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Quarterly Liquidity Insights - Q1/2018

Our last quarterly commentary noted that global narrow money trends had weakened significantly during the second half of 2017, a development suggesting weaker economic prospects and a less favourable liquidity backdrop for markets. Money trends softened further in early 2018, adding to our concerns. It is possible that US and Chinese money data will rebound over coming months, reflecting, respectively, the lagged impact of tax cuts and policy easing. A defensive investment stance, however, is recommended until such a recovery is confirmed.

Our key forecasting indicator is the six-month growth rate of real (i.e. inflation-adjusted) narrow money* in the G7 advanced economies and seven large emerging economies (the “E7”). Real money growth has led turning points in economic growth by nine months on average historically. The indicator peaked most recently in June 2017, falling significantly later in the year. This suggested that global economic momentum would slow from a peak to be reached around March 2018 – see chart 1.

CHART 1: G7 + E7 Industiral Output & Real Narrow Money (% 6M)

Chart showing G7 + E7 Industiral Output & Real Money (% 6M)

Recent economic news appears consistent with global growth passing a peak. The Markit Economics / J P Morgan global composite purchasing managers’ index, for example, is widely followed as a coincident indicator of economic activity and fell sharply from a 41-month high in February to a 16-month low in March.

Monetary trends, meanwhile, have weakened further in early 2018, with G7 plus E7 six-month real narrow money growth falling to a nine-year low in February. Real broad money has also continued to decelerate. The emerging economic slowdown, therefore, could extend into late 2018, allowing for the usual lead.

Weak money trends also imply less liquidity support for equity prices. Significantly, G7 plus E7 six-month real narrow money growth crossed below industrial output growth in December 2017, with the shortfall increasing in January / February. Global equities have underperformed US dollar cash by 7.2% per annum on average historically (i.e. over 1970-2017) when real money growth has been lower than output growth. The February / March set-back in markets is consistent with this experience.

Why could this prognosis be too gloomy? Economic optimists expect US tax cuts and higher federal spending to boost US / global growth later in 2018 and in 2019. Our view is that a significant positive impact should be signalled in advance by monetary reacceleration. We examined money trends around three previous large tax cuts and found a pattern of money growth rebounding two to four months after legislation was enacted. Recent behaviour has been consistent with the historical pattern, which suggests a rise in money growth in the second and third quarters – see chart 2. Such a recovery would imply better economic prospects for late 2018 / early 2019.

CHART 2: US Narrow Money (% 6M) - Current vs. Around Previous Major Tax Cuts

Chart showing 7 + E7 Survey Indicator & ACWI Revisions Ratio

Another upside risk is an early easing of Chinese monetary policy. A clampdown on speculative credit and shadow banking activity since late 2016 has been reflected in much weaker money trends, an economic slowdown and falls in house and producer price inflation. The authorities, on our assessment, are likely to need to relax restrictions to prevent GDP growth undershooting the 6.5% target. A recent decline in interbank interest rates may be an early sign of policy shift.

A rebound in US / Chinese money trends over the next three to six months would not alter the forecast here of a loss of global economic momentum through late 2018 but would suggest a reacceleration into 2019. A monetary rebound, coupled with near-term economic weakness, could conceivably result in global real money growth moving back above output growth later in 2018, reversing the current negative signal for equity markets.

Downside risks, however, are also present. Federal Reserve balance sheet contraction could offset any boost to monetary trends from tax cuts. Major central banks appear overly optimistic about economic prospects and may be slow to offer policy support as momentum cools. A late-cycle pick-up in labour cost inflation remains possible. Rising trade tensions, meanwhile, threaten to undermine business confidence and investment plans.

The recent global monetary slowdown has been remarkably synchronised across economies. Real narrow money trends remain particularly weak in Australia and Canada, with the UK joining the rear carriage following the November 2017 interest rate hike – see chart 3. These three equity markets underperformed in the first quarter. The UK Monetary Policy Committee is worried about rising labour cost pressures but monetary weakness argues for delaying a further rise in rates.

CHART 3: Real Narrow Money (% 6M)

Chart showing G7 + E7 Industrial Output & Leading Indicator

At the opposite end of the range, real narrow money growth remains respectable by historical standards in Japan and Euroland but has nonetheless fallen significantly since mid-2017. In contrast to the US and China, moreover, there are no strong grounds for expecting a monetary rebound. The recent success in Italian elections of parties advocating fiscal loosening is likely to strengthen the ECB’s resolve to wind down QE by end-2018.

Country-level monetary trends, therefore, are not currently giving strong signals for regional / country selection. The main strategy suggestion from our analysis is to reduce exposure to cyclical equity market sectors in favour of defensive sectors. This follows from the forecast of a near-term global economic slowdown and is also directly implied by the low level of global real narrow money growth – see chart 4.

CHART 4: Cyclicals vs. Devensives & G7 + E7  Real Narrow Money (% 6M)

Chart showing US GDP & Real Narrow Money (% 6M)

*Narrow money = currency in circulation plus demand deposits and close substitutes. Broad money = narrow money plus time deposits, notice accounts, repos and bank securities. Precise definitions vary by country. Narrow money has been more reliable than broad money for forecasting purposes historically and is consequently emphasised in the analysis here. Real = inflation-adjusted.

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