The latest evidence suggests that the global economy is weak but has not tipped over into contraction. The monetary backdrop, meanwhile, continues to improve and inflationary pressures are easing, at least temporarily. Assuming that the eurocrisis can be contained – a big if but possible if the ECB eases policy and continues to support peripheral bond markets – global economic momentum should revive moving into 2012.

The US Institute for Supply Management (ISM) manufacturing new orders index is a timely gauge of US economic momentum and stabilised just below 50 in August – see following chart. This is well above the level historically associated with whole-economy recessions. According to the ISM website, “A PMI in excess of 42.5 percent, over a period of time, indicates that the overall economy, or gross domestic product (GDP), is generally expanding; below 42.5 percent, it is generally declining.”

PMI new orders correlate with the equity analyst “revisions ratio” – upgrades to company earnings forecasts minus downgrades divided by the total number of analyst estimates. The ratio has moved sideways so far in September, suggesting no further deterioration in the PMI.

The same indicators look much worse for the Eurozone – PMI new orders fell to 46 in August and earnings revisions are signalling a further decline. This weakness is consistent with a contraction in the real narrow money supply since late 2010 (discussed in numerous previous posts), suggesting an evens chance of a recession.

The key issue all year has been whether Eurozone weakness, compounded by the ECB’s misguided policy tightening for which departing chief economist Juergen Stark bears significant responsibility, would trigger a global “double dip”. G7 PMI orders were little changed in August, with the Eurozone fall offset by US / Japanese resilience. Korean earnings revisions have historically been a good indicator of global momentum – key companies are export-orientated in “early-cycle” industries – and have ticked up in early September.

The favourite global monetary leading indicator here, G7 six-month real narrow money expansion, is likely to have accelerated further in August, based on US and Japanese data. The US numbers have been boosted recently by technical factors but the credit backdrop is improving – US commercial bank loans grew by 5% annualised in the three months to August, led by a 9% gain in the commercial and industrial segment.

As discussed in previous posts, sustained global economic weakness would be highly unusual against the backdrop of narrow money strength. Another consideration arguing against a global recession is recent stability of housebuilding activity, albeit at a very low level. At least during the post-war period, an annual fall in G7 housing starts has been a necessary (but not sufficient) condition for a recession – starts were up marginally year-over-year in June and will be supported by post-earthquake rebuilding in Japan.

Note: The six-bear average, referenced in several posts over the last year or so, is a history-based “forecast” derived from the recovery path of US equities after the six twentieth-century bear markets that involved a fall in the Dow Industrials index of about 50%. (The Dow fell by 54% between October 2007 and March 2009.) At yesterday’s close of 11247, the Dow was 1% above the average, which falls to a low in late October before embarking on a year-long recovery – see first chart below. A post from May 2010 details the component bear markets and subsequent equity market performance. The last update was in early August.
Reader’s comment: It looks to me like the average in the next couple of months comprises one very positive outcome and five outcomes that are about 10% lower than where we are now. Which bear market is the really positive one? Is there any reason why we should not be looking at the average excluding that one? On this basis there would be significant short-term downside from here as the reality of slower economic recovery and growth gets fully discounted?

Answer: Many thanks for your interesting question. The positive outlier is the rise from the bear market low of June 1901 – the earliest of the six cycles included in the calculation of the average. A “five-bear average”, excluding this rise, is currently 7% lower than the six-bear version. Moreover, it falls to a bottom 14% below the current level of the Dow by late December, as the following chart shows.

To exclude the post-1901 rise from the calculation, however, would seem to me to be unscientific, displaying bearish bias. The six bears were chosen simply on the basis that, like the 2007-09 episode, they involved a fall in the Dow of about 50%. If I were to omit the post-1901 rise because it looks too bullish, should I not also exclude the most pessimistic of the six scenarios, for balance?

A further point, which was not evident in the original chart (above) but is in the one below, is that the post-1901 line switches from being well above the average to below it during the course of 2012. So the five-bear average ends next year above the six-bear version, and above the current level of the Dow.

Whether or not the post-1901 rise is included, therefore, the analysis suggests that buying now will yield a profit on a 12+ month view. The issue is the extent and duration of any further near-term weakness.

The outlook for the global economy and markets is multi-polar, depending on how the eurocrisis develops.

Without the crisis, economic momentum and risk assets would probably now be recovering in response to faster G7 real money expansion since the spring. Recent heightened fears of an imminent hard Greek default and associated funding difficulties faced by some European banks threaten to delay the expected revival until late 2011.

An immediate involuntary write-down of Greek sovereign debt, even if accompanied by measures to shore up bank capital and ensure continued access to funding (including for Greek banks), would represent a further negative “shock”, probably extending economic weakness into early 2012.

As a recent Citi report argues, however, by far the worst-case scenario would be a Greek default accompanied by exit from EMU, involving the redenomination of Greek bank liabilities from euros to new drachmas. This precedent would trigger huge capital flight from other peripheral banking systems, requiring a massive expansion of ECB support to avert collapse. Associated damage to global business and consumer confidence would probably be sufficient to trigger another recession.

The base-case view here, admittedly held with limited conviction, is that, while a large write-down of Greek sovereign debt will ultimately be required, the Greek government will delay initiating such action until the country’s primary deficit has been closed – unlikely before 2013 at the earliest. Official lenders to Greece, meanwhile, will prefer to tolerate non-compliance with fiscal targets and continue to advance funding providing that the government maintains the illusion of co-operation – most of the cash, after all, is being used to service debt held mainly by European financial institutions rather than to cover the Greek primary deficit.

The risk, of course, is that populist pressure either in Greece or “core” Eurozone countries overwhelms such rational considerations, resulting in an immediate withdrawal of funding and involuntary default.

The challenging task for the Eurozone authorities in the latter scenario would be to prevent a Greek default from spiralling into forced exit from EMU. A key requirement would be a plan to allow the ECB to continue to act as lender of last resort to the Greek banking system – the banks, for example, could be recapitalised by the EFSF / IMF with the ECB granted preferred creditor status in some form.

“Kicking the can down the road” is still the least worst option.

The Swiss National Bank’s recent liquidity injection has pushed global bank reserves – the amount of cash held by banks in their accounts with central banks – to a new record.

The first chart below is the regular presentation of G3 bank reserves amended to include Switzerland. G3 reserves have retreated from a high in early August but the fall has been more than offset by the Swiss injection.

Swiss reserves – i.e. sight deposits of domestic banks with the Swiss National Bank (SNB) – have surged from CHF29 billion at the start of August to CHF208 billion last week. Total sight deposits – including holdings of Swiss non-banks and foreign institutions – have risen from CHF33 billion to CHF253 billion over the same period. The CHF220 billion rise is equivalent to 39% of Swiss annual GDP.

The SNB last week committed to unlimited foreign exchange intervention to defend a 1.20 floor for the euro-Swiss franc exchange rate. Some market participants may regard 1.20 as an attractive level to acquire francs to hedge against EMU breaking apart, forcing the SNB to abandon the floor. Such inflows would further swell sight deposits, although the SNB could try to sterilise the impact via bill sales or repos / swaps.

The SNB’s actions should support Swiss asset prices. Swiss equities outperformed world markets after the central bank set a floor for the deutschemark-franc exchange rate in October 1978, even though the policy was successful in weakening the currency.

The SNB’s liquidity injection contrasts with a recent reduction in Bank of Japan reserves, which correlate negatively with the yen – second chart. Markets may continue to pressure the Japanese currency higher to force a Swiss-style policy U-turn.

A post in March signalled a slowdown in emerging economies that would relieve upward pressure on commodity prices. This slowdown is well under way – combined industrial output in seven large emerging economies (the “E7”) rose by only 1% in the six months to July versus a 7% gain in the prior half-year.

Commodity prices, meanwhile, have softened – the Journal of Commerce index of 18 industrial raw material prices is currently 7% below its level at end-March. The tight correlation between changes in E7 industrial output and commodity prices described in the earlier post has persisted.

The forecast of slower growth was based on real money trends and a leading indicator derived from the OECD’s country leading indices. Both remain soft but suggest that economic weakness will abate. Commodity prices, therefore, may stabilise or revive in late 2011, although a return to earlier strength is not yet signalled.

E7 six-month real narrow money growth has revived from a low in May but remains historically weak. The increase partly reflects a slowdown in inflation that should extend into late 2011 as food and energy price pressures abate. Lower inflation, in turn, should allow monetary policies to ease in some emerging economies.

The OECD-based leading indicator bottomed in April and has led six-month industrial output growth by between two and five months at the last four turning points, suggesting that economic momentum will revive from September at the latest. Caveat: the latest indicator reading is for July – it may suffer a setback in August because of financial market weakness.

A recent pick-up in the Baltic dry index of bulk freight rates could be an early sign that E7 industrial weakness and associated commodity price declines are approaching an end.