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Quarterly Liquidity Insights - Q1/2019

The monetary forecasting approach followed here suggested that global economic momentum would continue to weaken through the first half of 2019. Incoming news has supported the scenario but equity markets have rallied strongly, partly reflecting an inflation-driven improvement in the monetary backdrop. We doubt that this will be sustained and expect further weak data to undermine investor hopes of an early economic recovery.

The forecasting process relies on the empirical rule that turning points in real (i.e. inflation-adjusted) money momentum lead turning points in economic momentum, on average by about nine months. The narrow M1 aggregate – comprising currency in circulation and demand or overnight deposits – has provided more reliable signals historically than broader money measures. Global* six-month real narrow money growth reached a 10-year low in October 2018, recovering through February 2019. The October low suggested that a low in economic momentum was unlikely to be reached until around July 2019. Consistent with the forecast, six-month industrial output expansion fell further through February 2019 – see first chart.

Chart 1: G7 + E7 Industrial Output and Real Money (% 6M)

Chart of G7 + E7 Industrial Output and Real Money (%6M)

Why, then, have equity markets rallied? The economic slowdown has fed through to earnings forecasts – the IBES consensus estimate for MSCI All Country World EPS in 2019 was cut by 5.1% between December and March – but the impact on equity prices has been more than offset by a fall in the discount rate as risk-free real yields have tumbled. We attribute this partly to the Fed’s policy U-turn and partly to the recovery in global real money momentum between October and February, which resulted in our two “excess” money indicators turning positive**. Excess money is associated with excess demand for financial assets at their prevailing prices, and consequent upward pressure on those prices (and downward pressure on yields).

We expect the economic/earnings backdrop for equity markets to remain challenging. As noted, money trends suggest a further weakening of global economic momentum through around July 2019. The recovery in real money growth between October 2018 and February 2019, moreover, was modest and was partially reversed in March: the March level was below the range over 2009-17 – first chart. The October-February increase mainly reflected a fall in consumer price inflation as weakness in oil and other commodity prices in late 2018 fed through into headline indices; with oil prices recovering in early 2019, this favourable inflation effect is now unwinding. Hopes of a significant bounce-back in global economic expansion during the second half of the year, therefore, are likely to be disappointed.

We doubt that earnings weakness will be offset by a further rerating of markets. The fall in global real money growth in March has resulted in one of our excess money indicators returning to negative territory. Policy developments, meanwhile, are likely to be less favourable than during the first quarter. The Federal Reserve plans to continue its balance sheet reduction programme through September and will probably hold rates at least until then, barring dramatic economic weakness. In China, the People’s Bank is starting to signal less expansive policy following a recovery in credit growth in early 2019.

Chinese economic prospects, of course, are key both for the global outlook and EM relative performance. Following the stronger credit data and a rebound in purchasing managers’ surveys, the consensus now expects a significant reacceleration of activity over the remainder of 2019, with comparisons being drawn with 2016, when China led a global economic rebound. We are unconvinced because growth of our favoured Chinese narrow money measure remains relatively weak: the recovery to date has been much smaller than before previous economic revivals, including 2009 and 2012-13 as well as 2016 – second chart. In addition, we are concerned by recent evidence of an inventory overhang in the US, which could result in cut-backs in imports from China and other emerging Asian economies.

Chart 2: China Nominal GDP and Narrow Money (% 6M)

Chart of China Nominal GDP and Narrow Money (% 6M)

Our seven-factor checklist for assessing emerging market relative performance prospects continues to suggest a cautious strategy. Only one factor is currently rated as favourable – the E7/G7 real money growth gap, which turned positive in March, reflecting a G7 slowdown. Two factors are negative – relative earnings revisions and global industrial momentum – with the remaining four judged to be neutral (valuation, global excess money, commodity prices and the US dollar).

Monetary trends have diverged significantly across major emerging economies recently, contributing to some changes to our country allocation. We have added to India, where narrow money growth has surged, probably partly reflecting a temporary election effect but suggesting favourable near-term economic prospects – third chart. The Russian outlook, by contrast, may be dimming, with real money now contracting and higher-than-expected inflation pushing back central bank policy easing.

Chart 3: Real Narrow Money (% 6M)

Chart of Real Narrow Money (% 6M) for Brazil, China, India & Russia

While Chinese monetary developments have, from our perspective, been disappointing, real narrow money growth is mid-range by EM standards and more likely to rise than fall. The weighting currently remains above-benchmark but we are considering scaling back if monetary data do not show greater improvement soon.

Money trends remain relatively healthy in Taiwan and have recovered in Korea, arguing for adding to exposure, although both markets are sensitive to global economic momentum, on which – as explained – we remain cautious. Real money is contracting in Brazil, Mexico, South Africa and Turkey, where we are underweight and / or reducing exposure.

Chart 4: Real Narrow Money

Chart of Real Narrow Money (% 6M) for Korea, Mexico, South Africa & Taiwan

*”Global” = G7 advanced economies and seven large emerging economies (E7).

**The indicators are 1) the difference between the six-month rates of change of G7 plus E7 real narrow money and industrial output and 2) the deviation of the 12-month rate of change of G7-only real narrow money from 3%.

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