From a liquidity perspective, market falls since late 2007 were caused by a fear-induced rise in the precautionary demand for money coupled with a withdrawal of credit from leveraged investors, resulting in forced selling of assets. Contrary to fears, the global supply of money has continued to expand but not sufficiently to offset these negatives.

As the second quarter begins, money supply trends are improving, risk aversion and precautionary cash demand appear to be moderating and investor leverage is at its lowest level for several years. This suggests support for equity markets but any rally faces hurdles from ongoing poor earnings news, a likely rise in issuance and a possible rebound in commodity prices.

A key policy development last quarter was the $1.15 trillion expansion of the Fed’s securities purchase programme, which promises to give a major boost to US and global monetary growth. Including the unutilised portion of earlier plans, the Fed could buy $1.4 trillion of assets over the remainder of 2009, equivalent to 11% of US M2+ and about 5% of our G7 broad money measure.

The demand for money is unobservable but cash hoarding is likely to diminish as fears of financial collapse abate and the economic cycle approaches a trough. Consistent with this view, measures of risk aversion have moderated recently – see chart – while narrow monetary aggregates have been rising relative to broader measures, which often precedes a pick-up in velocity.

Meanwhile, investor deleveraging appears to be well-advanced. US margin debt is back at 2003 levels while hedge fund returns have recently shown little correlation with equities, suggesting minimal market exposure. Hedge funds suffered investor withdrawals of $260 billion between November and January but outflows slowed to $17 billion in February, according to Trim Tabs.

While the liquidity backdrop for equities is improving, several factors could delay a significant recovery in markets. First, corporate newsflow may remain negative – another large fall in global GDP in the first quarter suggests the potential for downside surprises in coming earnings reports, even relative to recently-lowered expectations.

Secondly, any rally is likely to call forth an avalanche of issuance as companies seek to reduce gearing against the backdrop of high corporate borrowing costs. Balance sheet adjustment also implies that cash take-over activity and share buy-backs will remain weak for the foreseeable future.

Thirdly, “excess” liquidity resulting from a fall in money demand relative to supply could flow into commodity markets, particularly given investor concerns that unprecedented monetary and fiscal stimulus will lead to higher inflation over the longer term. A renewed commodity price surge would damage prospects for a recovery in economic activity and earnings recovery later in 2009.

Central bank surveys of bank loan officers are a key gauge of the success of recent policy initiatives in easing credit conditions.

In the last US survey, conducted in January, the net percentage of banks reporting tighter credit standards on loans to firms remained close to its historic high. This indicator correlates closely with the yield spread of non-investment-grade corporate bonds over Treasuries – see first chart.

The April survey is due for release in early May. As the chart shows, however, the equivalent UK indicator from yesterday’s Bank of England credit conditions survey fell significantly between November / December and February / March. A similar drop in the US indicator would suggest better prospects for high-yield bonds.

The UK improvement may have been exaggerated by country-specific factors, such as government agreements with Lloyds Banking Group and the Royal Bank of Scotland to expand lending and the Bank of England’s purchases of corporate securities. Nevertheless, recent policy actions should contribute to at least some fall in the US indicator.

The net tightening percentage, inverted, is also a good leading indicator of the economy – see second chart – so a fall would boost recovery hopes.

The current global recession is shockingly severe. Does this imply an increased risk of “depression” or will an equally-dynamic recovery unfold later in 2009?

The first chart below updates a comparison of the current fall in industrial output in the Group of Seven (G7) economies with the three largest declines over the prior 50 years. Output is now about 18% below its peak in February 2008 – significantly greater than the biggest previous drop of 12% in 1974-75.

In the three prior cycles there was an inverse relationship between the size of the peak-to-trough output fall and the time taken to retrace it – the bigger the decline, the faster the recovery. It took 31 months for output to regain its peak level in the mid 1970s but 49 months in the early 2000s, when production fell by “only” 7%.

Commenting on an earlier post, a reader noted that the areas between the curves and the 100% horizontal line look similar. This area measures the cumulative percentage loss of output relative to its peak monthly level. This cumulative loss is shown in the second chart. The reader’s observation is correct. The loss was 186% over 1974-76, 181% over 1980-83 and 163% over 2000-04 – a remarkably narrow range.

So a bigger peak-to-trough decline may not imply that a recession is significantly worse in terms of cumulative output loss. There may be natural forces tending to equalise this cumulative loss across cycles. This observation, however, may apply only to “normal” recessions. Once the output fall exceeds a certain amount, the dynamics may change, resulting in a recession developing into a depression or slump.

The case for a V-shaped revival later in 2009 is that this tipping point has yet to be reached and unprecedented monetary and fiscal policy stimulus will strongly reinforce natural recovery tendencies. Optimistic indicators include a surge in inflation-adjusted narrow money growth – third chart – and a widening gap between sales and production – fourth chart – suggesting a potential big boost from the stocks cycle.

The cumulative loss approach outlined above can be used to generate a forecast path for G7 industrial output in an optimistic economic scenario. Specifically, assume that:

1. The cumulative output loss in the current recession / recovery cycle is 200% (i.e. slightly greater than over 1974-76).
2. February 2009 proves to be the trough.
3. Output subsequently recovers at a constant rate.

These assumptions define the forecast path shown in the fifth chart, which implies a return of output to its February 2008 peak by June 2010.

A key argument against a V-shaped rebound in output is that credit supply constraints will short-circuit natural recovery tendencies and render policy stimulus ineffective. Surveys of bank loan officers will be important for judging if credit conditions are easing, boosting economic prospects. The latest Bank of England survey, released today, was encouraging – final chart.