Previous commentary suggested that equity market weakness in the late spring / early summer would prove temporary because the economic and liquidity environment remained benign. Three months on, historically-reliable indicators are still giving a positive message but are less favourable than earlier in 2013, consistent with a smaller fourth-quarter gain in markets – assuming no “shocks”.

The approach to forecasting the global economic cycle employed here relies on two key measures – real (i.e. inflation-adjusted) narrow money supply expansion and a longer leading indicator derived from OECD data. These measures lead global industrial output growth by about six months and both are currently at historically-respectable levels, although real money expansion has moderated slightly since the spring – see first chart.

The encouraging message is receiving confirmation from shorter leading indicators such as business and consumer surveys. The global manufacturing purchasing managers’ index, for example, reached its highest level since early 2011 in September, while consumer perceptions of labour market trends have improved, suggesting a faster fall in unemployment rates – second chart. This latter prospect is important because central bank policies are highly sensitive to labour market conditions.

The global economy, therefore, is on course to expand solidly at least through early 2014 – assuming no disruption from a US debt “crisis”. The liquidity environment, however, must remain favourable for economic progress to be reflected in equity market gains. A key global liquidity gauge is the gap between real money growth and industrial output expansion – a faster rise in real money than output may indicate that there is “excess” liquidity available to boost markets. This gap is still positive but has narrowed since early 2013 – first chart again.

The real money / output growth gap could close by early 2014 as industrial activity strengthens and / or real money expansion slows in lagged response to rises in market yields in 2013. The recent prolonged period of “excess” liquidity, in other words, may be approaching an end, cautioning against expecting equity markets to perform as well in 2014 as in 2013. The last liquidity “buy” signal occurred in September 2011, since when global equities have outperformed US dollar cash by 47%.

A change in the liquidity environment is more likely to be triggered in this way than by a shift in monetary policies. Falling unemployment is tilting central banks away from further easing but existing commitments imply a significant additional injection of cash into banking systems. Assuming that the Federal Reserve “tapers” to zero during the first half of 2014, the Bank of Japan (BoJ) adheres to its current plan and ECB actions are neutral, combined bank reserves in the big three developed economies will rise by about 40% by end-2014 – third chart.

The real money growth ranking across regions and countries can be used to inform investment allocation decisions. Previous commentaries questioned whether US equities would continue to outperform because US real money expansion had fallen back to around the global average; monetary trends in peripheral Eurozone markets and the UK, by contrast, had improved. The US underperformed international equities in the third quarter while peripheral markets rallied strongly. The UK beat the US and Japan, though lagged the rest of Europe – fourth chart.

Real money growth rates in the major economies are now bunched in a narrow range by recent historical standards, suggesting similar economic / liquidity environments and giving less reason to consider large active positions – fifth chart. UK real money expansion is modestly higher than the global average while Japan is lagging by a similar margin.
 

The relative weakness of Japanese monetary trends is, on the face of it, surprising given the current pace of BoJ securities purchases – twice as large, relative to the size of the economy, than those of the Fed. The increase in official buying, however, has been offset by stepped-up selling by banks, partly in response to the increase in their reserves, which has reduced the need to hold “safe” government securities – sixth chart. Inflation, meanwhile, has been boosted by yen weakness and is exerting a larger drag on real money expansion.


Bank bond sales may slow over coming months, allowing ongoing QE to have a larger impact on nominal monetary growth. A rise, however, is needed simply to offset the real money impact of a further inflation surge – albeit temporary – scheduled to arrive in spring 2014 when the sales tax is hiked from 5% to 8%. Caution on economic and market prospects, therefore, may be warranted, at least unless monetary trends improve significantly.

UK equities performed respectably in the third quarter but enjoyed less benefit than expected from robust monetary growth. This may partly reflect higher equity supply than in other markets, an influence that may persist near term. Domestic institutions, meanwhile, continue to direct the bulk of new inflows into bonds and overseas securities rather than UK equities. These drags argue against a large UK overweight.

Real money growth is almost the same in the core and peripheral Eurozone groupings but this conceals significant differences at the country level – the core / periphery distinction, in other words, has become less helpful. Greece and Ireland have moved to the top of the ranking, with the Netherlands bringing up the rear. France had been lagging but has improved sharply recently, with growth now on a par with Germany. Elsewhere in Europe, monetary trends remain favourable in Sweden but have weakened in Switzerland.

The last commentary noted that emerging E7 real money growth had recovered to match the G7 level, suggesting becoming less negative on emerging markets: the sign of the E7 / G7 gap has correlated with the relative performance of emerging equities in recent years – seventh chart. These markets kept pace with the US in the third quarter but underperformed international equities – fourth chart. The E7 / G7 real money growth gap is now positive, a condition that, if sustained, suggests adding to emerging equities.

Widely-ignored UK money supply measures predicted the current economic pick-up and suggest that growth will remain robust at least through the first quarter of 2014.

The “best” monetary measures for forecasting purposes are “non-financial” M1 and M4, i.e. excluding holdings of non-bank financial corporations*. Narrow money M1 comprises physical cash and sight deposits while the broader M4 aggregate adds time deposits and cash ISAs. M1 is a measure of money held for transactions purposes so tends to perform better as a leading indicator of the economy.

Annual growth in non-financial M1 and M4 rose substantially during 2012, clearly signalling a pick-up in economic expansion in 2013, allowing for a typical lead time of six months or so from monetary changes to demand and activity – see chart. M1 growth has continued to climb in recent months, with August’s reading of 11.0% the strongest since August 2004, before an economic boom**. M4 expansion, by contrast, has moderated to 4.8% from a peak of 5.6% in April, although remains higher than in any month between October 2008 and July 2012.

The M4 slowdown is currently of little concern because 1) it has been modest, 2) there has been no confirmation from M1 and 3) further analysis reveals that non-financial corporations have increased their foreign currency deposits significantly recently – such deposits are excluded from M4 but are probably relevant for assessing corporate liquidity and spending prospects***.

Consensus neglect of monetary signals partly reflects an obsession with bank credit. Credit has a much looser relationship than money with economic activity and tends, if anything, to lag the cycle. Annual non-financial M4 lending growth edged into positive territory in August for the first time since November 2011, consistent with a lagged response of credit demand to economic improvement – see chart. This pick-up should continue: arranged but unused sterling credit facilities – a leading indicator of lending – rose by an annual 1.5% in August, the fastest since February 2008.

The “monetarist” rule is that money supply changes affect economic activity in the short run but filter through to prices after about two years. The downside of recent monetary trends is that the current decline in inflation is likely to reverse from early 2014 in lagged response to the rise in money growth during 2012. The MPC may face a “crunch point” next spring as unemployment nears 7%, the housing market overheats and inflationary clouds darken.

*That is, comprising holdings of households and private non-financial corporations. The non-financial measures are not produced by the Bank of England but can be calculated from published data.
**Gross value added excluding oil and gas rose by 5.3% in the year to the fourth quarter of 2005.
***A wider aggregate including foreign currency deposits rose by an annual 5.6% in August.