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Quarterly Liquidity Insights - Q4/2018

The current message from our monetary and cycle analysis is that global economic momentum will continue to weaken during the first half of 2019 but may bottom out in the third quarter. Our seven-factor checklist for judging the relative attraction of emerging equity markets is becoming less negative but we retain a cautious stance pending confirmation that economic prospects for late 2019 are improving. Chinese money trends in early 2019 will be key to our assessment.

Money trends typically lead economic activity by about nine months. Global six-month real narrow money growth peaked in June 2017 and fell sharply into early 2018. This suggested that industrial output growth would peak around spring 2018 and trend lower into the fourth quarter. This forecast has played out – see first chart.

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

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

Real money growth weakened further in 2018, reaching a low in October and recovering into year-end. Allowing for the typical nine-month lead, this suggests that six-month output momentum will fall further into around July. The monetary recovery at end-2018 raises the possibility of a revival in economic activity later in 2019 but the pick-up needs to extend much further to warrant adopting this as a central scenario.

The US economy remained strong for most of 2018 because of the Trump fiscal boost but we believe that this strength misled the Federal Reserve into overtightening policy. Narrow money trends weakened significantly during 2018. We expect US GDP growth to undershoot official and consensus forecasts in the first half of 2019, forcing the Fed to suspend "quantitative tightening" and possibly even to cut rates. This could lead to a monetary revival during 2019.

The global economic slowdown started in China, where the authorities tightened policy significantly in late 2016 because of concern about excessive shadow credit expansion. The government bond yield curve inverted in 2017 and money growth fell significantly. Tighter monetary conditions fed through economic weakness in 2018. Policy is now easing and the yield curve has normalised but money growth has yet to rebound – second chart. We expect better monetary news in early 2019 but this is unlikely to be reflected in economic data until the fourth quarter or later.

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

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

The suggestion from monetary trends that the global economic downswing has further to run is supported by our cycle analysis. The stockbuilding or inventory cycle, in particular, appears to have peaked in late 2018 and is likely to act as a drag on global activity over coming quarters. The cycle has averaged about 3.5 years in length in recent decades, and our judgement is that the last trough occurred in early 2016, implying that another may be due in the second half of 2019.

Equities and other risk assets tend to perform poorly in the 18 months leading up to a trough in the stockbuilding cycle; indeed, these periods are often associated with crises and major bear markets – third chart. Emerging market equites, moreover, usually underperform developed markets. These trends reverse in the 18 months after a cycle trough. This suggests adding to EM exposure in the second half of 2019, assuming that first-half evidence shows sufficient weakness in stockbuilding, consistent with an approaching cycle trough.

Chart 3: Stockbuilding Cycle and Financial Market Events

Chart of Stockbuilding Cycle and Financial Market Events

Our seven-factor checklist continues to support a cautious stance, although has fewer negatives than three months ago. Three factors are rated as neutral, three negative and only one positive. The neutrals are valuation (forward P/E low relative to developed markets but not relative to history), earnings revisions (similar to DM) and the US dollar (no clear trend). The negatives are the E7 / G7 real money growth gap (which crossed below zero in late 2018), global industrial momentum (weakening) and commodity prices (falling). The sole favourable factor is global "excess" money, i.e. the differential between real money and industrial output growth, which recently turned positive; this factor, however, is often "early".

The prospect of a further slide in global economic momentum argues for retaining a cautious bias towards "cyclical" markets (i.e. those displaying a higher correlation with global activity historically), partly explaining our underweight positions in Korea and Taiwan. "Liquidity-sensitive" markets could benefit if the Fed continues to shift dovishly – we have increased exposure to South East Asia partly on this consideration. Our small overweight in China reflects an assessment that the market is less exposed to possible US economic weakness while policy easing is likely to lift money growth in early 2019 – the position will be adjusted depending on the data.

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