Chinese money trends remain moderately favourable but the economy has been held back by covid disruption and now faces an export threat from global recession. Stocks, meanwhile, have been hit by a ramping up of the Biden administration’s war on Chinese tech along with President Xi’s take-over of economic policy-making, which investors have viewed as negative for longer-term growth prospects. “Excess” money has accumulated in the bond market and has the potential to flow into the economy and equities if the covid drag fades and policy-makers signal a continued commitment to private-led economic expansion. 

Six-month growth rates of nominal narrow and broad money have risen significantly over the past year, with the recovery reflected in a rebound in two-quarter nominal GDP expansion in Q3 despite further covid lockdowns – see chart 1. August / September numbers hint at a peak in money growth but continuing policy support, including directions to banks to expand lending, argues against a relapse – chart 2. 

Chart 1

Chart 2

The faster growth of money than GDP, and of broad money relative to narrow, indicates that the transmission of monetary stimulus is incomplete and “excess” money is currently trapped in the financial system. The key reason for the impaired transmission, of course, is the zero covid policy. With economic activity suppressed, excess money has flowed into the bond market, reflected in a fall in government yields despite the global surge and a tightening of onshore credit spreads – chart 3. 

Chart 3

The economy, nevertheless, has been less weak than many feared, as confirmed by the Q3 GDP number and September monthly activity data, showing a pick-up in industrial output and a stabilisation of new home sales – chart 4. A H1 fall in the interest rate on new mortgages and other easing measures are supporting housing market activity, with secondary sales reportedly growing strongly – chart 5. 

Chart 4

Chart 5

Retail sales remain weak but household money holdings are growing solidly, suggesting fire-power to lift spending if / when covid disruption eases – chart 6. 

Chart 6

Six-month growth of Chinese real narrow money contrasts with contractions in most major economies – chart 7. The level of growth, however, is modest by historical standards, suggesting moderate economic expansion at best: current growth, for example, has been consistent with a manufacturing PMI new orders index of about 50 – chart 8. 

Chart 7

Chart 8

Export weakness due to global recession could drag the PMI lower, as occurred during the GFC. The Chinese reading, however, would be expected to hold up relative to global PMI new orders, which may be heading to 40. 

The moderately positive message for economic prospects from real money trends is supported by a recent recovery in a composite leading indicator calculated here, which attempts to mirror the components of the OECD’s US leading indicator – chart 9. 

Chart 9

Eurozone money measures are giving mixed signals. Headline broad money M3 rose by a strong 0.7% in September, pushing six-month growth up to 3.3% (6.6% annualised), the highest since December. Narrow money M1, by contrast, contracted on the month, with six-month growth falling further to 1.8% (3.7% annualised) – see chart 1. 

Chart 1

Broad money reacceleration, on the face of it, suggests an economic recovery towards mid-2023 after a sharp winter recession. The judgement here, however, is that broad money numbers have been boosted by technical / temporary factors and intensifying narrow money weakness is a better representation of current monetary conditions and economic prospects. 

The six-month rate of change of real M3, it should be emphasised, remains negative, with consumer prices (ECB seasonally adjusted series) rising by an annualised 8.2% between March and September. 

The sectoral breakdown of the headline M3 / M1 numbers, moreover, shows a significant recent contribution from rising money holdings of financial institutions. This probably reflects cash-raising related to weak markets and is not an expansionary / inflationary signal for the economy. 

The forecasting approach here focuses on non-financial money measures where available, i.e. encompassing holdings of households and non-financial firms only. Six-month growth of non-financial M3 was 2.6% in September versus 3.3% for M3 and has shown a smaller recent recovery – chart 2. 

Chart 2

A further reason for playing down the broad money pick-up is that it is not explained by any of the conventional “credit counterparts” – credit to the private sector and government, net external assets and longer-term liabilities. The counterparts analysis shows a positive contribution from unspecified residual items, which behave erratically, suggesting a future reversal – chart 3. 

Chart 3

Solid growth of lending to the private sector has been the key driver of recent M3 expansion. The October bank lending survey, however, showed a further plunge in credit demand and supply balances, signalling a future lending slowdown or even contraction – chart 4. 

Chart 4

Statistical studies show that real non-financial M1 has the strongest leading indicator properties of the various money and lending measures. Its six-month rate of change remains at the bottom of the historical range, suggesting no economic recovery before H2 2023 – chart 5. 

Chart 5

A “monetarist” UK recession probability model used here signalled a 70% likelihood of a recession in 2022 back in March. Coincident data suggest that contraction began in the summer. The model now indicates that the recession will last through Q2 2023, at least. 

Monthly GDP figures have been affected by holiday distortions and are often revised significantly but current data show a peak in May and a 0.9% drop by August. 

Employment is a lagging indicator so further growth in the PAYE jobs measure (also subject to large revisions) through September does not preclude a recession having begun*. Job vacancies, by contrast, are coincident. The ONS vacancies series peaked in May, falling steadily through September. 

The published ONS series is a three-month moving average but single-month numbers are available on a non-seasonally-adjusted basis, to which an adjustment procedure can be applied. The resulting total vacancies series peaked in April, falling modestly through July before plunging in August / September– see chart 1. The suggestion is that economic conditions worsened sharply at the end of Q3. 

Chart 1

The decline in total vacancies reflects a larger fall in private sector openings, which were down by 13% in September from a May peak, offset by a further rise in the public sector driven by health and social care. 

The official vacancies numbers are from a survey of employers but the ONS also compiles weekly indices of online job adverts from data supplied by Adzuna. These indices have a short history and are not seasonally adjusted but the year-on-year change in total job adverts mirrors that of total vacancies – chart 2. 

Chart 2

Inputs to the recession probability model include real money measures, interest rates, credit spreads, share prices, house prices and the effective exchange rate – see previous post for more details. The model looks out three quarters and the probability estimate stood at 79% at end-Q3, suggesting that the economy will still be in recession in Q2 2023 – chart 3. 

Chart 3

House price strength was a moderating influence on the model reading until recently but coming weakness may contribute to the probability estimate remaining in recession territory. 

*The Labour Force Survey measure of employees in employment fell between May and July but recovered in August.

The “monetarist” rule of thumb that monetary changes feed through to prices with a lag of about two years suggests that G7 consumer price inflation will fall steeply from early 2023. 

G7 headline annual CPI inflation, as calculated here*, moved back up to 7.6% in September, just below a June high of 7.7%. 

A QE-driven surge in G7 annual broad money growth in 2020-21 was similar in magnitude to a bank lending-driven surge in the early 1970s. A peak in money growth in November 1972 was followed by an inflation peak exactly two years later – see chart 1. 

Chart 1

The 2020-21 money growth surge was largely complete by June 2020, although the final peak occurred in February 2021. The expectation here is that the June 2022 peak in CPI inflation will hold but the two-year norm suggests that a big fall will be delayed until after February 2023. 

Annual broad money growth collapsed from February 2021, falling much faster and further than after the 1972 peak. Then, money growth bottomed above 10% in 1975 and rebounded into 1976, remaining in double digits until 1980. Sustained strength allowed high inflation to become entrenched. 

Annual broad money growth is now below 4% (September estimate), with QT plans and a likely credit crunch suggesting further weakness. 

Money growth was relatively stable between 2013 and 2018, averaging 4.3% pa. CPI inflation averaged just 1.2% over 2015-20 (i.e. allowing for a two-year lag). Current monetary weakness suggests similar or lower inflation outturns in 2024. 

While headline probably peaked in June, core inflation continued to rise into September – chart 2. Core strength is feeding pessimism about inflation prospects, but shouldn’t. Contrary to popular mythology, core usually lags headline at turning points. Base effects boosted the G7 core annual rate over July-September but turn more favourable from October through next May (seasonally adjusted, the core index rose by an average 0.44% per month over October 2021-May 2022 versus 0.19% over July-September 2021). 

Chart 2

*GDP-weighted, Japanese September CPI estimated from Tokyo data.

Recent dramatic tightening of UK credit conditions along with Bank of England plans for large-scale QT and a “significant” rate hike could tip current weak broad money growth over into contraction, in turn threatening a deflationary depression. 

To recap, the preferred broad measure here – non-financial M4, comprising sterling money holdings of households and private non-financial firms – grew at an annualised rate of just 0.8% in the three months to August. 

The Bank’s broad measure, M4ex, also includes money holdings of financial institutions, which may rise sharply in September / October, reflecting pension funds’ “dash for cash”. Any such strength is not expansionary / inflationary, increasing the importance of focusing on non-financial money measures. 

In real terms, non-financial M4 has retraced almost back to its pre-pandemic trend as the 2020-21 money surge has passed through to prices – see chart 1. There is no longer a monetary “excess” to support spending or sustain high inflation. 

Chart 1

Current monetary weakness will take time to be reflected in slower price momentum. Prices may continue to outpace nominal money expansion near term, sustaining the real-terms squeeze. 

How likely is it that nominal broad money will begin to contract? 

The “credit counterparts” analysis links movements in broad money to changes in four other components of the banking system’s balance sheet: lending to the public and private sectors, net overseas assets and non-deposit funding. 

Lending to the public sector includes QE / QT. The Bank plans to reduce its gilt holdings by £80 billion over the next 12 months, equivalent to 3.4% of non-financial M4. 

The monetary drag will be smaller to the extent that there is a compensating rise in commercial banks’ gilt holdings. Banks bought £13 billion of gilts in the year to August. Purchases reached a maximum 12-month rate of £50 billion in the wake of the GFC when banks were under strong regulatory pressure to boost their liquid assets. A plausible scenario is that banks will absorb between a third and a half of the QT supply, in which case lending to the public sector would have a contractionary impact on broad money of 1.7-2.2% over the next 12 months. 

Bank lending to the private sector has been supporting broad money growth recently: lending to households and private non-financial firms expanded at a 3.1% annualised rate in the three months to August. The Bank’s Q3 credit conditions survey, released yesterday, signals weakness ahead: future credit demand balances remained soft while availability plunged – chart 2. 

Chart 2

The survey closed on 16 September so does not capture the further surge in market rates and spreads in the wake of the mini-Budget. 

Residential mortgages account for 70% of the stock of lending to households and non-financial firms. The future demand and availability balances for secured credit to households last quarter were comparable with the lows reached at the depths of the GFC – before recent turmoil. Mortgage approvals could halve – chart 3.

Chart 3

Bank lending expansion, therefore, could plausibly grind to a halt, as it did in the wake of the GFC. The combined monetary impact of public and private sector lending would then become contractionary.

The other credit counterparts – banks’ net overseas assets and their non-deposit funding – are volatile and difficult to forecast but have had a combined contractionary impact over the last 12 months. The joint influence, however, tends to correlate inversely with lending to the private sector, so could become supportive as lending weakens. 

The “best case” scenario appears to be weak broad money expansion with a significant risk of contraction. 

The warranted policy response is to cancel QT and rate hikes. The Bank, instead, has boxed itself into a restrictive stance in a misguided effort to rebuild its shattered credibility and avoid a charge of “fiscal dominance”. 

The hope is that a government U-turn on the mini-Budget together with an easing of global interest rate pressures result in a reversal of recent market-driven credit tightening. A Bank policy shift is coming but may have to wait for evidence of sharply contracting economic activity.

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.