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Quarterly Liquidity Insights - Q2/2018

Emerging equity markets have remained under pressure from a slowing global economy, ongoing Fed tightening and the Trump administration’s trade war with China. Our seven-factor checklist for the asset class is currently still gloomy, with four negative, two neutral and only one positive. Relief, however, could be on the horizon, with our monetary analysis suggesting that the US economy will lose momentum in late 2018 / early 2019, in which case Treasury yields and the US dollar could fall back. Chinese money trends are key: a revival in response to recent policy easing would warrant hopes of an EM recovery in 2019.

Previous quarterly commentaries suggested that the global economy would lose momentum progressively during 2018. This forecast is on track: six-month growth of industrial output in the G7 economies and seven large emerging economies* peaked in December 2017 and fell sharply over April-June 2018, with no significant recovery in July-August – see first chart.

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

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

The key forecasting indicator followed here – six-month growth of G7 plus E7 real (i.e. inflation-adjusted) narrow money** – bottomed in February 2018 and has moved sideways through September. Allowing for a typical nine-month lead, this suggests that industrial output growth will reach a low in late 2018, stabilising at a weak level in the first half of 2019.

A stabilisation of economic momentum, even without a rebound, would remove one drag on emerging equity markets, which are usually highly sensitive to the global industrial cycle. The status of the cycle is one of our checklist factors and is currently scored as negative; an upgrade to neutral could soon be warranted.

*Brazil, Russia, India, China, Korea, Mexico and Taiwan.

**Narrow money = currency in circulation plus demand deposits and close substitutes.

Narrow money trends, moreover, are now weaker in the US than in other major economies, suggesting that US relative economic strength will fade over coming quarters. With US core inflation and inflation expectations so far remaining stable, softer activity news could result in the Fed pausing its tightening campaign in early 2019, relieving upward pressure on the US dollar – another of our checklist factors scored as negative at present.

A third factor getting closer to an upgrade is valuation. The current rating is neutral – EM equities are on a larger-than-average discount to developed markets but have not appeared inexpensive in absolute terms. Recent weakness, however, has pushed EM price-to-book and 12-month forward PE ratios below their long-term (i.e. 25 year) averages.

Chinese money trends will be key to our assessment of whether prospects for EM equities are improving. Six-month growth of our narrow money measure remains weak but recovered slightly in September, possibly indicating that policy easing is starting to gain traction – second chart. A further pick-up during the current quarter would suggest a revival of economic momentum around mid-2019. Stimulus efforts, however, could be offset by market-driven credit tightening and capital outflows, dampening the monetary response.

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

Chart showing China Nominal GDP & Narrow Money (% 6M)

The sole checklist factor currently rated as positive is relative monetary trends: E7 six-month real narrow money growth remains above the G7 level, although the gap has narrowed – third chart. The remaining three factors are relative earnings revisions, commodity prices and global “excess” money growth, scored as negative, neutral and negative respectively. An upgrade to the latter factor, however, could be warranted soon: six-month growth of G7 plus E7 real narrow money was above that of industrial output in August, the latest available month, although year-on-year growth was lower.

Chart 3: G7 & E7 Real Narrow Money (% 6M)

Chart showing G7 & E7 Real Narrow Money (% 6M)

With global economic momentum expected to remain weak, we retain a cautious bias towards cyclical markets (i.e. those displaying a higher correlation with global activity historically), including Korea, Taiwan, Brazil and Indonesia. A scenario in which the Fed becomes less hawkish, resulting in a decline in Treasury yields, could favour markets such as Thailand, Malaysia and Chile, which are usually sensitive to changes in US monetary conditions. Chile also benefits from relatively high real narrow money growth, as does Russia, but money trends are weak in India and Korea, among others – fourth chart. India and South Africa run sizeable external / fiscal deficits and are vulnerable to further oil price strength.

Chart 4: Real Narrow Money (% 6M) - Selected Countries

Chart showing Real Narrow Money (% 6M) - Selected Countries

 

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