A case was previously made that a covid-driven Q2 collapse in global business investment marked the completion of the 7-11 year Juglar cycle, which last bottomed in Q2 2009. Available Q3 data, indicating a strong rebound, are consistent with this view, which implies that business capex will act as a tailwind for growth in 2021 and beyond.

A Q2 trough implies that the latest cycle reached the maximum 11 years, following a relatively short prior cycle of 7.25 years (i.e. Q1 2002-Q2 2009).

The Q3 bounceback is evident in hard data on capital goods output, orders and imports. US core capital goods orders moved above their pre-covid level in August. The Atlanta Fed’s nowcast model was forecasting a 4.9% annualised fall in equipment investment in Q3 at end-July but now projects 38.1% growth following a series of upside data surprises.

The consensus expected a Q2 profits collapse to weigh on investment but profits appear to be rebounding similarly strongly. Sceptics now suggest that Q3 capex was boosted by a temporary catch-up effect, with renewed weakness likely in Q4 and into 2021. This is not supported by forward-looking capex components of business surveys: a G7 composite measure rose further in September and is close to its long-run average – see first chart.Globally, China is leading the capex comeback. Manufacturing fixed asset investment returned to year-on-year growth in value terms in August on the back of a 19.1% surge in profits and solid enterprise money expansion – second chart. Business money growth is stronger in G7 economies.

The typical pattern is for business capex upswings to be financed initially from internal resources, with access to external credit increasing in importance as the cycle matures. Encouragingly, the September Cheung Kong Graduate School of Business monthly survey reported a further easing of credit conditions: the corporate financing index, which correlates with money growth, hit a 15-month high – third chart. The hope is that the next set of G7 quarterly bank loan officer surveys will show a similar reversal of credit tightening.

Business investment and employment decisions are closely related so the Juglar cycle turnaround is hopeful for labour market recuperation. The US Conference Board consumer survey for September reported a reduction in pessimism about job availability, suggesting that the “permanent” unemployment rate (i.e. excluding those classified as being on temporary layoff) was stable or fell last month – fourth chart.

The recent reversal in equity markets has been attributed to renewed pessimism about global economic prospects due to waning fiscal support, surging European virus cases and deadlocked UK-EU trade talks.

Investor concerns, according to this interpretation, were supported by mixed flash PMI results for September – in particular, a shock fall in the Eurozone services activity index to 47.5, a four-month low.

The Eurozone manufacturing survey, however, was notably stronger, while business expectations for the coming 12 months were the highest since February, improving in both manufacturing and services and across Germany, France and the rest of the euro area as a whole.

Globally, the flash results suggest that the manufacturing new orders index will have risen further in September, with inventories indices slipping back. The new orders / inventories differential – a widely watched indicator of cyclical direction – may reach its highest level since 2017. This manufacturing differential has tended to lead services activity historically – see first chart (which incorporates data through August only).

An alternative explanation for market weakness is that a strong economic rebound is reversing an earlier “excess” money boost to asset prices. The equities / cash switching rule followed here requires six-month growth of global real narrow money to be above that of industrial output in order to recommend holding equities. A previous post suggested that this differential, which reached a record in April, would turn negative in October.

The switching rule takes account of data reporting lags so an October cross-over would not generate a recommendation change until December. Reacting in real time would not have produced better performance historically.

Have this year’s unusual conditions resulted in heightened market sensitivity to monetary shifts, shortening the normal response time? The differential between three-month growth rates of real narrow money and industrial output turned negative in July – second chart. Again, using the three- rather than six-month growth differential for the switching rule would not have generated better performance historically.

If the excess money explanation is correct, the good news is that the recent reversal may already be tailing off. Monthly growth of global real narrow money has fallen back sharply but still averaged about 1% in July / August – third chart. Monthly growth in industrial output is likely to moderate to below this level in Q4 as the pre-covid peak is surpassed.

A further monetary slowdown would be concerning but also surprising given QE / rates support. Remaining countries will release August monetary numbers over the coming week, starting with the Eurozone tomorrow, while the US weekly report later today will give a read on mid-September.

Sectoral monetary details in the Fed’s Q2 financial accounts, released yesterday, strengthen the case for economic optimism.

The additional information in the quarterly financial accounts allows calculation of the M3 broad money measure, which the Fed discontinued in 2006. Annual M3 growth was 25.3% at end-Q2, a record in the 70+ year history of the financial accounts and above growth of the published M2 measure, of 22.9% in June – see first chart. (M3 additionally includes large time deposits, institutional money funds and security repos).

The encouraging new information in the report is that the monetary surge was distributed across sectors. As expected, money holdings of non-financial business grew most strongly as firms took advantage of the Paycheck Protection Program (PPP) and raised a record amount in bond markets. Annual household growth, however, was also a record, while growth of financial* holdings remained high – second chart.

Household M3 holdings are three times larger than those of non-financial business. Faster household growth has been the key driver of the M3 surge, accounting for two-thirds of aggregate M3 growth of 25.3% in the year to end-Q2. Household money holdings are likely to be in excess of underlying demand, suggesting a flow into consumer spending, housing investment and financial markets.

Correspondents claim that corporations have increased borrowing temporarily to boost precautionary money holdings and will repay debt as economic conditions normalise, causing M3 to contract. The significant household contribution to the M3 surge argues against a reversal scenario, as does the concentration of corporate borrowing in bond markets, suggesting semi-permanence. The rise in bank borrowing, moreover, was entirely due to PPP loans, most of which will be forgiven (with no negative impact on M3).

Another hopeful piece of news from the accounts is that the net financial position of nonfinancial corporations (i.e. outstanding liabilities net of assets) was little changed between end-Q4 and end-Q2, with the profits hit from the covid shock fully offset by cuts to fixed investment and inventories. The corporate “financing gap” – capital spending minus retained earnings – was slightly negative in Q2. A broader measure of financing requirements including borrowing for share retirement has fallen significantly below its long-run average as a share of GDP, suggesting a rebound in corporate spending – third chart.

 *Insurance companies, pension funds and GSEs.

Global industrial output may already have executed a perfect V. The G7 plus E7 aggregate calculated here plunged 17.7% from a December high to an April low but had retraced 87% of the decline by July. A further 2.3% rise is needed to regain the December level, which is likely by this month and may even have occurred in August, in which case each side of the V would have taken four months to complete. (Output rose in August in the US, China and Russia, while a jump in Japanese export volumes points to an increase there.)

The output rebound reflects an even stronger rise in consumer goods demand, which has traced out a reversed italic V. G7 plus E7 real retail sales reached a new record in June, rising slightly further in July (and probably August, based on US / Chinese results).

A restocking boost to output is now under way as companies attempt to reverse unanticipated inventory depletion due to demand resilience and lost production. The six-month change in US wholesale sales moved above the corresponding inventories change in July, echoing a crossover in May 2009 – second chart. Stockbuilding contributed 2.5 pp to US GDP growth over the four quarters to Q3 2010.

Industrial output momentum is moderating as the prior peak is reached but monetary trends suggest strength through Q2 2021, at least. G7 plus E7 six-month real narrow money growth appears to have reached a marginal new high in August, based on partial data – third chart. Base effects will ensure a fall from September but the usual nine-month lead implies no significant output slowdown until after May 2021.

Pessimists expect output to relapse as profits damage feeds through to capital spending weakness and job losses. Profits, however, are rebounding with output and business capex almost certainly bottomed in Q2: G7 capital goods output was up by 34.3% from an April low in July while the global manufacturing PMI investment goods new orders index hit a two-year high in August – fourth chart. A Q2 low was the latest compatible with the 7-11 year Juglar cycle, which previously troughed in Q2 2009.

The next surprise – following confirmation of a V recovery in profits and capex – could be the speed of recuperation of labour markets. The US “permanent” unemployment rate (i.e. excluding those classified as temporarily laid off) remains low by historical standards at 4.6% in August, consistent with Conference Board consumer survey results showing only moderate negativity about current labour market conditions and prospects – fifth chart.

The voluntary quit rate, meanwhile, has recovered surprisingly strongly from a January-April plunge – sixth chart. The quit rate, under normal conditions, is a gauge of alternative job opportunities and workers' ability to demand higher wages. Job openings have also rebounded.

A speculative hypothesis is that the covid shock has triggered a burst of entrepreneurial activity, which is speeding labour market adjustment and recovery. US business formations have surged, according to Census Bureau experimental data, including of entities assessed as having a high propensity to create jobs – seventh chart. UK new incorporations were also unusually high over June-August, according to Mobunti.

Cyclical equity sectors excluding tech have outperformed defensive sectors significantly since the March low in markets. Economic prospects and valuations suggest a further relative gain.

A start of year commentary expressed caution on cyclical assets because global monetary trends suggested lacklustre economic growth. Money measures were surging by end-March, warranting a shift to a positive view.

MSCI divides the 11 GICS equity market sectors into “cyclical” and “defensive” categories. The cyclical grouping includes the tech sectors of IT and communication services. These sectors have displayed economic sensitivity historically but recent performance has been driven by structural themes and covid. This suggests separating them out from the other cyclical sectors (i.e. materials, industrials, consumer discretionary, financials and real estate).

Since a 23 March low in the MSCI World index, cyclical sectors ex tech have rallied by 53.2% in US dollar terms versus a 58.3% rise in tech and only 35.9% in defensive sectors (consumer staples, health care, utilities and energy) – see first chart. The strongest individual sector over this period was consumer discretionary (which includes Amazon) with a 68.3% gain followed by materials and IT at 65.7% and 65.3% respectively.

The ratio of the cyclical ex tech and defensive sectors indices has fully retraced the February-April fall, reaching its highest level since November – second chart

This ratio correlates with global economic momentum and the stockbuilding cycle in particular. The third chart shows a comparison with the contribution of stockbuilding to the annual change in G7 GDP. Stockbuilding cycle lows are highlighted (green squares) along with nearby lows in the cyclical ex tech / defensive sectors ratio (black circles).

The lows in the ratio corresponding to the last six stockbuilding cycle lows were followed by rallies lasting between 18 and 25 months, i.e. until the next major peak in the ratio. With the current rally starting in March, this suggests no peak before September 2021 at the earliest. The path to the next peak, of course, could involve a significant correction.

The earliest cycle shown in the chart, i.e. associated with the stockbuilding cycle low in 1995, was the exception – the rally in the ratio reversed after only six months. This anomaly may reflect relative valuation: the ratio of the price to book of cyclical sectors ex tech to that of defensive sectors was unusually high in 1995 – fourth chart.

The current valuation ratio is unexceptional at 0.65. The peaks in the last six cycles ranged between 0.69 and 0.75, suggesting a further rerating of 5-14% from the current level.

The final chart also shows the ratio of price to books of cyclical ex tech sectors and tech. Low relative valuation of the other cyclical sectors and their sensitivity to changes in economic momentum could imply outperformance of tech as well as defensive sectors if the global boom scenario suggested by monetary trends plays out.

G7 annual broad money growth was little changed at 16.9% in June. Recent growth is the fastest since 1973 – the post-WW2 peak was 18.3% in November 1972. The average in the post-GFC decade (2010-19) was 3.7%.

The monetarist view is that the monetary surge in 2020 will be reflected in a bulge in nominal GDP growth and inflation in 2021-22 as the velocity of circulation normalises following an involuntary plunge caused by government restrictions on economic activity.

The magnitude of the inflation rise and the extent of a subsequent reversal will depend on how far and fast money growth falls back from the current extreme.

On reasonable assumptions about velocity and money growth, G7 inflation could average 4-5% in 2021-22, as explained below.

G7 broad money velocity (i.e. nominal GDP divided by the money stock) trended lower over 1964-2019 but the rate of decline increased between the two halves of this period – see first chart. A simple approach is to model velocity as a split time trend with a break at the mid-point of the period (i.e. end-1991). 

Actual velocity was close to this trend in Q4 2019 but the covid crash in nominal GDP resulted in a 19% undershoot in Q2 2020. The forecast below assumes that 1) velocity returns to trend and 2) the trend rate of decline remains constant (1.75% pa).

Multiplying the money stock by trend velocity generates an implied level of nominal GDP towards which the actual level, on the monetarist view, is likely to gravitate. The historical path of this implied level is shown in the second chart along with a projection based on broad money rising at a constant 4% annualised rate from its July level, i.e. close to the post-GFC average.

Assume now that actual nominal GDP converges with the implied level in Q4 2022. This would imply a 17% rise in nominal GDP from its pre-covid level in Q4 2019 in the three years to Q4 2022.

Real GDP is expected to return to its pre-covid level by early 2021 and may continue to grow strongly into 2022 but the cumulative rise over Q4 2019-Q4 2022 is unlikely to exceed 6%. A 17% increase in nominal GDP, therefore, could imply a 10-11% rise in prices, as measured by the GDP deflator, in the three years to Q4 2022.

Monetary changes usually take at least year to be reflected in prices so inflation is likely to remain low in H2 2020. The GDP deflator could rise by about 1% between Q4 2019 and Q4 2020. The suggested 10-11% increase in the three years to Q4 2022 would then imply a rise of 9-10% between Q4 2020 and Q4 2022, i.e. an inflation rate of 4-5% pa.

An unsatisfactory feature of the above analysis is the lack of an economic explanation for the falling trend in velocity. The rate of decline, in theory, could speed up, offsetting the inflationary impact of the 2020 monetary surge.
 
Such an explanation was provided in previous posts on the “quantity theory of wealth”. The demand to hold money depends on the level of wealth as well as nominal income. A rise in the wealth to income ratio explains most of the secular decline in velocity.

The empirical analysis also suggests a role for real government bond yields – the fall in real yields since the 1980s may explain the faster rate of decline of velocity in the second half of the 1964-2019 period noted earlier. (This is consistent with Keynes's "speculative" motive for holding money: “high” yields cause some investors to expect a fall and consequent capital gain, leading them to switch from money to bonds; conversely, “low” yields generate expectations of capital loss so increase money demand.)

The third chart compares actual G7 broad money velocity with the fitted values of a simple model based on these two factors, i.e. the G7 wealth to income ratio and 10-year real government bond yields. Like the split time trend model discussed earlier, this model suggests an unprecedented divergence between actual velocity and its “equilibrium” level.

Since real bond yields are unlikely to repeat their decline since the 1980s, the model implies a slowdown in the trend fall in velocity unless the wealth to income ratio rises even faster than in recent decades.