The recent reversal in equity markets has been attributed to renewed pessimism about global economic prospects due to waning fiscal support, surging European virus cases and deadlocked UK-EU trade talks.

Investor concerns, according to this interpretation, were supported by mixed flash PMI results for September – in particular, a shock fall in the Eurozone services activity index to 47.5, a four-month low.

The Eurozone manufacturing survey, however, was notably stronger, while business expectations for the coming 12 months were the highest since February, improving in both manufacturing and services and across Germany, France and the rest of the euro area as a whole.

Globally, the flash results suggest that the manufacturing new orders index will have risen further in September, with inventories indices slipping back. The new orders / inventories differential – a widely watched indicator of cyclical direction – may reach its highest level since 2017. This manufacturing differential has tended to lead services activity historically – see first chart (which incorporates data through August only).

An alternative explanation for market weakness is that a strong economic rebound is reversing an earlier “excess” money boost to asset prices. The equities / cash switching rule followed here requires six-month growth of global real narrow money to be above that of industrial output in order to recommend holding equities. A previous post suggested that this differential, which reached a record in April, would turn negative in October.

The switching rule takes account of data reporting lags so an October cross-over would not generate a recommendation change until December. Reacting in real time would not have produced better performance historically.

Have this year’s unusual conditions resulted in heightened market sensitivity to monetary shifts, shortening the normal response time? The differential between three-month growth rates of real narrow money and industrial output turned negative in July – second chart. Again, using the three- rather than six-month growth differential for the switching rule would not have generated better performance historically.

If the excess money explanation is correct, the good news is that the recent reversal may already be tailing off. Monthly growth of global real narrow money has fallen back sharply but still averaged about 1% in July / August – third chart. Monthly growth in industrial output is likely to moderate to below this level in Q4 as the pre-covid peak is surpassed.

A further monetary slowdown would be concerning but also surprising given QE / rates support. Remaining countries will release August monetary numbers over the coming week, starting with the Eurozone tomorrow, while the US weekly report later today will give a read on mid-September.

Sectoral monetary details in the Fed’s Q2 financial accounts, released yesterday, strengthen the case for economic optimism.

The additional information in the quarterly financial accounts allows calculation of the M3 broad money measure, which the Fed discontinued in 2006. Annual M3 growth was 25.3% at end-Q2, a record in the 70+ year history of the financial accounts and above growth of the published M2 measure, of 22.9% in June – see first chart. (M3 additionally includes large time deposits, institutional money funds and security repos).

The encouraging new information in the report is that the monetary surge was distributed across sectors. As expected, money holdings of non-financial business grew most strongly as firms took advantage of the Paycheck Protection Program (PPP) and raised a record amount in bond markets. Annual household growth, however, was also a record, while growth of financial* holdings remained high – second chart.

Household M3 holdings are three times larger than those of non-financial business. Faster household growth has been the key driver of the M3 surge, accounting for two-thirds of aggregate M3 growth of 25.3% in the year to end-Q2. Household money holdings are likely to be in excess of underlying demand, suggesting a flow into consumer spending, housing investment and financial markets.

Correspondents claim that corporations have increased borrowing temporarily to boost precautionary money holdings and will repay debt as economic conditions normalise, causing M3 to contract. The significant household contribution to the M3 surge argues against a reversal scenario, as does the concentration of corporate borrowing in bond markets, suggesting semi-permanence. The rise in bank borrowing, moreover, was entirely due to PPP loans, most of which will be forgiven (with no negative impact on M3).

Another hopeful piece of news from the accounts is that the net financial position of nonfinancial corporations (i.e. outstanding liabilities net of assets) was little changed between end-Q4 and end-Q2, with the profits hit from the covid shock fully offset by cuts to fixed investment and inventories. The corporate “financing gap” – capital spending minus retained earnings – was slightly negative in Q2. A broader measure of financing requirements including borrowing for share retirement has fallen significantly below its long-run average as a share of GDP, suggesting a rebound in corporate spending – third chart.

 *Insurance companies, pension funds and GSEs.