A widely-held view is that the covid-19 shock has been the trigger for a “late cycle” global economy to enter an overdue and probably sustained period of weakness, to be reflected in a trend rise in unemployment and widening output gaps.

This view is encapsulated by the latest IMF forecasts of a 4.9% fall in global GDP in 2020 followed by a rise of only 5.4% in 2021, implying that the level of GDP next year will be barely higher than in 2019 and about 6.5% lower than projected in January.

The cycle analysis here yields an opposite conclusion: rather than acting as a catalyst for a new period of cyclical weakness, the virus shock has magnified but probably marks the end of a pre-existing downswing dating back to early 2018. Key cycles are now shifting from acting as a headwind to providing a tailwind to global economic momentum.

The cycles methodology followed here is based on the “European” approach, which recognises independent cycles in the components of (investment) demand, rather than the dominant but misleading “American” approach, which asserts the notion of a single, all-encompassing “business” cycle*.

The European approach identifies three main cycles: a stockbuilding or inventory cycle ranging between 3 and 5 years in length (i.e. measured from low to low), a business investment cycle of 7 to 11 years and a longer-term housing cycle averaging 18 years.

Why no consumer spending cycle? Consumption is a derivative of the above cycles. It is influenced by employment trends, which echo the business investment cycle. Consumption booms typically occur during the late upswing phase of the housing cycle, reflecting house price-driven wealth effects and strong mortgage credit growth / home equity withdrawal.

The first chart shows suggested dates of stockbuilding cycle lows, based on the contribution of stockbuilding to G7 annual GDP growth. The pre-covid view here was that the cycle had bottomed in Q4 2019. The shock appears to have shifted the low to Q1 2020. The negative GDP impact last quarter was larger than at many previous cycle lows and, at 4 years, the current cycle is already longer than a 3.4 year average.

A business survey inventories indicator shown in the second chart correlates closely with the GDP growth contribution and supports the view that the bottom is in.

Suggested dates of business investment cycle lows are given in the third chart, showing annual growth of G7 non-housing fixed capital spending. With the previous trough in Q2 2009, the maximum 11 year length of this cycle implies that Q2 2020 is the latest possible date for the current cycle low.

The annual investment fall was insufficiently large to mark a cycle low in Q1 but will be more pronounced in Q2. A Q2 trough is supported by a business survey capex indicator, which bottomed in April, rebounding significantly in May with a further increase indicated for June, based on partial data – fourth chart.

A counterargument is that investment is unlikely to bottom before profits. The lead time of profits at troughs historically, however, was often only one quarter. Profits weakened more than investment in Q1 and it is possible that their annual change bottomed in that quarter.

Business money trends are consistent with an investment trough having been reached. The fifth chart shows the relationship for the US, which has the longest business money data history, but the recent surge is echoed elsewhere.

A common misperception is that a business investment cycle recovery requires a rebound in “animal spirits”. This usually occurs later in the upswing. Replacement capital spending plays an important role in the initial revival: such spending is postponed during the downswing, creating a reservoir of pent-up demand that is released as economic conditions stabilise.

*Wesley C. Mitchell, the pioneer of the American approach, defined business cycles as fluctuations in overall economic activity varying in duration “from more than one year to ten or twelve years”. The wide range is a consequence of inappropriately aggregating component cycles, which has the effect of discarding valuable forecasting information based on their individual periodicities. One consequence is that the research agenda of Mitchell et al. focused on the development of leading indicators for forecasting.

Annual growth of US broad money, on the M2+ definition* used here, rose further to 25.7% in May, the fastest since 1943 and more than 20 percentage points higher than a year earlier.

The economist consensus is that the monetary surge will not result in a rise in inflation because of an offsetting fall in velocity**. The required 20% plunge, however, would be unprecedented – about double, for example, the decline in 2008 at the height of the GFC.

The view here is that an inflation pick-up will be avoided only if the monetary surge is rapidly reversed. A return of growth to its prior level is insufficient – the level of the money stock needs to contract significantly.

Such a scenario should not be dismissed out of hand. Broad money contracted by 5.2% between May 2009 and June 2010 during the initial economic and market recovery after the GFC. That weakness, however, partly reflected commercial banks restructuring their balance sheets to meet official demands for an increase in capital ratios, while a larger decline would be required now because of the monetary overhang.

Two other scenarios should be considered. Annual broad money growth is almost certainly peaking. Suppose that it returns to its year-ago level of 5.1% in 12 months’ time. Allowing for a rough two-year lead from money to prices, this would suggest a temporary inflation rise to a peak in 2022 followed by a return to around the 2010s average.

An alternative scenario, favoured here, is that broad money growth will remain elevated by recent standards, meaning high single digits, at least, compared with a 10-year average (to 2019) of 3.9%. This would suggest a structural shift higher, or secular rise, in inflation.

What are the probabilities of the above three monetary scenarios? A starting point for an assessment is an analysis of the causes of the recent surge.

Unlike other central banks, the Fed does not provide a counterparts breakdown linking changes in broad money to other elements of the monetary system balance sheet. The table cobbles together available information.

Several points are notable. First, the Fed’s securities purchases made the largest contribution to the rise in money growth over the past 12 months but much of the impact was offset by an increase in the Treasury’s balance at the Fed. The latter has had the effect of deferring part of the monetary boost from QE until the Treasury disburses the funds.

Secondly, purchases of government securities by commercial banks and money market funds, surprisingly, made the second largest contribution. This buying can be viewed in two ways. Market weakness in Q1 caused investors to switch into cash. Institutional money funds, in particular, experienced large inflows and invested excess liquidity in Treasury bills.

An alternative explanation is that banks and money funds – along with the Fed – are the buyers of last resort of Treasuries and agencies. There has been record issuance of both – $3.29 trillion of marketable Treasury securities in the 12 months to May and $505 billion of agency securities in the 12 months to March. With the household sector and foreign investors selling Treasuries / agencies, banks and money funds have been required to increase holdings despite record Fed absorption.

Thirdly, banks’ commercial and industrial (C&I) lending rose significantly but broad money growth would be above 20% even without this boost. Much of the lending was associated with the Paycheck Protection Program (PPP), which stood at $510 billion at end-May compared with a 12-month increase in C&I loans of $703 billion.

The contribution to the rise in money growth of the other counterparts, derived as a residual, was similar to that of C&I lending. This may partly reflect banking system lending to foreign entities to relieve a shortage of US dollars, including Fed lending via central bank liquidity swaps, which stood at $448 billion at end-May.

The figures for May 2021 in the right-hand column of the table represent speculative projections based on the following considerations.

The Fed’s contribution to broad money growth is likely to be much smaller but still significant over the coming 12 months. The June policy statement committed the Fed to increase its holdings of Treasuries and agencies at least at the current pace, i.e. $80 billion and $40 billion per month respectively. The projection assumes that purchases continue at this rate through December, implying totals of $560 billion of Treasuries and $280 billion of agencies.

The Treasury’s balance at the Fed stood at $1.33 trillion in late May and has since climbed further to more than $1.6 trillion. The projection assumes a fall to $500 billion in May 2021, still well above "normal" (it averaged $300 billion in 2019). The current high balance partly reflects pre-funding of PPP loan forgiveness, the bulk of which is likely to occur during H2 2020.

The net monetary impact of PPP loan forgiveness, assumed here to cover most of the program, will be neutral because the Treasury pay-out will be offset by a fall in commercial banks’ C&I lending – banks will, in effect, swap loans for reserves at the Fed. With excess reserves already high, this is unlikely to result in additional lending.

System-wide bank lending to firms, however, could be boosted by the Fed’s Main Street Lending Program (MSLP) and its Primary and Secondary Corporate Credit Facilities (CCFs), involving purchases of corporate bonds. The MSLP and CCFs have size limits of $650 billion and $750 billion respectively and will run until end-September. MSLP take-up and Fed CCF buying are uncertain: the table assumes a combined $500 billion, balancing the suggested fall in C&I loans.

Another entry subject to significant uncertainty is commercial bank and money market fund transactions in Treasuries and agencies. Economic and market normalisation might be expected to reverse recent inflows to banks and money funds, resulting in them selling securities. Treasury issuance, however, will remain high, possibly requiring additional absorption. Based on the CBO forecast of federal deficits of $3.7 trillion and $2.1 trillion respectively in fiscal years 2020 and 2021, the earlier assumption of Fed Treasury purchases of $560 billion in the year to May 2021 implies central bank coverage of perhaps only one-quarter of Treasury funding needs.

The residual counterparts are assumed to undershoot their contribution in the year to May 2019 to compensate for an overshoot over the past 12 months.

The projections, in combination, suggest broad money growth of about 10% in the 12 months to May 2021, consistent with the medium-term inflationary scenario outlined earlier. The individual assumptions can certainly be questioned, although the intention was to be conservative. The main takeaway from this exercise, however, is the difficulty of generating a forecast of monetary contraction to reverse the recent surge and support consensus inflation complacency.

*M2+ = M2 + large time deposits at commercial banks + institutional money funds. M2+ is the broadest available monthly measure. The old M3 measure, discontinued in 2006, also included repos and Eurodollar deposits – the Fed no longer releases monthly data on these.
**Conventional velocity, i.e. the ratio of nominal GDP to money, rather than “true” velocity, as defined in the quantity theory of wealth.

Recent posts on the “quantity theory of wealth” may have been heavy going, so what follows is an attempt to explain the approach more simply using charts of US data extending back over 100 years.

The starting point is the observation that the stock of broad money has risen by more than nominal GDP over the long term*.

There has, in other words, been a trend decline in the income velocity of money (nominal GDP divided by the money stock). Velocity fell at an average rate of 0.5% pa over 1913-2019.

If nominal GDP had risen line with broad money since 1913, its 2019 level would have been 79% higher.

What explains this divergence? The demand to hold money depends on wealth as well as income. In the same way that consumers and firms hold money in proportion to their income / spending transactions, owners of financial and real assets hold money in proportion to the size of their portfolios.

While nominal GDP has risen by less than broad money since 1913, wealth has risen by more**.

The quantity theory of wealth assumes that a 1% rise in nominal GDP has the same effect on the demand for money as a 1% rise in wealth. Further, a 1% rise in both leads to a 1% rise in money demand. These assumptions are reasonable and imply that the overall demand for money depends on the geometric average of nominal GDP and wealth (the square root of their product).

It works! The actual money stock has grown in line with the predicted level based on the combined nominal GDP and wealth measure.

Equivalently, actual nominal GDP and wealth, in combination, have grown in line with the prediction based on the money stock.

The difference between the combined nominal GDP and wealth measure and its prediction indicates whether current levels of economic activity and prices of goods, services and assets are “too high” or “too low” relative to the money stock.

The largest “overvaluations” occurred ahead of the 1929 stock market crash / Great Depression and during the 1990s tech bubble. The largest “undervaluations” occurred during the Depression and in the inflationary 1970s, with those lows being challenged now.

The last data point in the chart is based on the current level of the money stock and 2019 levels of nominal GDP and wealth. Wealth is little changed from end-2019 but nominal GDP is down sharply. The model suggests that the combined nominal GDP / wealth measure would be 18% “too low” relative to the money stock even with nominal GDP back at its 2019 level.

A return to “fair value” requires some combination of a fall in the money stock and rises in nominal GDP and wealth. If the money stock were to remain stable at its current level, and nominal GDP and wealth were to rise equally, the implied percentage increase in each would be 22% (a 22% rise would eliminate the 18% “undervaluation”). If nominal GDP were also to remain stable (i.e. returning to its 2019 level but no higher), the implied increase in wealth would be 48%.

The chart shows that movements away from “fair value” can take many years to be reversed – the valuation measure is of no use for short-term timing. The value of the approach lies in indicating whether the monetary backdrop will act as a headwind or tailwind for economic activity and prices – including asset prices – over the medium term. The current message is positive.

*”M2+” is defined here as M2 plus large time deposits and institutional money funds. The old M3 measure also included repos and Eurodollar deposits – the Fed no longer compiles monthly data on these.
**”Wealth” is defined here as the combined market value of the outstanding stocks of equities, bonds and residential real estate.

Global inflation is expected here to pick up significantly over the next 2-3 years. This would be consistent with the Kondratyev “long wave” price / inflation cycle, which implies a multi-year rise to a peak in the late 2020s, as well as current monetary trends – G7 annual broad money growth may have reached 16% in May, which would be the fastest since 1973.

How, though, can this forecast be squared with conventional models of the inflation process, emphasising labour market slack and the “output gap”?

The view here is that much of the current unemployment surge is temporary and will reverse swiftly as the global economy stages a V-shaped recovery. Of the 21.0 million US unemployed in May, 15.3 million or 73% were classified as temporarily laid off – rehiring of such workers accounted for the surprise drop in the aggregate jobless rate. “Permanent” unemployment rose but only to 3.6% of the labour force versus a recent low of 3.0% – see first chart.

Permanent unemployment is certain to increase further but is likely to peak well below levels reached after prior recessions. “Structural” unemployment, meanwhile, may rise because of demand shifts caused by the health crisis and deglobalisation. Labour market pressures, therefore, could emerge at an early stage of the coming economic upswing, wrong-footing analysts expecting a repeat of post-GFC experience.

A near-term inflation rise would probably be driven by a rebound in commodity prices as the global economy recovers strongly. Firms in industries suffering supply shortages would be able raise prices and profit margins, at least temporarily. Higher headline inflation coupled with rapidly falling unemployment could drive an early pick-up in wage demands – wage pressures depend on the rate of change as well as the level of labour market slack.

The forecast of a medium-term inflation upswing is predicated on continued monetary strength – plausible given monetary financing of fiscal deficits and official pressure on banks to boost lending to support economic growth. A reasonable judgement is that G7 broad money needs to – and will – expand at a high single digit pace, at least, through end-2021; for comparison, growth averaged only 3.7% pa over 2010-19.

A seven-factor checklist for assessing the relative attraction of emerging market equities is giving the most promising message since 2016. The table compares current judgements about the factors with the position in mid-2018, when commentaries here expressed caution about EM equities.

In addition to a favourable global monetary backdrop and improving economic prospects, EM equities are cheap, earnings estimates have held up better than in developed markets and commodity prices appear to have bottomed – see charts.

Surging US money growth, meanwhile, has quenched excess demand for US dollars, raising the prospect of a decline in the US currency – icing on the cake of a bullish EM scenario.

A much stronger monetary pick-up in the US than China explains a negative gap between E7 and G7 real money growth – the sole unfavourable checklist factor. The sign of the gap has correlated with EM relative performance on average historically but there is a case for downplaying the signal when money growth in the two groups is moving fast in the same direction. A similar set-up in 2009 – a joint surge but with the G7 leading – was associated with EM outperformance.

Within EM, markets that typically outperform in global economic upswings include Russia, Indonesia, Brazil and Korea. Money growth is strong in all four cases.

EM relative performance correlates directionally with the developed markets metals and mining price relative, with the latter often leading at bottoms and giving a positive signal currently – fourth chart.

Incoming monetary news remains strong, supporting the expectation here of a V-shaped global economic recovery accompanied by buoyant markets and an inflationary pick-up in 2021-22.

Sceptics argue that monetary growth has been weakly correlated with inflation in recent decades while velocity is in secular decline.

With respect to the former, monetary growth shapes the medium-term inflation path not short-term movements. The trend decline in broad money growth in the 1980s / 1990s and subsequent stability laid the foundation for sustained low inflation in the 2000s. The current monetary upsurge is unrivalled since the 1970s. Statistical results based on the period of relative monetary stability are unlikely to be reliable.

Regarding the velocity decline, this reflects the diversion of money into asset markets, as explained by the “quantity theory of wealth”. Economic pessimists expecting the velocity downtrend to accelerate fail to recognise that this would imply an asset price boom.

Most countries have now released April monetary data (the UK is late, as usual). Six-month growth rates of “global” (i.e. G7 plus E7) real narrow and broad money are estimated to have risen further to 9.6% and 8.1% respectively (not annualised), surpassing highs reached before the post-GFC economic rebound – see first chart.

The global money measures extend back to the 1990s. The second chart shows G7-only nominal money growth data over a much longer period. Annual broad money growth of 13.6% in April was the strongest since 1976 while narrow money growth of 16.1% marked a post-WW2 high.

The monetary upsurge has been led by the US but growth has also sky-rocketed in Australia, Canada, Sweden, Brazil, Russia and Korea with smaller but still significant increases elsewhere – third and fourth charts.

Weekly data suggest that US annual broad money (M2+) growth will reach 25% in May. On the conservative assumption that the money stock remains static from May, growth in 2020 would average 19%, exceeding a prior peacetime peak of 17.5% in 1881 during the Gilded Age economic boom – fifth chart.

The consensus forecast of weak nominal GDP prospects would imply an unprecedented rupture of the money / nominal GDP growth relationship shown in the chart.