6th April 2012
The mood in markets has improved dramatically since last autumn. What happened?
The mood was very gloomy last autumn, with some measures of investor risk appetite at record lows. This partly reflected the Eurozone sovereign debt and banking crisis but investors were also worried about hard landings in the US and China. There were, however, some signs that conditions were about to improve. In particular, global money supply growth, adjusted for inflation, had been weak in early 2011 but began to pick up in the summer. The monetarist rule of thumb is that money leads the economy by about six months, so this suggested that growth would revive going into 2013, with positive implications for equities and other risk assets.
Central bank polices have also contributed to the turnaround, right?
The pick-up in global real money growth last summer was partly the result of the Fed's QE2 securities purchases. In addition, the ECB's injections of three-year money starting late last year stabilised the banking system and provided additional fuel for the rally in markets.
Does your forecasting approach rely solely on the money supply?
The monetarist rule has been remarkably accurate for forecasting the economy in recent years, predicting both the 2008-09 recession and the subsequent recovery. However, we look for confirmation for the monetary signals from shorter-term leading indicators, such as business and consumer confidence measures. We calculate a global composite leading indicator that usually turns about three months before the economy, and three months after the money supply. This indicator turned up last autumn, confirming the earlier positive signal from the monetary data.
How well is the global economy doing in early 2012?
The recent improvement has yet to feed through fully to the hard data but is clearly evident in business survey data. The global purchasing managers' output index, for example, rose to a 12-month high in February. Markets, meanwhile, have rallied strongly, with the MSCI world equity index up by more than 20% in US dollar terms from its October low.
Will faster growth be sustained over the remainder of the year?
Unfortunately, such a scenario is questioned by more recent monetary data showing a slowdown since late 2011. The suggestion is that economic growth will peak in the late spring and moderate later in 2012.
So should investors batten down the hatches?
That might be premature. It was right to be overweight equities and other risk assets in late 2011 and a more neutral strategy may now be warranted. However, the level of real money growth is still respectable by historical standards. Also, the recent slowdown has yet to be confirmed by a downturn in our leading indicator. It is probably safe to wait for this to fall before shifting to a defensive investment strategy.
What would cause you to become more bullish on market prospects?
The key necessary development is a revival in global money supply growth. This could yet occur. For example, Eurozone money supply growth could pick up in response to the ECB's liquidity injections – there are some tentative signs of improvement in the latest numbers. Alternatively, China and other emerging economies could ease policies, although in many cases curbing inflation is still a greater priority than stimulating growth.
The US has been growing faster than other developed economies – do you see this continuing?
The pick-up in global money supply growth in summer 2011 was mainly due to a surge in the US. This surge has been reflected in a strong performance of the US economy in late 2011 and early 2012. US money trends, however, have slowed sharply in recent months as the impact of QE2 has faded. This suggests that the US economy will lose momentum during 2012 although growth will probably continue to compare favourably with other major economies.
At the other end of the scale, peripheral Eurozone economies are in recession – is there any light at the end of the tunnel?
The ECB's recent actions have stabilised banking systems but have yet to reverse monetary contractions in these peripheral economies. This suggests that recessions will deepen into mid 2012, in turn undermining plans to cut fiscal deficits. The crisis, therefore, looks set to rumble on.
Let's talk about inflation. Headline rates have eased a bit in recent months as commodity price rises a year ago drop out of the calculation. Do you see this continuing?
The money supply is also useful for forecasting inflation but the lags involved are longer than for the real economy – the usual rule of thumb is that money leads inflation by about two years. The recent inflation decline follows a slowdown in global money growth two years earlier in late 2009 and early 2010. It picked up again after mid 2010, however, suggesting that inflation will trend higher again later this year and into 2013. This could prevent central banks from delivering further monetary stimulus should growth slow.
Inflation has been particularly high in the UK but the Bank of England expects a return to the 2% target later this year. Do you agree?
We expected inflation to overshoot again this year, reflecting stickiness in core inflation and upward pressure on global industrial commodity prices. The consensus had bought into the Bank's optimism but forecasts are now being revised up.
It looks as if the Bank will have to push out its forecast by yet another year.
To sum up, you think global economic conditions could deteriorate later in 2012 and that investors should be alert to warning signals, right?
The money supply is giving a warning signal but I would await confirmation from our leading indicator before turning defensive. I wouldn't expect any weakness in equities and other risk assets to be severe. For one thing, monetary trends are suggesting a slowdown in economic growth rather than a recession. For another, equity valuations look reasonable: a measure of the earnings yield on world equities adjusted for the economic cycle is above its average in recent decades. This suggests that any weakness in
response to less favourable economic news could represent another longer-term buying opportunity.
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