Today’s stronger services purchasing managers’ survey for April is further evidence in favour of the “monetarist” forecast here of solid UK economic growth in 2013, reflecting the lagged impact of faster real money supply expansion.

Monetarist optimism contrasts with “creditist” pessimism, based on the idea that a pick-up in bank lending is a precondition of a stronger economy. This notion, however, is at odds with historical evidence that, while money leads the economic cycle, credit is a coincident or lagging indicator. In the US, the Conference Board includes bank business loans and consumer credit in its lagging economic index.

This lagging relationship suggests that bank lending will revive as growth continues to strengthen during 2013. There are already hopeful signs, such as a rise in sterling unused credit facilities in the six months to March,  the first such increase since 2007 – see chart. A credit pick-up, in turn, would provide additional support for monetary expansion.

The authorities, of course, will claim that a recovery in bank credit reflects the success of the funding for lending scheme and will try to argue that this recovery is driving a stronger economy, rather than vice versa.

The monetary foundations for a sustainable economic recovery have been laid. The Bank of England should avoid further policy experimentation and focus on achieving its inflation target while allowing banks to operate in a stable regulatory environment.

Emerging equities have continued to underperform developed markets so far in 2013 but relative monetary trends and valuations suggest an imminent turnaround.

The first chart shows the ratio of MSCI’s emerging equity markets index to its developed markets index – a rise in the line indicates that emerging equities are outperforming and vice versa. This ratio is compared with real (i.e. inflation-adjusted) money supply growth in the Group of Seven (G7) major countries and seven large emerging economies – the “E7”*.

Monetary strength signals favourable economic prospects and liquidity support for markets. The chart shows a relationship between the relative performance of emerging equities and the gap between E7 and G7 real money growth. The index ratio peaked in late 2010 as the gap narrowed sharply, turning negative in early 2011. The glory days of emerging equities in 2009-10 and before the financial crisis, by contrast, occurred against the backdrop of relative monetary buoyancy.

An update in February suggested remaining cautious on emerging markets because E7 real money growth, while improving, had not yet crossed above G7 expansion. Emerging equities have since underperformed by a further 7% but the awaited cross-over has now occurred, based on March money supply data. Monetary trends have strengthened in most of the E7 countries and there have been similar or larger gains in smaller emerging economies not included in the aggregate.

Emerging markets, meanwhile, appear inexpensive: the price to earnings ratio based on forecast earnings over the next 12 months is 10.1 versus 13.2 for developed markets, according to I/B/E/S – second chart. The 23% discount is the largest since 2006.

*The E7 is defined here as BRIC (Brazil, Russia, India, China) plus Korea, Mexico and Taiwan.

Better monetary trends from mid 2011 signalled the recent recovery in UK “underlying” economic growth. March monetary statistics suggest that this recovery will extend over the remainder of 2013.

Last week's post on the first-quarter GDP estimate contained a chart showing the quarterly change in “underlying” output, i.e. gross value added* excluding oil and gas production and adjusted for extra bank holidays and the Olympics. This quarterly change has risen from a low of -0.1% in the fourth quarter of 2011 to 0.0%, 0.1%, 0.2%, 0.2% and 0.3% in the first quarter of 2013. Far from “flatlining”, the economy has been gradually gaining momentum since late 2011.

The chart below shows the change in actual and underlying output over two rather than one quarters, comparing this with the six-month change in the real “Divisia”** money supply, including and excluding money holdings of financial institutions. Economic weakness in 2011 was foreshadowed by a contraction in the real money supply starting in mid 2010. The six-month change in real non-financial Divisia, however, turned positive in late 2011 and rose steadily during 2012, signalling an accelerating economic revival from mid 2012, allowing for the typical half-year lead of money to activity.

Six-month real Divisia growth has stabilised since late 2012 but at a level historically associated with solid output expansion. The message is that economic momentum will continue to build through late 2013 (at least). The view here remains that 2013 will be the best year for the economy since 2006.

*Gross value added = gross domestic product excluding indirect taxes and subsidies.
**The Divisia measure combines the components of the M4 broad money supply using liquidity weights based on interest rates.

Lofty global bond prices partly reflect expectations of a wave of Japanese buying prompted by Bank of Japan (BoJ) suppression of domestic yields. The Japanese, however, may never arrive.

Japanese investors remained net sellers of foreign bonds and notes in the week before last, as they have been in 11 of the last 12 weeks – see first chart.

The suggestion is that they are about to pile into overseas bonds to escape lower domestic yields and a weakening yen. The real trade-weighted yen, however, is near the bottom of its historical range, having fallen by more than 20% over the last 10 months – second chart. Risk-averse Japanese investors are unlikely to judge it a good time to raise their foreign currency exposure.

The yield pick-up for accepting such exposure, moreover, has declined. JGB yields of all maturities are higher now than at end-March, before the 4 April BoJ announcement of expanded QE. The five-year benchmark yield has climbed from 0.13% to 0.24%, delivering a 0.57% capital loss (i.e. four years of yield). With five-year yields falling in the US (and elsewhere), the US / Japanese spread is almost back to the low reached in summer 2012, in turn suggesting that dollar / yen has overshot – third chart.

Global bond markets are at risk from a liquidation of speculative long positions opened in anticipation of the arrival of “greater fool” Japanese buyers.