Eurozone monetary statistics for October are disappointing, showing a further decline in annual growth of narrow money M1 (from 6.2% to 4.9%) and continued sluggishness in the broader M3 measure.

Real (i.e. inflation-adjusted) M1 is the best monetary leading indicator of the economy and has stagnated over the last six months, signalling a sharp slowdown in Eurozone industrial output in early 2011 – see first chart. Recent buoyancy in business surveys is unlikely to last.

M3 grew an annual 1.0% in October. The counterparts analysis reveals mutual support operations by banks and governments last month – credit to general government rose by €165 billion, or 5%, while central governments increased their deposits and holdings of bank securities by €70 billion. Also notable was a €108 billion fall in banks' net external assets, consistent with non-bank residents moving funds out of the Eurozone area.

The slump in six-month real M1 growth contrasts with a strong pick-up in the US, suggesting that the US economy will outpace Euroland in early 2011 – second chart. With the US trend improving, G7 real M1 growth remains consistent with respectable global economic expansion. 

Monetary trends suggest that the global economy will grow at a respectable pace during the first half of 2011. The liquidity backdrop for markets remains unfavourable currently but may improve early next year.

The forecasting approach here places weight on the Friedmanite rule that movements in the real (i.e. inflation-adjusted) money supply lead the economy by about six months. Consistent with this rule, a slowdown in G7 industrial output growth from an annual 10% in May to about 5% currently was presaged by a fall in real narrow money expansion from 14% in August 2009 to 4% by early this year – see first chart.

Real money growth, however, has stabilised at 4% since early 2010 – above its long-term average and historically consistent with solid output expansion. As the chart shows, the five global recessions over the last 50 years were preceded by a contraction in real narrow money.

The liquidity backdrop for markets depends less on the level of real money growth than whether it is higher or lower than output expansion – a positive differential may imply that there is "excess" money available to drive up asset prices. Empirical evidence supports this approach: on average, world equities have outperformed cash by a substantial margin when the gap has been positive while underperforming at other times – see earlier post.

Real money growth fell beneath output expansion in early 2010 and remains lower currently, warranting a cautious stance on equities, which have trod water since the spring. The annual output rise, however, should slow further over coming months, partly reflecting base effects, suggesting that the gap will turn positive by early 2011 if real money expansion is stable – second chart. Near-term weakness in equity markets, therefore, could present a buying opportunity.

Revised figures confirm that GDP grew by 0.8% in the third quarter, with additional detail suggesting a further healthy gain in the current quarter.

Industrial production and services output both rose by 0.6% last quarter, with the increase in overall GDP boosted to 0.8% by a 4.0% rise in construction.

A monthly GDP estimate based on industry and services data stood 0.5% above its third-quarter average in September, implying significant positive carry-over into the current quarter – see chart. With further growth likely in these sectors, GDP should rise by at least 0.4% this quarter even if construction reverses its third-quarter increase.

The expenditure breakdown shows a surprise 0.4 percentage point contribution to GDP growth from net exports – this had not been suggested by monthly trade figures. It would be premature to infer that the economy is finally "rebalancing" in response to the lower exchange rate, since the improvement follows four successive quarters of deterioration.

Household spending rose by only 0.3%, reflecting an inflation squeeze on real employee compensation, while business investment fell by 0.2%. The latter, however, is at odds with encouraging survey evidence on capital spending and early estimates have been consistently revised higher in recent quarters.

Stockbuilding was modest, at 0.1% of GDP. Inventory levels remain much lower than before the recession, suggesting scope for a further rebuild that will contribute to future growth.

The price deflator for household spending – the broadest measure of consumer inflation – rose by 4.9% in the year to the third quarter, above both CPI inflation of 3.1% and a 4.7% gain in the RPI excluding mortgage interest payments. (The CPI understates inflation because it excludes some housing costs and uses geometric averaging to combine prices of individual items.)

Nominal or current-price GDP rose by 5.9% in the year to the third quarter. Growth needs to be constrained to about 4.5% per annum over the medium term to be consistent with the inflation target.