The forecasting approach employed here continues to give a positive signal for global economic growth in the first half of 2013 but equities and other risk assets may already have largely discounted this outlook.

The approach relies on three key indicators of the global economic cycle:

• Global real narrow money growth, which leads industrial output expansion by an average of six months (based on a comparison of turning points in recent cycles).

• A composite leading indicator derived from the OECD’s country leading indices, with an average three-month lead.

• A “leading indicator of the leading indicator”, designed to give earlier warning of turning points, with an average five-month lead.

As discussed in previous posts, all three indicators have picked up since spring 2012 and are currently at a level historically consistent with solid global economic expansion.

Market performance, however, appears to be related to the direction of change of the indicators rather than their level. All three were moving lower before the 13% correction in world equities in spring 2012 (as measured by the MSCI World index in US dollars). The “double-lead” indicator turned up in May last year, followed by real money growth in June and the leading indicator itself in July. This warranted optimism about equity market prospects, particularly given depressed investor sentiment at the time.

Directionally, global real narrow money growth and the leading indicator are still giving a positive signal but the double-lead measure is flashing amber, declining in the latest two months – see Monday’s post for details. This ambiguity may warrant more conservative portfolio positioning, particularly with investors now relatively bullish – the Credit Suisse risk appetite measure is well above average while fund managers are holding the least cash since April 2011, according to Merrill Lynch.

Global six-month real money expansion appears to have risen further in December, based on data for 60% of the components – see chart. The recent divergence with the double-lead indicator is unlikely to persist; it will be resolved either by real money growth turning down or the indicator rebounding. This will determine whether the next shift in market view here will be towards greater caution or renewed optimism.

A 9.5% (not annualised) plunge in Japanese industrial production between March and September 2012 reflected both a fall in exports due to global weakness and a strong yen and softer domestic demand. Downside risk had been signalled by a sharp slowdown in narrow money, M1, expansion in late 2011 / early 2012 – see first chart.

Six-month M1 growth, however, bottomed in May 2012 and has since recovered strongly. The broader aggregates are now giving a confirming positive signal – six-month M2 and M3 expansion rose to a 10-year high in December. Combined with a 14% depreciation of the trade-weighted yen since July, this suggests much better economic data in early 2013. The snap-back in the latest economy-watchers’ survey may be an early taster – second chart.

Against this backdrop, it is far from clear that a further expansion of the Bank of Japan’s asset purchase program (APP) is either necessary or desirable. Current APP plans already imply securities purchases of ¥36 trillion, or about $400 billion, during 2013. The central bank should aim for stable monetary growth above the average in recent years, avoiding surges and inevitable relapses that increase economic volatility.

The latest fiscal "stimulus", meanwhile, is a throwback to the failed packages of the 1990s and 2000s, which had no lasting impact save to trash the government’s balance sheet.

Fiscal expansionism and the removal of the last vestiges of central bank independence risk wrecking a promising economic outlook by raising the spectre of uncontrolled inflation, thereby putting upward pressure on bond yields and tipping Japan into a debt trap as interest servicing costs spiral. Equities may initially climb further as the BoJ injects liquidity but the current policy shift warrants increased caution, not optimism, about medium-term prospects.

CPI inflation was unchanged at an annual 2.7% in December, though was flattered by an erratic-looking slowdown in air fares – this subtracted 0.1 of a percentage point and should reverse next month.

The forecast here remains for CPI inflation to move up to 3.0% in early 2013 and fluctuate around this level for the remainder of the year – the first chart shows a possible profile. The goods component is likely to drive the pick-up, a suggestion supported by recent stronger industrial price-raising plans – second chart.

Producer price figures for home-grown food suggest a further rise in CPI fresh food inflation, although a 2008-style surge is not in prospect – third chart.

The forecast inflation profile is judged here to be conservative since it assumes limited upward pressure on global wholesale energy prices, which could be pushed higher by stronger economic growth and / or geopolitical events.

Gilt market RPI inflation expectations have shot up following the National Statistician’s decision last week to retain the existing calculation method for the index – fourth chart. Implied inflation in five years’ time is now 3.1%, the highest since June 2011, according to the Bank of England.

Future RPI inflation of 3% plus is unlikely to be compatible with on-target CPI inflation – the “formula effect” gap between CPI and RPI inflation is currently -0.85% and may narrow as the Office for National Statistics implements smaller methodological changes, such as improved collection of clothing prices. A similar level of market-implied inflation in early 2011 probably contributed to the MPC’s hawkish bias at the time: three members – Dale, Sentance and Weale – voted to raise Bank rate in the four months from February to May 2011.

The OECD’s leading indicator indices continue to signal a stronger global economy in early 2013. There is a hint in the latest data that the pick-up will lose momentum in the spring but the bias here is to play this down, since it is at odds with a further rise in global real money supply growth at end-2012.

The OECD’s leading indicators are a useful forecasting tool but it is necessary to transform the raw data and ignore the OECD’s own commentary in order to obtain maximum value. When August figures were released in October, for example, the OECD opined that “most major economies will continue to see weakening growth in the coming quarters”. Yet a global indicator calculated here rose for a second consecutive month in August, clearly signalling an improving outlook – see previous post. Recognition of this improvement contributed to the strength of equities and other risk assets in late 2012.

The OECD has, belatedly, become less downbeat, stating today that November results show signs of a stabilising global economic outlook. The numbers, in fact, suggest solid growth in early 2013: the transformed leading indicator, which leads global industrial expansion by three months on average, continued to climb and is now at a robust level by historical standards – see first chart.

The data can be tortured further to yield a longer-range forecasting measure, termed here the “leading indicator of the leading indicator”, which signals growth turning points by an average five months. In contrast to the standard indicator, this edged lower in both October and November – second chart. The suggestion is that the growth pick-up will tail off in the spring, although the “double-lead” indicator has yet to signal material weakness.

Turning points in this longer-range indicator, however, usually follow or coincide with peaks or troughs in global six-month real narrow money expansion – the primary forecasting tool employed here. This remained robust in November – third chart – and early indications are that it rose further in December, reflecting US strength. A positive cyclical view will be maintained until global real money growth peaks.