The US Institute for Supply Management (ISM) December semi-annual survey of manufacturing and non-manufacturing business signals brighter prospects for capital spending in 2013 while suggesting that spare capacity in the economy is much smaller than conventionally assumed.

The first chart shows the annual rate of change of business investment together with a weighted* average of the capital spending forecasts for manufacturing and non-manufacturing in the December ISM survey of the previous year. The survey has correctly predicted the direction of change of investment momentum in 11 of the last 12 years. The weighted average forecast of 7.1% in 2013 is the strongest since 2007. Based on data for the first three quarters, business investment is on course to rise by about 7% in 2012, down from 8.6% in 2011 but well above the forecast of 0.3% in the December 2011 survey.

The second chart compares the weighted average operating rate reported by ISM firms with the OECD’s estimate of the US “output gap” – the percentage deviation of GDP from “potential”. The operating rate has fallen slightly since the April 2012 survey but remains close to its long-run average, casting strong doubt on the OECD’s claim of a negative output gap of about 4%. US inflation is likely to rise much faster than the Fed expects if it achieves its goal of significant GDP acceleration in 2013.

*Weighted by shares in national income of domestic private industries in 2011.

Chinese money and lending trends continue to suggest stronger economic growth but – thankfully – no return to the credit-fuelled frenzy of 2009-10.

The chart compares six-month changes in industrial output and four measures of real money / lending. The least bullish is real narrow money M1, which was the best of the indicators in signalling economic weakness in 2012. Six-month growth has revived significantly since mid-year but remains modest by historical standards.

The most bullish is real total social financing – a broad credit measure including non-bank trust loans, acceptances and bond financing as well as conventional bank lending. Six-month growth* climbed to an estimated 9.5%, or almost 20% annualised, in November – the strongest since June 2010. The authorities clamped down on credit disintermediation in 2011, resulting in social financing expanding at a similar pace to bank loans. They appear to have reversed course in 2012 in order to stimulate the economy, with a significant growth gap opening up again since the spring.

A scenario of strengthening growth but no boom is supported by the OECD’s Chinese leading indicator, a transformed version of which climbed to a 22-month high in October but remains below half the level reached ahead of the 2009 economic surge.

*A stock series was estimated from flow data and deflated by the consumer price index.

The “monetarist” forecast here that the global industrial cycle would bottom in autumn 2012 and recover into 2013 receives further support from today’s release of OECD leading indicator data for October. As previously discussed, the OECD fails to extract maximum forecasting value from its indicators. The first chart shows a transformed measure covering the G7 and emerging E7 economies. This measure leads industrial output momentum by three months on average and rose for a fourth successive month in October, implying that the incipient global pick-up will extend through January at a minimum.

The second chart shows, additionally, a “leading indicator of the leading indicator”, designed to signal turning points even further in advance – its average lead at peaks and troughs is five months. This fell slightly in October, breaking a run of five consecutive gains and suggesting that a rebound in global industrial growth will peak out around February. The measure, however, is especially sensitive to data revisions and the modest October loss could be revised away.

The bias here is to play down the fall in the double-lead indicator since it is not supported by monetary data. Global six-month real narrow money growth continued to strengthen in October, reaching its highest level since December 2011 – third chart. Real money has an average lead time to industrial output of six months so usually – though not always – turns before the double-lead indicator. A “monetarist” forecast, therefore, is that the global economy will accelerate into next spring, at least.

Importantly, the October increase in the global leading indicator reflects broad-based improvement across countries. Eurozone economic weakness, in particular, should abate, with the regional indicator rising for a third month, consistent with a revival in real narrow money since the spring – fourth chart. The relative optimism about Eurozone prospects held here is also supported by recent firmer survey evidence, including today’s Sentix results for December, which suggest further recoveries in the Ifo and PMI measures – fifth chart.

The global upswing is unlikely to be derailed by US fiscal tightening in 2013, which an eventual budget deal may restrict to 2% of GDP or less. Assuming a Keynesian multiplier of 0.5 (the IMF’s claim to have uncovered a much larger number does not withstand scrutiny), a 2% package would cut US growth by 1 percentage point in 2013 and world expansion* by 0.2 of a point – modest relative to the probable boost from current expansionary monetary conditions.

*IMF measure based on purchasing power parity. US weight in 2011 = 19.1%.

The Chancellor appears to have performed a conjuring trick. He announced an additional £5.4 billion of infrastructure investment  in 2013-14 and 2014-15 while foregoing £4.0 billion of tax receipts in 2014-15, by cancelling / postponing fuel duty rises, raising the personal allowance, temporarily boosting investment allowances and cutting corporation tax. Yet the Office for Budget Responsibility (OBR) judges that, despite these giveaways and a weak economy, he is on course to meet his “fiscal mandate” of returning the cyclically-adjusted current budget (CACB) to balance one year earlier than the five-year requirement (i.e. in 2016-17 rather than 2017-18).

What explains the magic? The Chancellor announced further cuts to departmental and welfare spending but these were required to meet his previous assumptions for “total managed expenditure” through 2016-17. He paid for his giveaways partly by a further tax raid on banks and higher-earners – uprating the higher rate threshold by only 1% per annum coupled with restricted pension relief and a hike in the bank levy raise £2.7 billion by 2016-17. The larger part of the bill, however, was met by banking a number of windfalls – QE income, the operating surplus of Bradford & Bingley / Northern Rock Asset Management, tax “repatriation” from Switzerland and, in 2012-13, the 4G spectrum sale. The first two more than account for the forecast CACB surplus of 0.4% of GDP in 2016-17.

The OBR, in addition, has been less brutal than it might have been in assessing the Chancellor’s plans, judging that most of this year’s economic weakness is cyclical (i.e. temporary) rather than structural, despite contrary evidence from its own “cyclical indicators” approach. The OBR has, admittedly, further reduced its assumption for future potential growth, which hits the CACB by 0.9% of GDP by the end of the forecast period. Its projections for potential output, however, remain at the optimistic end of the range of external forecasts, while “other forecasting changes” improve the CACB by 0.3% of GDP relative to the March forecast. The OBR also assumes that future losses on the QE programme will be covered by capital grants so will not affect the current budget balance.

The larger fiscal picture is little changed by this Statement. Deficit reduction has been modest less because of economic weakness than because the ratio of current spending to GDP has yet to be cut significantly – the OBR projects the share at 42.3% of GDP in 2012-13 versus a 2009-10 peak of 42.9%. The Chancellor’s plans imply a whopping 5.4 percentage point fall in this share over the next five years – see chart. This is far from unachievable – the Thatcher Government managed a larger reduction between 1984-85 and 1989-90, albeit with the tailwind of a strong economy – but the task has barely begun.

A post in late 2009 noted that the fall in global industrial output in the 2008-09 recession was similar in depth and duration to that during the 1974-75 “first oil shock” downturn. The two busts were preceded by money / credit booms spurred by financial deregulation and loose monetary policy, and were triggered partly by a real income squeeze caused by a commodities-driven inflation spike. Both involved major financial stress – greater in 2008-09, although the UK secondary banking crisis of 1973-75 necessitated a Bank of England bail-out – and ushered in a prolonged period of further monetary accommodation, characterised by negative real interest rates.

Global industrial output can be proxied today by the combined production of the G7 major countries and seven large emerging economies (the “E7”, defined here as BRIC plus Korea, Mexico and Taiwan). In 2008-09, G7 plus E7 industrial output fell from peak to trough by 14% over 12 months, bottoming in February 2009. The global economy in the 1970s was dominated by the G7, with emerging countries playing only a minor role. G7 industrial output fell by 12% over 12 months to a trough in May 1975.

The earlier post suggested, based on the similarities between the two episodes, that G7 plus E7 output would trace out a recovery path resembling that followed by G7 production from the May 1975 trough. The chart below updates one from the original post, overlaying the 1970s path of G7 output on recent G7 plus E7 production*. The remarkable fit has persisted, with the level of G7 plus E7 output in October (partly estimated) within 0.5% of the “prediction” based on the 1970s G7 path.

The similarity, should it continue, suggests that global industrial production will grow solidly in 2013. This is consistent with the current positive message from global real narrow money expansion, confirmed by a tentative upturn in shorter-term leading indicators. (An important October update to the global leading indicator followed here will be available on Monday 10 December.)

The late 1970s upswing aborted as prolonged monetary laxity triggered another surge in commodity prices and inflation that cut G7 real incomes and forced policy-makers to prioritise price stability over containing unemployment, resulting in real interest rates being pushed back into positive territory. G7 industrial output peaked in February 1980 and fell by 8% over 34 months to a trough in December 1982.

The current-cycle equivalent of February 1980 is November 2013. While inflation is expected here to trend higher in 2013-14, however, it may not rise by enough to prompt a monetary policy shift towards tightening in 2013 sufficient to trigger another recession by year-end. The similarity with the late 1970s, in other words, may break down in late 2013, with the current upswing extending into 2014-15, before the costs of prolonged policy laxity finally fall due.

*The May 1975 trough in G7 industrial output was aligned with the February 2009 G7 plus E7 trough while the level of the G7 index was rebased to equalise the values of the two series in January 2003, the start-date of the chart.