US stocks have rallied recently despite equity analysts making more downgrades to 12-month-forward company earnings estimates than upgrades. The "revisions ratio" (i.e. the difference between the numbers of upgrades and downgrades in a particular period, divided by the total number of earnings estimates) correlates with business surveys; current weakness suggests that the ISM manufacturing new orders index will fall further to around the break-even 50 level, while remaining above the 45 threshold consistent with a "double dip" – see chart.

Public sector net borrowing exceeded expectations in August but this was roughly balanced by downward revisions to earlier months in 2010-11, reflecting lower central government current expenditure and a higher yield from the bank payroll tax (now estimated at £3.5 billion versus £2.5 billion in the June Budget). Borrowing remains on course to undershoot the OBR's full-year forecast of £149 billion by a significant margin.

Attempting to adjust for seasonal factors, borrowing excluding the temporary impact of financial interventions averaged £11.65 billion in the first five months of the fiscal year, or £140 billion annualised – see chart. The OBR forecast, therefore, implies renewed deterioration over the remainder of 2010-11.

This is unlikely because the benefits of economic recovery should grow as the year progresses while much of the £8.1 billion of spending cuts and tax rises announced since the election has yet to take effect. Even assuming no further decline in the underlying run rate, these measures should lower full-year borrowing to £136 billion or less.

The evolving undershoot increases doubts about the wisdom of the coming VAT hike (projected to raise £12.1 billion 2011-12), especially with consumers facing a large rise in food bills this winter – food commodity prices have continued to climb recently, with the CRB spot foodstuffs index in sterling terms now 11% above its August average.

Following its recent rally, the Dow Industrials index stands only 2% below the "six-bear average" path discussed in previous posts, based on recoveries after previous large US stock market declines – see chart.

A post in May speculated that tighter global liquidity would push the Dow, then trading in line with the average, into the lower half of the six-bear range, thereby presenting a buying opportunity. At the trough in early July, the index was 10% below the six-bear mean and only 1% above the bottom of the historical range.

Liquidity indicators have improved at the margin but have yet to turn positive, suggesting that the Dow will struggle to move above the six-bear average. G7 real M1 expansion is still well below industrial output growth in year-over-year terms but is close to converging on a six-month basis. The G7 monetary base has been moving sideways after falls in the spring and summer, with an increase possible if the Federal Reserve embarks on "QE2" and / or the Japanese authorities conduct further unsterilised currency intervention.

The six-bear average moves gradually higher over the remainder of 2010, finishing the year 6% above the Dow's closing level on Friday.

Combined industrial output in the G7 and seven large emerging economies (the "E7") moved above its pre-recession peak in July – see first chart. US and Chinese data suggest a further gain in August. Output fell by 14% between February 2008 and February 2009 and it has taken 17 months to recapture the loss – not quite a V-shaped recovery but close.

The heavy lifting, of course, has been performed by emerging economies, with the E7 contributing 9 percentage points of the 16% recovery in combined output from the February 2009 low – second chart. E7 output is 15% above its pre-recession peak and 1% higher than its log-linear trend since 2000 – a positive "output gap" is reflected in rising domestic inflationary pressures.

G7 plus E7 industrial output continues to track the path of G7 production during the mid 1970s recession and subsequent recovery – see previous post and third chart. (G7 output was a good proxy for global activity in the 1970s, when the E7 were much smaller and / or locked out of world trade.) This comparison suggests a significant near-term slowdown in growth but no "double dip" – a scenario consistent with recent monetary trends.

According to the CPI, clothing and footwear prices fell by 1.7% in the year to August. The alternative RPI clothing and footwear index, by contrast, rose by 6.3%. The difference is large enough to affect an assessment of economy-wide inflation – the headline 12-month CPI rise would have been 3.5-3.6% rather than 3.1% in August if the clothing and footwear component had matched the increase in the RPI measure.

The technical explanation for the difference is that the CPI uses geometric averaging to combine price movements of individual items, while the RPI uses arithmetic averaging. A non-technical explanation is that the CPI assumes that consumers are expert at shopping around for best value – so expert that they can obtain the same volume of clothing and footwear as a year ago while reducing their spending by 1.7%, despite a 6.3% rise in label prices.

This stretches credulity. If the same volume could be bought for 1.7% less, it would be reasonable to expect total cash spending on clothing and footwear to be little changed from a year ago. Retail sales figures, however, show a 6.4% rise in turnover in textile, clothing and footwear stores in the year to August. Based on the 1.7% CPI fall, this suggests an increase of 8.2% in the volume of purchases – implausible when overall consumer spending has been growing weakly.

While difficult to prove, the 6.4% rise in cash spending is likely to have been driven by higher unit costs rather than a surge in consumer demand for clothing and footwear. The 6.3% increase in the RPI clothing and footwear index, in other words, is probably a better reflection of consumers' experience than the 1.7% decline in the CPI measure, in turn implying that the headline CPI understates true cost of living inflation.  

Official intervention to weaken a currency is more likely to succeed when the exchange rate is overvalued relative to "fundamentals" and investor sentiment is at a bullish extreme, implying that opposing buyer power has been exhausted. These conditions do not apply to the yen currently, suggesting that massive, unsterilised intervention will be required to stem the currency's rise. A consequent large increase in the Japanese monetary base would improve prospects for global equities.

A possible further rise in the yen was flagged in a post in May, which argued that the currency was undervalued, in contrast to prevailing investor opinion. Subsequent appreciation has, apparently, hardened the consensus belief – a net 72% of fund managers now regard the yen as overvalued, a record high and up from 51% in May, according to Merrill Lynch.

Japan's real effective exchange rate, however, is close to its long-term average – see first chart. Japan's high real interest rates, moreover, justify the currency trading at a premium to a long-run competitive level – the implied future depreciation back to this level would then offset the interest advantage of holding yen. Japanese 10-year real yields are 2.0% versus 0.6% in the US, 1.2% in Germany and zero in the UK (using nominal government yields minus the current rate of harmonised CPI inflation).

Claims of yen overvaluation are also at odds with balance of payments trends, with Japan's surplus on the current account and net direct investment flows rising to 2.3% of GDP in the year to June from 0.3% in the previous 12 months – second chart.

With fundamentals supportive, and little evidence of a major overhang of long positions to be "shaken out", yen suppression is likely to require a prolonged campaign of large-scale, unsterilised intervention. Even this could prove fruitless, as recent Swiss experience shows. The attempt to weaken the yen, moreover, could create conflict with the US authorities, hastening the Federal Reserve's adoption of "QE2".

The "battle of the yen", therefore, could be the trigger for renewed central bank monetary base expansion, adding to the picture of an improving liquidity backdrop for markets and suggesting further strength in equities, commodities and other "risk" assets in late 2010.