QE2 euphoria resulted in stocks, commodities and other "risk" assets performing strongly last quarter. However, our key indicator of global liquidity availability – the annual growth rate gap between G7 real narrow money and industrial output – remains negative, suggesting a cautious investment stance in early 2011.

The world economy expanded robustly in 2010, with the IMF's GDP measure rising by an estimated 4.8% – far above predictions of about 3% at the start of the year. Growth is likely to moderate in 2011 but rising inflation may force more widespread monetary policy tightening. Markets may struggle against this backdrop as the Fed's QE2 stimulus runs out.

Our liquidity indicator had given a "buy" signal for equities in late 2008 but turned negative in early 2010 as slowing G7 real money growth fell beneath surging output expansion. Equities subsequently corrected sharply and the EAFE index in US dollar terms was still down from its end-2009 level at the start of October. Markets reversed, however, as the Fed signalled a new QE initiative, following through with an announcement in November of a further net $600 billion of securities purchases to be completed by mid-2011.

On the latest full data, for October 2010, G7 real narrow money was up by 4% from a year earlier versus a 6% gain in industrial output. The gap has been narrowing as output expansion moderates and a positive cross-over is possible soon, assuming stable real money growth. The latter, however, could also fall as inflation picks up. Caution is warranted until a "buy" signal is confirmed – equities, historically, have sometimes weakened sharply in the final months of a negative liquidity environment.

A further reason for questioning the current bullish consensus is the historical pattern of recoveries after large bear markets. The Dow Industrials index fell by about 50% on six occasions during the last century. The nearby chart compares an average of the subsequent recoveries with the rally from the March 2009 trough, which followed a 54% decline. The "six-bear average" has proved a reasonable guide to recent performance and suggests that equities are entering a flat to weaker phase.

A key supportive factor for equities this year should be a further pick-up in M&A activity, which reached a nine-quarter high in dollar volume terms last quarter, according to Bloomberg. Corporate liquidity is plentiful and confidence is returning, as reflected in strengthening capital spending and recent signs of firming labour demand. Bank credit supply, however, could constrain large cash-financed deals.

GDP growth exceeded expectations in most developed and emerging economies last year but greater variation is likely in 2011. Monetary trends suggest solid US prospects (money growth was accelerating before QE2) but a sharp slowdown in the Eurozone, as the southern periphery stagnates. The emerging world is buoyant currently but overheating pressures and associated further monetary policy tightening promise a shift towards weakness later in the year.

Our regional / country allocation is informed by relative money supply growth, which was strong in Canada and the US and very weak in the EMU-periphery at the start of last quarter. The Canadian and US markets outperformed in common currency terms over the three months, though were beaten by Japan, while the Eurozone lagged badly.

Recent real narrow money trends are shown in the second accompanying chart. The US has improved further but Canada has fallen back to the middle of the ranking, with money growth now stronger in Australia. Other markets scoring well include Sweden and Switzerland. Monetary trends, meanwhile, have weakened further in Euroland while giving a neutral message in Japan and the UK.

The monetary pick-up in Australia suggests that this market is a potential "buy" but some caution is warranted given the strength of the currency, which has been boosted by recent commodity price gains and could correct if these subside as QE2 stimulus fades and emerging economies slow later in 2011.

While UK monetary trends are lacklustre, the market could benefit disproportionately from a further increase in global M&A while retail interest in equities is reviving. Discouragingly, however, UK institutions continued to sell domestic equities in the third quarter, a trend that may continue given a recent fall in their cash holdings.

Eurozone equities look cheap relative to other markets following last year's underperformance: the price to book of the region relative to the World index is at its lowest since 1996. With money supply weakness spreading from the periphery to core economies, however, and the ECB constrained by philosophy and above-target inflation from pursuing Fed-style QE, a reversal may be delayed.

The outperformance of the Japanese market last quarter reflected, as usual, foreign buying, which could continue in early 2011 as economic news improves. Monetary trends are unexciting but Japan is at no risk of inflation and policy settings will remain loose – a potential attraction in a year when many other countries could tighten.

Real narrow money growth remains generally strong in emerging economies but this may now be a hindrance rather than help to equities because of the implications for inflation and further policy restriction. With emerging markets, unusually, trading at a price to book premium to developed markets, and worries growing about a Chinese "hard landing", the consensus expectation of continued outperformance is questionable.


The recent sell-off in gilts would have been more severe but for heavy buying by banks and building societies, according to November monetary statistics released today.

Banks and building societies bought £10.0 billion of gilts in November, the largest amount since January 2009. The purchases offset sales of £5.7 billion by domestic non-bank investors, while overseas buying slowed to £3.3 billion, the smallest since June.

Despite the November fall, overseas investors have absorbed £50.6 billion of net gilt issuance of £107.8 billion in the first eight months of 2010-11, or 47%. With foreign demand probably now waning, further strong banking-sector buying is likely to be needed to avert a rise in gilt yields.

Large-scale November purchases may have partly reflected banks' surprise that the MPC failed to copy the Federal Reserve by launching QE2 that month. This would have boosted their cash reserves at the Bank of England, allowing them to meet their objective of raising liquid asset holdings without buying more gilts.

Monetary news within today's release was mixed, suggesting a slowdown in economic growth during the first half of 2011. The Bank's preferred broad money aggregate, M4ex, rose at a faster 3.5% annualised rate in the three months to November but has been boosted by a probably-temporary rise in securities dealers' deposits. Money holdings of private non-financial corporations fell over the latest three months, reducing annual growth to 2.6% from 5.1% in September. Narrow money, M1, also contracted, echoing weakness in the Eurozone.

A key concern is the squeeze on real money supply trends from rising inflation, with the CPI headline rate on course to exceed 4% in early 2011. The demand to hold money may simultaneously decline as real deposit interest rates fall deeper into negative territory but the net effect may be to constrain the economic recovery.

The inflation squeeze would be less intense had the MPC raised rates last summer; this would have boosted sterling, restraining import cost increases, while firing a shot across the bows of firms planning price hikes. Policy tightening is now urgently required; medium-term growth prospects will be much worse if the current inflation overshoot becomes entrenched.