UK employment numbers this week were grim but had been foreshadowed by a drop in vacancies – a leading indicator – this spring.

Vacancies, however, have stabilised since the summer, suggesting that the labour market is stagnant rather than entering a new decline.
 
The earlier fall reflected public sector weakness as an increase in late 2010 and early 2011, partly related to temporary hires in connection with the recent census, unwound. Both private and public sector vacancies have been static recently.

Chinese monetary trends remain weak, indicating that the authorities need to loosen policy soon if the economy is to avoid a bumpy landing.

Real M1 was unchanged in the six months to September – unusual for an economy with a high trend growth rate. A similar stagnation in 2008 preceded a contraction in industrial output.

Real M2 looks a little better, with six-month growth recovering from a low in July, though still weak by historical standards.

The authorities are hanging tough because of sticky inflation, with consumer prices rising 6.1% in the year to September. The increase, however, slowed to 4.3% annualised in the latest three months, adjusted for seasonal factors.

The approach to forecasting the global economic cycle employed here places emphasis on two variables – the global real (narrow) money supply and a leading indicator derived by combining and transforming the OECD’s country leading indices.

Historically, global real money has led turning points in industrial output by about six months versus about three months for the OECD-based indicator.

The chart below shows the six-month rates of change of global (i.e. G7 plus emerging “E7”) output and real narrow money. Real money led at each of the four output momentum turning points since 2008, with no false signals. The lead times ranged from six to nine months, averaging 7.75.

The next chart superimposes the OECD-based leading indicator, which has a similarly good record with lead times of between two and five months, averaging 3.25.

A powerful signal is generated when the two indicators confirm a shift in direction, as they did positively in early 2009 and negatively in early 2011 (allowing for data reporting lags). Such signals have foreshadowed big changes in consensus expectations about the cycle and associated swings in risk assets.

The six-month change in real money remained positive during the latest downswing and has been moving up since May 2011. The OECD-based indicator, however, continued to fall through July – second chart. The Eurozone financial crisis, moreover, threatened to abort the upswing in the money measure, resulting in another “double negative” signal.

Thankfully, the latest data – for August – show a further recovery in global real money growth and a leveling off the OECD-based indicator, though at a very weak level. This stabilisation – if confirmed – is slightly ahead of schedule based on the bottoming out of real money expansion in May and an average lead of real money on the indicator of 4.5 months at the last four turning points.

September OECD leading index data, to be released in early November, therefore, will be key. A rise in the composite indicator from August would confirm the message from real money growth, giving a “double positive” signal – the last such signal occurred in August 2010 as the “QE2” rally was gathering steam.

With a possibility of further negative financial developments in the Eurozone, investors should await the data. The chart below shows that the OECD-based leading indicator usually turns before equities – the average lead on the six-month change in prices has been 2.25 months at the last four turning points. Confirmation of an August bottom in the indicator, therefore, would imply a recovery in equity market momentum from October or November.

Any hint of a bottoming and upturn in the global economic cycle could have an outsized positive impact on risk assets given depressed investor sentiment and an ongoing injection of liquidity by central banks. As shown below, aggregate bank reserves at the major central banks have risen by about $500 billion since equities topped in the spring, with UK QE2 scheduled to deliver a further $115 billion boost.

Following completion of the further £75 billion of gilt purchases announced last week, the UK’s QE operation will be 43% larger in relation to GDP than the US programme, and two and half times the size of Japan’s intervention in the early 2000s.

The additional £75 billion will lift the securities holdings of the asset purchase facility (APF) to £275 billion, or 18.3% of estimated 2011 GDP, up from 13.3% currently. For comparison, the Fed’s securities holdings have risen by $1,919 billion since 30 June 2007, before the financial crisis, equivalent to 12.8% of 2011 US GDP.

This comparison, moreover, ignores the longer average maturity of the UK holdings, implying a larger transfer of interest rate risk from the market to the central bank. The Fed expects the average maturity of its securities to rise from 75 months currently to about 100 months, or 8.3 years, following the completion of “operation twist”, involving sales of shorter-term Treasuries to finance buying of longer maturities. The average maturity of the APF’s holdings is more than 10 years currently and should be sustained by the additional purchases, which will be spread evenly between the 3-10 year, 10-25 year and over 25 year sectors.

For comparison, the Bank of Japan’s holdings of Japanese government securities rose by ¥36 trillion between 31 December 2000 and 31 December 2004, equivalent to 7.2% of Japanese GDP in 2004. The ECB, meanwhile, has bought €222 billion under its covered bond purchase and securities markets programmes, equal to 2.4% of 2011 GDP.

The larger scale of QE in the UK, even before the additional £75 billion, has contributed to solid growth of nominal GDP – 8.4% in the two years to the second quarter of 2011, the same as in the US and above a 5.9% increase in the Eurozone, with Japan contracting by 2.3%. The inflation / real GDP split, however, has been unfavourable – real GDP rose by only 2.8% over the two years versus 5.0% in the US, 3.8% in the Eurozone and 2.2% in Japan. The UK’s underperformance casts doubt on the Bank of England’s claim that QE1 had a larger impact on real GDP than prices.

Previous posts have argued that UK QE2 was unjustified because – in contrast to the position when QE1 was launched in early 2009 – current economic woes do not reflect a shortage of money. QE2 should prove more powerful than QE1 because the “transmission mechanism” has been partially restored by the financial recuperation of the last two years – questioning the view that the programme will need to be expanded significantly further. “Excess” liquidity created by the policy, however, may serve to buoy asset prices and – by suppressing sterling – sustain above-target inflation rather than provide a meaningful lift to economic activity.

Markets are concerned about a “hard landing” in China but a transformed version of the OECD’s leading index sustained its recent recovery in August, hinting at a stabilisation of industrial output momentum – see first chart. (The transformation yields an indicator that spots turning points earlier than the raw index.)

Largely reflecting the Chinese component, a composite “E7” indicator has also risen modestly, contrasting with further pronounced G7 weakness – second chart. This divergence is unlikely to be sustained. The E7 indicator has led at recent turning points, suggesting a turnaround in the G7 measure in September or October – also implied by stronger G7 real money growth since the spring.

The E7 / G7 deviation is mirrored in exaggerated form by Mexico and the US – third chart. Is the strength of the Mexican indicator signalling an imminent upshift in US economic momentum, as it did in late 2008 and early 2010, in addition to foreshadowing slowdowns in 2009 and late last year?