The MSCI World equity index closed yesterday at a new post-crisis high and is only 5.7% below the all-time peak reached in October 2007*. Recent solid performance is consistent with two investment rules followed here.

The first rule, discussed in numerous posts in recent years, switches between global equities and US dollar cash depending on whether the annual growth rate of the G7 real narrow money supply is above or below that of industrial output. The motivation is that “excess” money growth is usually associated with asset price inflation. This rule outperformed buying-and-holding equities by 3.6% per annum between 1969 and 2012. G7 real money growth is currently still above output expansion but the two series are converging, raising the possibility of another “turn defensive” signal within the next 12 months – see first chart.

The second rule, discussed in a post in May, switches between equities and cash depending on whether the G7 longer leading indicator followed here is above or below its long-run average. The indicator is derived from the OECD’s country leading indices and is designed to predict turning points in six-month industrial output growth. A cross of the indicator below the long-run average suggests sub-trend economic growth (or worse) – equities underperform cash on average during such episodes. This rule outperformed buying-and-holding equities by 5.3% per annum between 1969 and 2012. The second chart compares the cumulative return with that of the excess money investment rule.

These returns are hypothetical because they are based on currently-available data. This is less of a problem for the excess money rule – annual real money and industrial output growth could have been calculated in real time and subsequent data revisions would probably have made little difference to the timing of cross-over signals. By contrast, the leading indicator series incorporates changes over the years in the construction and constituents of the OECD’s country leading indices. Data revisions to these indices, moreover, are sometimes significant. The historical return of the leading indicator rule, therefore, is unlikely to have been achievable in practice.

The G7 longer leading indicator was above its long-run average in August but has fallen since May – third chart.

Both investment rules, therefore, currently still favour equities over cash but, if recent trends are sustained, may issue warning signals over the next 12 months. The rules, it should be noted, are designed to capture the bulk of gains during market upswings while limiting losses during downswings – they rarely mark the exact top of a bull run or bottom of a bear market.

*US dollar index. The return index including reinvested dividends is 11.4% above the October 2007 peak.

UK consumer price inflation was unchanged at 2.7% in September, while the “core” rate monitored here – which excludes energy, unprocessed food and undergraduate tuition fees – edged up from 2.0% to 2.1%. Headline inflation is forecast to moderate near term, averaging about 2.5% over the next six months, before rebounding to more than 3% later in 2014 in lagged response to faster monetary expansion in 2012-13 and associated economic strength – see first chart.

The expected near-term decline, despite another hike in household energy tariffs, reflects lower petrol costs, a likely slowdown in food inflation and an assumed dampening impact on other import prices from recent sterling appreciation. The rise in energy tariffs will be similar to last year so will have limited impact on headline inflation. An easing of food pressures, meanwhile, is suggested by recent declines in output price and input cost inflation in food manufacturing.

The forecast that inflation will trend higher during 2014 and early 2015 reflects the two-year leading relationship between monetary expansion and core price pressures – see previous post for more details. It incorporates a judgement that there is limited effective economic slack, so that solid growth will generate capacity strains and lift corporate pricing power. This is supported by the third-quarter British Chambers of Commerce survey released last week, showing that the proportions of firms in services and manufacturing working at full capacity are normal and high respectively – second chart.

Former MPC member David Blanchflower has accused the author of this journal of “crying wolf again” by forecasting that inflation will rise in 2014-15. The consistent view here in recent years has been that the stance of monetary policy was incompatible with returning inflation to the 2% target; this judgement has proved correct. The last forecast of a major inflation upswing was made in autumn 2010, ahead of a surge in the headline CPI rate to a peak of 5.2% in September 2011*.

*The forecast was that inflation would average 3.9% in 2011, which compared with Bank of England and consensus projections at the time of 2.8% and 2.6% respectively. The outturn was 4.5%.

Chinese September money numbers cast doubt on hopes that the economy is regaining momentum.

Six-month growth rates of real M1 and M2 fell last month and have declined significantly since spring 2013, towards levels reached during the 2011-12 “hard landing” scare – see chart. This suggests that economic expansion will slow in late 2013 / early 2014 unless exports pick up on the back of stronger global activity.

Six-month real money growth, moreover, is below that of industrial output, based on an August number for the latter*. There appears, in other words, to be no “excess” liquidity available to boost asset prices.

The fall in real money expansion in September partly reflected a food-driven rise in inflation – likely to reinforce an official bias against further monetary policy easing at present.

*A September figure is due this week.

Japanese monetary trends remain lacklustre despite ultra-aggressive QE. Six-month expansion of narrow money M1 slipped again in September while growth of broad M3 was stable. Bank lending* has also failed to accelerate – see first chart.

As previously explained, the muted response of monetary growth to QE partly reflects stepped-up sales of government securities by banks, which have offset the Bank of Japan’s purchases. Holdings of such securities by domestically licensed banks** fell by ¥24.6 trillion between March and August (the latest available month) versus an increase of ¥38.0 trillion at the BoJ over the same period.

Monetary growth is weaker in real terms because of a pick-up in inflation, mainly due to the weaker yen. The six-month change in real M1 in September was the lowest since July 2012, while that of real bank lending turned negative in August – second chart. Real narrow money expansion is lower in Japan than in other major economies – third chart.

Real money growth, of course, will be squeezed further by the April 2014 sales tax rise from 5% to 8% – expected to boost consumer prices by about 2.5%.

The optimistic scenario is that banks will stop selling government securities, allowing ongoing QE to boost nominal money growth substantially before the tax hike hits. There is some support for this scenario in statistics showing a sharp slowdown in the rate of decline of their holdings in July and August*. The September monetary data, nonetheless, were disappointing. The assessment here of Japanese economic prospects will remain cautious until monetary trends improve significantly.

*The lending series in the chart adjusts for special factors, data for which are available only up to August.
**This category is a sub-set of the banking sector, which also includes Japan Post, among other institutions.
***Banks’ holdings fell by only ¥1.0 trillion July / August versus a ¥23.6 trillion reduction during the second quarter.

Leading indicators followed here suggest that the global economy will expand respectably through early 2014 (at least), a message supported by monetary trends.

The global leading indicators are derived from the OECD’s country leading indices, which combine information on economic and financial series that tend to move ahead of demand and output. The composition of the indices differs by country; the US index, for example, includes business and consumer survey responses, housing starts, new orders, weekly hours, share prices and the yield curve.

The OECD country-level data are aggregated and transformed to produce short- and longer-term leading indicators that have led turning points in global industrial output growth by an average of three and five months respectively in recent years.

The short-term leading indicator rose slightly for a second month in August, suggesting a modest pick-up in output expansion into late 2013. The longer-term measure, however, eased back after a recent gain, consistent with growth levelling off around year-end – see first chart.

The small decline in the longer-term indicator follows a reduction in global real narrow money expansion in June / July – monetary trends lead the economy by about six months, according to the “monetarist” rule. Real money growth, however, partially reversed this decline in August and remains historically solid – second chart. Monetary trends, in other words, are consistent with continued if moderate economic expansion through early 2014.

The emerging E7 component of the global longer-term leading indicator has risen recently, while the G7 component has declined – third chart. This coincides with a significant downgrade in the IMF’s growth forecast for emerging economies – the IMF always reflects the consensus view so is often a good contrarian indicator. These signals suggest adding to emerging market equities if forthcoming monetary data confirm that E7 real money growth has moved above the G7 level.

Peripheral Eurozone equity markets* rose by only 1.5% during 2012 versus a 13.2% gain for the MSCI World index. So far this year, they are up by 15.6% versus a 13.8% increase in the global index. This turnaround reflects better monetary trends and an associated improvement in economic prospects.

The first chart shows year-to-date price performance of various markets relative to MSCI World. Peripheral markets were weak during the first half but have surged since mid-July. They are now ahead of core markets and closing in on the US and Japan; the UK and emerging markets have underperformed, as have Canada and Australia.

The rebound follows a recovery in monetary trends. The six-month change in real narrow money in the periphery was still negative in December 2012 but had risen to the top of the global ranking by April 2013 – second chart. The turnaround reflects ECB support for peripheral economies since late 2011 in the form of rate cuts, long-term liquidity operations and the "outright monetary transactions" (OMT) programme – these measures have restored confidence, causing capital flight to reverse and increasing the demand to hold narrow money as spending intentions revive.

Will outperformance continue? The recent surge has probably been driven by underweight investors covering their positions. This process could extend further but six-month real money growth in the periphery has moderated since April and is now in the middle of the global pack – second chart.

The strong rebound in peripheral equities may offer a cautionary message to investors expecting further weakness in emerging markets: surveys indicate that these markets are significantly underowned, while emerging E7 monetary trends have improved since late 2012 – second chart.
 
*Spain, Italy, Ireland, Portugal and Greece, weighted by market capitalisation.