chart 3. 

Chart 3

Historically (i.e. over 1970-2021), global equities outperformed cash on average only when both measures were positive, with underperformance greatest when both were negative. 

Previous posts suggested that the first measure would turn positive during H2. This remains possible despite the disappointing August monetary data: the measure has recovered since June as industrial momentum has fallen and output may soon be contracting at a faster pace than real money. 

The second measure, however, is likely to remain negative until well into 2023: 12-month real money momentum weakened further in August and the long-term nature of the moving average implies that it will make little contribution to closing the current wide gap.

The projected development of the measures, i.e. the first crossing back above zero but the second remaining negative, would suggest a slowdown but not reversal in the bear market in late 2023. 

The message for government bond markets is more hopeful. Changes in bond yields have been inversely correlated with changes in the first excess money measure historically, i.e. bonds have, on average, rallied when the measure has risen, even while it has remained negative – chart 4**. 

Chart 4 

The six-month change in the excess money measure turned positive in August, having been negative – implying an unfavourable monetary backdrop for bonds – between November 2021 and July. US 10-year Treasuries have outperformed cash by 4.2% pa on average historically following positive readings. 

*The estimate incorporates monetary data covering two-third of the aggregate and complete CPI results.

**The change in the measure is plotted inverted in the chart.

Global six-month consumer price inflation peaked in June and fell further in August, reflecting pass-through of lower oil prices and a small decline in core momentum. Current commodity prices suggest a sizeable further drop into Q4 – see chart 1*. 

Chart 1

Annual as well as six-month CPI inflation probably peaked in June, with the peak occurring within the expected time band following a major top in annual broad money growth in February 2021 – money trends lead inflation by two to three years, according to the monetarist rule of thumb. 

G7 annual broad money growth is estimated to have fallen further to below 4% in August, widening an undershoot of its 4.5% average in the five years before the pandemic – chart 2. The suggestion is that G7 inflation rates will be back at or below target around end-2024, if not before. 

Chart 2

Markets were spooked by last week’s news of a hefty monthly rise in US core CPI in August but six-month momentum was little changed and below a June peak, while PPI pressures continue to ease – chart 3. 

Chart 3

Central bankers are supposedly focused on preventing high inflation from becoming embedded in expectations. The view here has been that expectations were unlikely to become “unanchored” against a backdrop of weak money growth. The latest consumer surveys by the New York Fed and University of Michigan show longer-term inflation expectations back within 2010s ranges – chart 4. 

Chart 4

UK annual core CPI inflation made a marginal new high in August but money trends mirror the global picture and are signalling a 2023-24 collapse – chart 5. The latest Bank of England / Ipsos inflation attitudes survey, meanwhile, reported a fall in consumer longer-term inflation expectations, which have remained within the 2010s range – chart 6. 

Chart 5

Chart 6

The apparent anchoring of longer-term US / UK expectations suggests that wage pressures will dissipate rapidly as current inflation rates fall sharply in 2023. 

*The GSCI commodity price index uses US prices for the natural gas component; the series shown by the gold line in the chart incorporates an adjustment for European prices.

UK monetary trends continue to argue against Bank of England policy tightening. 

Annual growth of non-financial M4 – comprising money holdings of households and private non-financial firms – was 3.7% in July, below a 4.4% average in the five years preceding the pandemic. The aggregate expanded at an annualised rate of only 2.0% in the latest three months – see chart 1. 

Chart 1

Growth of the Bank’s preferred broad money measure, M4ex, is higher, at 4.8% in the year to July and 4.9% annualised in the latest three months. This aggregate includes money holdings of financial companies, which have been rising strongly but are of little relevance for near-term demand prospects. 

Excessive money growth in 2020-21 boosted demand and “accommodated” price pressures due to various supply shocks, resulting in current high inflation. Is there still a monetary overhang from that period, warranting further policy tightening despite recent slow money growth? 

Expressed in real terms relative to consumer prices, non-financial M4 is almost back to its pre-pandemic trend – chart 2. The suggestion is that the monetary excess has already been largely “absorbed” by higher prices. 

Chart 2

In the absence of an overhang, the recent pace of money growth, if sustained, should be consistent with inflation returning to target within the two to three year horizon relevant for policy. Further tightening risks unnecessary economic pain and an eventual undershoot. 

Are the Truss government’s plans for large-scale fiscal loosening inflationary, warranting offsetting monetary policy action? 

Whether energy subsidies, tax cuts  etc. will prove inflationary depends on how they are financed. The banking system is likely to provide at least part of the funding, implying a first-round boost to broad money. 

A renewed rise in annual non-financial M4 growth to more than 6% would be inconsistent with medium-term inflation normalisation, requiring offsetting Bank action. 

Such a scenario, however, is far from guaranteed. Money growth was arguably on course to fall to a dangerously low level, reflecting planned Bank QT of £80 billion a year (equivalent to 3.4% of the current level of non-financial M4), a slowdown in mortgage lending and external outflows due to an expanded balance of payments deficit. 

A boost from monetary financing of fiscal loosening may offset such negative influences without pushing money growth significantly higher. 

A sensible approach, therefore, would be for the Bank to wait to assess the monetary consequences before deciding whether fiscal plans require a policy response. The current MPC membership, of course, has no understanding of or interest in monetary analysis. 

The Keynesian consensus view is that fiscal expansion necessarily implies a higher level of demand that the Bank cannot allow. The monetarist response is that, unless it leads to faster money growth, fiscal loosening will push up market interest rates and “crowd out” private spending. Surging gilt yields suggest that this scenario is already playing out. The Bank should avoid piling on the pain.