Monetary trends and cycle analysis have been suggesting a cautious view of global economic and equity market prospects. An argument for remaining neutrally-positioned or overweight in equities and other risk assets at present runs as follows.

Major equity market declines historically were associated with US / global recessions. The US Treasury curve (10s-2s) inverted well before every recession since the mid 1950s but has yet to do so. The term premium, moreover, is unusually low, meaning that the flatness of the curve exaggerates monetary tightness. The curve, in other words, needs to become significantly negatively sloped to indicate a recession. Once this occurs, investors will have time to derisk portfolios before markets weaken.

This argument is dangerous for several reasons.

First, equity markets usually decline before / during economic slowdowns as well as recessions. Slowdown-related falls can often be severe, e.g. the 1966-67 US economic slowdown was associated with a 22% peak-to-trough decline in the S&P 500. Investors should dial down risk ahead of slowdowns as well as recessions, to the extent that either can be anticipated.

Secondly, the focus on the US yield curve may be misguided. The current global slowdown originated in China / Asia and has spilled over to Europe. The Chinese yield curve inverted in mid-2017 – see first chart.  It is possible that this will prove to have been the recession warning signal in this cycle, with the US curve lagging.

The last Asian-driven global economic slowdown was in 1997-98. It did not develop into a recession partly because of US / G7 monetary policy easing and partly because the region was a smaller part of the global economy. Asia ex Japan now accounts for 37% of world GDP at purchasing power parity, up from 19% in 1997, according to the IMF.

Thirdly, monetary trends argue against the view that the yield curve signal has been distorted by a low term premium. The slope of the G7 curve has been closely correlated historically with the six-month rate of change of G7 real narrow money – second chart. The two measures are giving an identical message at present – both suggest restrictive monetary conditions. If the term premium had introduced a distortion, one would expect real money growth to be diverging positively from the curve (assuming, reasonably, that the premium has little impact on money trends).

Fourthly, the argument that investors have time to adjust their portfolios after a yield curve inversion may be correct in principle but the relevant curve now may be China’s. The MSCI All Country World Index peaked in January 2018, eight months after the Chinese inversion.

The normalisation of the Chinese curve since mid-2017 suggests that China / Asia will lead a global economic recovery but Chinese money trends currently remain weak, arguing that any revival is unlikely until the second half of 2019 at the earliest.

The baseline view here is that the current global economic downswing will extend into the first half of 2019, and probably beyond mid-year. Incoming news is consistent with this scenario.

Near-complete monetary data for October confirm that G7 plus emerging E7 real narrow money growth fell to a new low  – see first chart. This suggests that six-month industrial output momentum is unlikely to reach a trough until around July 2019 at the earliest, based on the historical average nine-month lead time at turning points.

As an aside, G7 plus E7 real narrow money growth may have crossed back below industrial output growth in October, with partial data indicating a rebound in the latter – an October estimate is included in the chart. If confirmed, the first of the two equities / cash switching rules described in a previous post will move from equities to cash at end-December*.

Non-monetary leading indicators are signalling a near-term further economic slowdown. The OECD will release October data for its composite leading indicators on 10 December but most of the component information is already available, allowing an independent calculation. The G7 indicator is estimated to have fallen further in October, reflecting declines in all countries bar Japan (where weather-related disruption to activity and a subsequent recovery may have distorted recent readings) – second chart**. The indicators are designed to predict the direction of detrended GDP, i.e. a decline signals below-trend growth.

Previous posts argued that a downswing in the global stockbuilding cycle would act as a drag on growth in late 2018 and 2019. The cycle has averaged about 3.5 years, measured from trough to trough, and the last low is judged to have occurred in early 2016, implying that the next one could be reached in the second half of 2019. Global manufacturing PMI survey results for November support the view that the cycle is at or past a peak, with the finished goods stocks index close to the series high and diverging from weak new orders – third chart.

Stockbuilding cycle downswings in 2011-12 and 2015-16 were associated with significant global economic slowdowns. The current downswing may coincide next year with a downswing in the longer-term business investment cycle, which last troughed in 2009 and is scheduled to reach another low by 2020 at the latest. The risk of the current economic slowdown developing into a recession, in other words, is greater than in 2012 and 2016.

Global narrow money trends would need to weaken further for a recession to be adopted as the central case here. The six-month change in G7 plus E7 real narrow money turned negative ahead of the 2008-09 recession – first chart. It fell to 0.4% (not annualised) ahead of the milder 2001 recession. The October reading was 1.0%. A reasonable judgement is that a recession call would be warranted by a further fall to 0.5%.

As previously discussed, the recent collapse in the oil price will provide near-term support to real money growth by cutting headline inflation. The six-month change in G7 plus E7 consumer prices could fall by about 0.5 of a percentage point if commodity prices, as measured by the energy-heavy GSCI, are stable at current levels – fourth chart.  Six-month nominal narrow money expansion, therefore, might need to fall by a further 1 percentage point to push real growth down to 0.5%.

*The second rule, based on whether G7 annual real narrow money is above or below 3%, remains in cash currently. Its recommendation at end-December will depend on November monetary / inflation data to be released over the course of this month. Both rules were in cash during October.
**Of the G7 country indicators, only Canada’s includes a monetary aggregate.