UK monetary trends continue to support a positive view of economic prospects – the forecast here remains that GDP will rise by about 2% in 2013 versus a sub-1% consensus.

The monetary aggregates most relevant for assessing the immediate economic outlook are broad money M4 and narrow money M1 excluding holdings of financial corporations (i.e., comprising holdings of the household sector and non-financial corporations). Six-month growth of non-financial M1 rose to 5.6%, or 11.6% annualised, in April – the fastest since October 2005. Non-financial M4 has slowed modestly since early 2013 but six-month growth was still a solid 2.5%, or 5.1% annualised – higher than between June 2008 and July 2012.

Faster growth of M1 than M4 signals that the collapse in bank deposit interest rates since last summer is affecting consumer and business behaviour – the movement of money into more liquid forms is a likely precursor of a pick-up in spending.

Empirically, future economic activity is more closely related to real (i.e. inflation-adjusted) than nominal monetary trends. Real money expansion has been further boosted by a sharp, though probably temporary, drop in inflation – see charts. Recent real money trends suggest that growth prospects are at least as good as in mid-2009 – GDP is currently estimated to have risen by 2.4% in the year to the third quarter of 2010.

The consensus remains too negative on economic prospects partly because of continued credit weakness. While money leads the cycle, credit is a coincident or lagging indicator. There are signs, in any case, that the credit cycle is turning: M4 lending to households and non-financial corporations was unchanged in the six months to April while arranged but undrawn credit facilities – a leading indicator – are rising for the first time since 2007.

Eurozone monetary trends are signalling a return to growth over the remainder of 2013, with the periphery participating in the recovery during the second half – a development that would stun a bearish Keynesian consensus.

Eurozone-wide and country real (i.e. inflation-adjusted) narrow money trends have been an excellent guide to economic prospects in recent years, forewarning of the 2008-09 and 2011-12 recessions as well as widening core / periphery divergence. Eurozone real M1, however, resumed expansion in mid-2012 and is now growing solidly – by 3.1%, or 6.4% annualised, in the six months to April. Allowing for the usual half-year lead, this suggests a rise in Eurozone GDP / industrial output in the second quarter and faster growth during the second half – see first chart.

M1 comprises currency in circulation and overnight deposits – forms of money more likely to be related to economic transactions, explaining forecasting relevance. The ECB publishes a breakdown of overnight deposits by country of the receiving bank. The second chart shows the six-month change in real overnight deposits split between core and periphery (i.e. Italy, Spain, Greece, Portugal and Ireland). Peripheral contraction slowed during 2012 and deposits have surged in early 2013, partly reflecting a reversal of capital flight. Peripheral GDP should fall again in the second quarter but a second-half recovery may result in growth converging with the core by end-2013.

Economists who pay attention to the monetary data typically focus on broad money and credit so are likely to miss the positive message from narrow money. Real M3 has been an inferior leading indicator historically – it failed to warn of the 2008-09 recession – but is expanding modestly, consistent with economic recovery. Private-sector credit is a coincident or lagging indicator. Real loan contraction has slowed recently, consistent with a turning point in the economic cycle – first chart.

The pick-up in peripheral real narrow money has been led by Italy although Spain has also improved – third chart. Only Portugal is still contracting on a six-month basis. France moved into positive territory in April but continues to lag, as does the Netherlands. The core / periphery distinction, in other words, is becoming less relevant.

A recent post suggested reducing equity exposure on the grounds that monetary and leading indicator evidence has turned mixed, having been clearly positive in late 2012. This ambiguity is illustrated by two formal equity versus cash investment rules.

The first rule, discussed in several previous posts (e.g. here), invests 100% in global equities if G7 annual real narrow money growth is above industrial output expansion but holds 100% US dollar cash otherwise*.

The second rule is based on a G7 “double-lead” indicator derived here from OECD country leading index data. The rule invests 100% in equities unless the leading indicator suggests below-average economic growth.

The first chart compares the cumulative return relative to cash of the two rules with a buy-and-hold strategy. The “excess money” rule would have delivered an excess return averaging 3.6% per annum since 1970 relative to buy-and-hold. The leading indicator rule would have delivered 5.2% pa.

These returns are hypothetical because they are based on currently-available data. This is less of a problem for the excess money rule – annual real money and industrial output growth could have been calculated in real time and subsequent data revisions would probably have made little difference to the timing of cross-over signals. By contrast, the leading indicator series incorporates changes over the years in the construction and constituents of the OECD’s country leading indices. Data revisions to these indices, moreover, are sometimes significant. The historical return of the leading indicator rule, therefore, is unlikely to have been achievable in practice.

The two rules are now giving an opposite signal for the first time since August 2012. G7 real money growth remains above industrial output expansion on both an annual and six-month basis, although the surplus has fallen since late 2012. Accordingly, the excess money rule is still invested in equities.

By contrast, the G7 double-lead indicator fell marginally below its long-term average in March, causing the associated investment strategy to shift into cash – second chart.

Still-solid global real money growth raises the possibility that the weakness of the double-lead indicator will prove to be a false signal that is either revised away or reversed over coming months. Greater caution, however, may be warranted until the signals from the two approaches become realigned – either positively or negatively.

*A six-month lag is applied before buying equities after a positive cross-over.