Global six-month real narrow money momentum – a key leading indicator in the forecasting approach employed here – is estimated to have fallen to another new low in September. Real money momentum has led turning points in global PMI new orders by an average 6-7 months historically, so the suggestion is that a recent PMI slide will extend through end-Q1 – see chart 1.

Chart 1

Chart 1 showing Global Composite PMI New Orders & G7 + E7 Real Narrow Money (% 6m)

The September real narrow money estimate is based on monetary data for countries with a two-thirds weight in the global (i.e. G7 plus E7) aggregate and CPI data for a higher proportion.

The estimated September fall reflects additional nominal money weakness coupled with a further oil-price-driven recovery in six-month CPI momentum – chart 2.

Chart 2

Chart 2 showing G7 + E7 Narrow Money & Consumer Prices (% 6m)

Among countries that have released September data, six-month real narrow money momentum fell in the US and Brazil, was little changed in China / Japan and recovered in India (because inflation reversed lower after a food-driven spike) – chart 3.

Chart 3

Chart 3 showing Real Narrow Money (% 6m) Early Reporters

Real narrow money momentum is primarily a directional indicator but the current extreme negative reading seems unlikely to be consistent with hopes of a “soft landing”.

One argument for the latter is that a drag on manufacturing trade and activity from a downswing in the stockbuilding cycle is coming to an end, to be followed by a recovery into 2024. A trough by end-2023 has long been the base case here but monetary weakness suggests that the cycle will bump along the bottom rather than enter an upswing.

More precisely, an initial boost from an ending of destocking may fizzle as the usual multiplier effects are offset by slower or falling final demand due to monetary restriction.

Stockbuilding cycle upswings historically were always preceded by a recovery (of variable magnitude) in global real narrow money momentum – chart 4.

Chart 4

Chart 4 showing G7 Stockbuilding as % of GDP (yoy change) & Global* Real Narrow Money (% yoy) *G7 + E7 from 2005, G7 before

Current conditions are reminiscent of the early 1990s, when real money momentum remained near its low between H2 1989 and H1 1991 and an easing of a stockbuilding drag in 1990 was followed by a relapse into 1991. Monetary weakness, on that occasion, appears to have resulted in an extended cycle, with a final low in Q2 1991 occurring 4 1/2 years after the previous trough in Q4 1986 versus an average cycle length of 3 1/3 years. For comparison, the current cycle started in Q2 2020 so has recently moved beyond the 3 1/3 year average.

A bottoming out of the global stockbuilding cycle could be associated with a near-term recovery in manufacturing survey indicators. Money trends suggest that any revival will be modest / temporary and offset by wider economic weakness. 

Economic news has been unusually mixed since end-2021, with GDP weakness contrasting with labour market strength and manufacturing deterioration offset by services resilience. Confusing signals have contributed to market hopes of a “soft landing”. 

Sectoral and regional divergences may persist in H2 2023. The expectation here is that manufacturing survey weakness will abate but labour market data will worsen significantly. Money trends continue to cast strong doubt on soft landing hopes. Europe is likely to underperform the US. 

The US ISM manufacturing new orders index – a widely watched indicator of industrial momentum – hit a low of 42.5 in January and retested this level in May before recovering to 45.6 in June. 

Reasons for expecting a further rise include: 

  • The index has been in the 40s since September 2022 and the mean duration of sub-50 periods historically was eight months (ignoring episodes of three months or less). 
  • The global stockbuilding cycle remains on track to bottom out during H2 2023 and lows historically were usually preceded by a recovery in US / global manufacturing new orders. 
  • Recent price falls for raw materials and other production inputs may further incentivise firms to step up purchasing to maintain or replenish inventories.

Korean manufacturing is a bellwether of US / global trends and the latest Federation of Korean Industries survey reported a marked improvement in optimism, consistent with ISM new orders moving back above 50 – see chart 1. 

Chart 1

Chart 1 showing US ISM Manufacturing New Orders & Korea FKI Manufacturing Business Prospects

Sustained recoveries in ISM new orders from the mid 40s into expansionary territory historically occurred against a backdrop of positive and / or rising six-month real narrow money* momentum. Current trends are unfavourable, with momentum still significantly negative and moving sideways – chart 2. 

Chart 2

Chart 2 showing US ISM Manufacturing New Orders & Real Narrow Money (% 6m)

Examples of recoveries to above 50 without a supportive monetary backdrop include 1970 and 1989-90. In both cases the rise was modest (peaking below 55), short-lived and followed by a decline to a lower low. The recovery in 1970 occurred within an NBER-defined recession and in 1989-90 just before one. 

An ISM rebound might not be mirrored by much if any revival in European manufacturing surveys. Money trends are even weaker than in the US, while the stockbuilding adjustment started later in the Eurozone and probably has further to run – charts 3 and 4. 

Chart 3

Chart 3 showing Real Narrow Money (% 6m)

Chart 4

Chart 4 showing Stockbuilding as % of GDP

*Narrow money definition used here = M1A = currency + demand deposits.

Beautiful view of a Puerto Vallarta beach on the Pacific coast of Mexico.

Latin America has outperformed other emerging markets over the past two years and this positive performance can be attributed to several key factors. However, the challenge lies in sustaining this momentum and ensuring it is not merely temporary.

MSCI World Small Cap Index vs MSCI Emerging Markets Latin America Index, 2021 to 2023

Graph showing the outperformance of the Latin America small cap index relative to its global peers between June 2021 and June 2023.

Source: Bloomberg

Notably, the combination of currency rallies among some Latin American countries and an emerging markets rally is uncommon. Reasons for this mismatch include:

  • Latin America leads the way in interest rate hikes worldwide. Starting in the first half of 2021, Chile and Brazil raised rates, helping control inflation levels, although they are still high but manageable. Chile will likely start its easing process next week, followed by Brazil within the year. This has boosted their respective stock markets, which were already undervalued in our view.
  • Additionally, Mexico has benefitted from the “nearshoring” theme. Nearshoring is nothing new to local investors, having been present in the region for decades. What is new is the level of intensity and amount of investment expected over the next three to five years. This has resulted in increased earnings per share (EPS) of 15% to 20% CAGR in the near term for some Mexican companies, outperforming the MSCI Emerging Markets Small Cap Index and contributing to higher valuations in Mexico’s market compared to its Latin American peers. However, there are questions about whether Mexico’s growth is comparable to its peers or to countries like Indonesia or Vietnam that are also heavily dependent on US imports.
  • Commodities also play a significant role in the region’s performance. Despite a global slowdown, certain commodities, like copper, have maintained high prices due to supply constraints. We believe the anticipated electric vehicle (EV) boom will further drive copper demand, ensuring a deficit in the market from 2026 onwards. For example, every EV, which weigh approximately two tons each, consumes around 60 additional kilos of copper.
  • Furthermore, the region has demonstrated better fiscal discipline, with countries like Chile and Mexico ending 2022 with fiscal surpluses or manageable deficits, respectively. This responsible fiscal approach has also supported their currencies. There is always the potential for Brazil to surprise on the downside due to its high fiscal spending and debt levels; however, the country has seen no “disruptive” events lately.
  • US rates hikes have favoured value over growth factors in emerging markets, benefitting markets like Latin America’s over countries perceived as growth-driven, such as Korea or India.
  • Innovation has not been a main driver for Latin America, but that is starting to slowly change. Moreover, the market has begun recognizing and crediting good companies with sustained growth expectations, which has historically been uncommon in the region. This trend in recognizing innovation and good companies is crucial for bottom-up investors like us who prioritize companies with solid balance sheets, strong cash flow generation and sustained competitive advantages. More Latin American companies have started to share these characteristics.

Latin America is still a small region relative to the rest of the world and it is dominated by, and benefits from, global trends, even though its politics are not always market friendly. However, sustained positive factors like the commodities momentum and nearshoring may make global investors more indifferent to the region’s internal dynamics.

What needs to happen for long-term compounder growth stories to emerge, like Nestle in India or TSMC in Taiwan? To maintain sustainable growth, we believe the region needs to align with external factors and foster strong domestic sectors and companies that promote growth. Improving innovation and adapting to rapidly changing environments are also key. For example, the financial sector in Mexico and Chile remains solid, while the transport-logistics sector in Mexico offers interesting opportunities. Brazil’s large population presents significant potential for emerging middle-class growth, creating opportunities in various sectors.

Latin America has growth engines and the key is to identify the best companies capable of maintaining a sustained differentiation over time. By focusing on these opportunities, our portfolio is well-positioning to capture their potential growth.

Company example

JSL (JSLG3 BZ) has the largest portfolio of logistics in Brazil, with long expertise operating in a variety of sectors and a nationwide scale of services. The company has long-lasting business relationships with clients that operate in several economic sectors, including pulp and paper, steel, mining, agribusiness, automotive, food, chemical and consumer goods, among others. JSL also has a unique position in the Brazilian highway logistics market, as leader for 19 years and much larger than its nearest competitor.

The logistics industry in Brazil is highly fragmented, with a high level of informality and low capitalization among players. This creates opportunities for further consolidation, especially for companies with structured businesses. According to Citibank, the top 10 companies have close to a 2% market share. JSL has roughly 1% market share (almost 5x the second-largest player) and is well placed to continue consolidating the industry. JSL also has a favourable M&A track record, which has been a growth driver in recent years. JSL has acquired seven companies since its re-IPO in October 2020 implying c20% annual organic growth and c60% EBITDA growth considering the acquisitions, maintaining strong returns. 

We also expect JSL to continue expanding its ROIC going forward, driven by the ongoing consolidation of new acquisitions into JSL’s financials, the company’s strategy to becoming a less capital intensive, asset light business, and strong revenue growth to maintain gaining scale and operating leverage. The logistics industry offers a lot of opportunities to implement tech-driven innovation, and we see JSL well-positioned to use its sector platform and status as a leading tech player. The stock has performed very well this year, partially driven by rate cut expectations and also strong earnings. We expect the company to continue delivering good results in upcoming quarters amid a highly fragmented sector, creating both organic and inorganic growth engines.

The Sahm rule states that the (US) economy is likely to be in recession if a three-month moving average of the unemployment rate is 0.5 pp or more above its minimum in the prior 12 months. 

The rule identified all 12 US recessions since 1950 but gave two false positive signals based on current (i.e., revised) unemployment rate data (1959 and 2003) and four based on real-time data (additionally 1967 and 1976). 

The signal occurred after the start date of the recession in all 12 cases, with a maximum delay of seven months* (in the 1973-75 recession). 

The Sahm condition hasn’t yet been met in the US – the unemployment rate three-month average was 3.6% in June versus a 12-month minimum of 3.5%. 

The rule has, however, triggered a warning in the UK, where the jobless rate averaged 4.0% over March-May, up from 3.5% over June-August 2022. 

UK Sahm rule warnings occurred on nine previous occasions since 1965, six of which were associated with GDP contractions. 

The Sahm signal is another indication that the UK economy is already in recession – see previous post – but a stronger message is that earnings growth is about to slow. 

Annual growth of average earnings fell after the Sahm signal in eight of the nine cases, the exception being the 2020 covid recession, when earnings numbers were heavily distorted by composition effects – see chart 1. 

Chart 1

Chart 1 showing UK Average Earnings (3m ma, % yoy) & Rise in Unemployment Rate (3m ma) from 12m Minimum

Previous generations of monetary policy-makers understood the dangers of basing decisions on the latest inflation and / or earnings data, which reflect monetary conditions 18 months or more ago. 

The current reactive approach, apparently endorsed by the economics consensus, may partly reflect mythology about a 1970s “wage / price spiral”. Rather than causing each other, high wage growth and inflation were dual symptoms of sustained double-digit broad money expansion. 

The monetarist case is summarised by chart 2, showing that earnings growth is almost coincident with core inflation whereas broad money expansion displays a long lead. (The correlations with core inflation are maximised with lags of four months for earnings growth and 24 months for money growth.) 

Chart 2 

Chart 2 showing UK Core Consumer / Retail Prices, Average Earnings & Broad Money (% yoy)

Recent monetary weakness argues that core inflation and wage growth will be much lower by late 2024; the Sahm rule signals that the decline is about to start.

*Eight months taking into account a one-month reporting lag.

A recession likelihood gauge placing weight on monetary variables indicates a high probability of a contraction in UK GDP / gross value added (GVA) over the remainder of 2023. 

The indicator, regularly referenced in posts here, is based on a model that generates projections for the four-quarter change in GVA three quarters in advance using current and lagged values of a range of monetary and financial inputs. 

Using data up to June 2022, the model assigned a 70% probability to the four-quarter change in GVA being negative in Q1 2023. The current ONS estimate of this change is +0.2%. 

UK Gross Value Added (% yoy) & Recession Probability Indicator. Source: Refinitiv Datastream.

The probability reading rises to 96% incorporating data through March 2023, i.e. there is a 96% likelihood of the four-quarter change in GVA in Q4 2023 being negative, according to the model. 

The statistical analysis underlying the model indicates that GDP prospects are significantly influenced by movements in real narrow money (non-financial M1) and real corporate broad money (M4). Six-month rates of change of these measures have moved deeper into negative territory since mid-2022. 

The model’s increased pessimism also reflects a deepening inversion of the yield curve and falling real house prices. Other inputs include credit spreads and local share prices, which have yet to display recession-scale weakness.

DM flash results released last week suggest that the global manufacturing PMI new orders index fell sharply in June, having moved sideways in April and May following a Q1 recovery – see chart 1. 

Chart 1

Global Manufacturing PMI New Orders, & G7 + E7 Real Narrow Money (% 6m). Source: Refinitiv Datastream.

The relapse is consistent with a decline in global six-month real narrow money momentum from a local peak in December 2022. A recovery in real money momentum during H2 2022 had presaged the Q1 PMI revival. 

Real narrow money momentum is estimated to have fallen again in May, based on partial data, suggesting further PMI weakness into late 2023. 

The global earnings revisions ratio has been contemporaneously correlated with manufacturing PMI new orders historically but remained at an above-average level in June, widening a recent divergence – chart 2. 

Chart 2

Global Manufacturing PMI New Orders, & MSCI ACWI Earnings Revisions Ratio. Source: Refinitiv Datastream.

Based on monetary trends, a reconvergence is more likely to occur via weaker earnings revisions than a PMI rebound. 

Charts 3 and 4 show that revisions resilience has been driven by cyclical sectors – in particular, IT, industrials and consumer discretionary. Notable weakness has been confined to the materials sector. Cyclical sectors may be at greater risk of downgrades if the global revisions ratio heads south. 

Defensive sector revisions have underperformed recently but are likely to be less sensitive to economic weakness. 

Chart 3

MSCI ACWI Earnings Revisions Ratios - Cyclical Sectors. Source: Refinitiv Datastream.

Chart 4

MSCI ACWI Earnings Revisions Ratios - Defensive Sectors. Source: Refinitiv Datastream.

The positive divergence of earnings revisions from the PMI may reflect firms’ ability to push through price increases to compensate for slower volumes. The deviation of the global revisions ratio (rescaled) from manufacturing PMI new orders – i.e. the gap between the blue and black lines in chart 2 – has displayed a weak positive correlation with the PMI output price index historically (contemporaneous correlation coefficient = +0.41). 

Any earnings support from pricing gains is now going into reverse: the output price index has crashed from an April 2022 peak of 63.8 to 49.8 in May, with DM flash results suggesting a further fall last month.

Why believe the “monetarist” forecast that recent G7 monetary weakness will feed through to low inflation in 2024-25? 

Monetary trends correctly warned of a coming inflationary upsurge in 2020 when most economists were emphasising deflation risk. 

The forecast of rapid disinflation is on track in terms of the usual sequencing, with commodity prices down heavily, producer prices slowing sharply and services / wage pressures showing signs of cooling. 

A further compelling consideration is that the monetary disinflation expected in G7 economies has already played out in emerging markets. 

A GDP-weighted average of CPI inflation rates in the “E7” large emerging economies* crossed below its pre-pandemic (i.e. 2015-19) average in March, falling further into May – see chart 1. 

Chart 1

G7 & E7 Consumer Prices (% yoy). Source: Refinitiv Datastream.

The E7 average is dominated by China but inflation rates are also below or close to pre-pandemic levels in Brazil, India and Russia. 

Inflation rose by much less in the E7 than the G7 in 2021-22, opening up an unprecedented negative deviation that has persisted. 

The recent plunge in the E7 measure reflects a significant core slowdown as well as lower food / energy inflation. 

The divergent G7 / E7 experiences are explained by monetary trends. Annual broad money growth rose by much less in the E7 than the G7 in 2020 and returned to its pre-pandemic average much sooner – chart 2. 

Chart 2

G7 & E7 Broad Money (% yoy). Source: Refinitiv Datastream.

E7 broad money growth crossed below the pre-pandemic average in May 2021. CPI inflation, as noted, followed in March 2023, i.e. consistent with the monetarist rule of thumb of a roughly two-year lead from money to prices. 

G7 broad money growth crossed below its pre-pandemic average in August 2022 and has yet to bottom, suggesting a return of inflation to average in summer 2024 and a subsequent undershoot. 

E7 disinflation, however, may be close to an end. Annual broad money growth has recovered strongly from a low in September 2021, signalling a likely inflation rebound during 2024 – chart 3. Broad money acceleration has been driven by China, Russia and Brazil. 

Chart 3

E7 Consumer Prices & Broad Money (% yoy). Source: Refinitiv Datastream.

E7 annual broad money growth is around the middle of its longer-term historical range and has eased since February. Chinese numbers may have been temporarily inflated by a shift in banks’ funding mix in favour of deposits. 

The expected rise in E7 inflation may not extend far but restoration of a positive E7 / G7 differential is likely in 2024.

*E7 defined here as BRIC + Korea, Mexico, Taiwan.

The FOMC’s updated economic forecast for the remainder of 2023 is inconsistent with Committee members’ median expectation of a further 50 bp rise in official rates during H2, according to a model based on the Fed’s past behaviour. Policy is more likely to be eased than tightened if the forecast plays out. 

The model estimates the probability of the Fed tightening or easing each month from current and lagged values of core PCE inflation, the unemployment rate and the ISM supplier deliveries index, a measure of production bottlenecks. It provides a simple but satisfactory explanation of the Fed’s historical decision-making, i.e. the probability estimate was above 50% in most tightening months and below 50% in most easing months – see chart. 

US Fed Funds Rate & Fed Policy Direction Probability Indicator.

The probability of the Fed tightening at yesterday’s meeting had been estimated by the model at 36%, the first sub-50% reading since September 2021. (The FOMC started to taper QE at the following meeting in November.) 

The FOMC’s median forecast for core PCE inflation in Q4 was revised up to 3.9% from 3.6% previously (currently 4.7%). The unemployment rate forecast was lowered to 4.1% from 4.5% (currently 3.7%). 

The model projections shown in the chart assume that core PCE inflation and the unemployment rate converge smoothly to the Q4 forecasts, while the ISM supplier deliveries index remains at its current level. Despite the revisions, the probability estimate still falls to below 10% in Q4, consistent with the Fed beginning to ease by then. 

The projections highlight the Fed’s historical sensitivity to the rates of change of core inflation and unemployment as well as their levels. It would be unusual for policy-makers to continue to tighten when inflation and unemployment are trending in the “right” directions, especially given the magnitude of the increase in rates to date. 

One difference from the past is that Fed now forecasts its own actions. Has yesterday’s guidance that rates have yet to peak boxed policy-makers into at least one further rise? This may mean that the model’s probability estimate for July – currently 29% – is too low. Still, next month’s decision will hinge on data, with inertia plausible barring stronger-than-expected news.

Global growth optimists expect continued solid services sector expansion to offset manufacturing weakness. PMI results for May appear, on first inspection, to support this view: services activity and new business indices rose further to 18- and 22-month highs respectively even as manufacturing new orders remained stalled below 50 – see chart 1. 

Chart 1

Chart 1: Global PMI New Orders /  Business. Chart compares manufacturing new order vs. services new business from 2015 to 2023. Source: Refinitiv Datastream.

There are, however, several reasons for discounting the strong headline services readings. 

First, backlogs of services work fell sharply to a four-month low despite stronger new business – chart 2. This suggests that current output is running ahead of incoming demand, in turn implying a future adjustment lower unless demand picks up further. 

Chart 2

Chart 2: Global PMI Backlogs of Work. This chart compares manufacturing vs. Services from 2015 to 2023. Source: Refinitiv Datastream.

Manufacturing backlogs also fell sharply last month, breaking below their November 2022 low. 

Secondly, the sectoral breakdown of the activity and new business indices shows that May rises were driven by a surge in financial services – chart 3. Consumer services indices eased on the month. Financial services strength is difficult to understand given monetary stagnation, slowing bank lending and flat trading volumes, so may prove short-lived. 

Chart 3

Chart 3: Global Services PMI New Business. This chart compares consumer, financial, and business from 2015 to 2023. Source: Refinitiv Datastream.

Thirdly, the high May readings of the global activity and new business indices reflect strong contributions from the US and Chinese components but national services surveys are significantly weaker. 

The US ISM services activity index fell to a three-year low in May even as the S&P Global equivalent series reached a 13-month high – chart 4. 

Chart 4

Chart 4: US Services PMI Business Activity. This chart compares S&P Global vs ISM from 2015 to 2023. Source: Refinitiv Datastream.

The Chinese NBS non-manufacturing new orders index moved below 50 in April and fell further in May, in puzzling contrast to the S&P Global / Caixin services new business index, which reached its second-highest level since November 2020. 

The global manufacturing new orders and services new business indices have been strongly correlated historically but statistical tests indicate a tendency for manufacturing to lead services rather than vice versa*. With global monetary trends continuing to give a negative economic signal, the current unusually wide gap is more likely to be closed by services weakness than a manufacturing revival. 

*In regressions using monthly data with three lags, lagged manufacturing new orders terms are significant in the regression for services new business, but lagged services new business terms are insignificant in the regression for manufacturing new orders.

Monetary trends continue to give a negative message for global economic prospects, suggesting that European / US weakness will outweigh resilience in major EM economies. 

G7 plus E7 six-month real narrow money momentum fell again in April, extending a move down from a local peak in December and suggesting a decline in economic momentum through late 2023 – see chart 1. 

Chart 1

Chart 1 showing Global Manufacturing PMI New Orders & G7 + E7 Real Narrow / Broad Money (% 6m)

A revival in real narrow money momentum in H2 2022 was reflected in a recovery in global manufacturing PMI new orders between December and March. The recovery stalled in April / May and the forecast here remains for a relapse and possible retest of the December 2022 low during H2 2023. 

Narrow money has outperformed broad money as a leading indicator historically, in terms of reliability in signalling turning points in economic momentum. Narrow money usually weakens relative to broad money when interest rates rise as depositors are incentivised to shift funds to less liquid accounts. This is an important feature of the transmission mechanism and one of the reasons narrow money outperforms as a forecasting indicator. 

An argument, however, has been made that the unusual speed of the rise in interest rates over the past year, coupled with worries about deposit safety following recent bank failures and an associated switch into money market funds, may have exaggerated narrow money weakness relative to “true” economic prospects. This would suggest giving greater weight to broad money trends at present. 

As chart 1 shows, global six-month real broad money momentum recovered more strongly during H2 2002 and has stalled rather than fallen back since December. Still, the message for economic prospects is weak, suggesting no growth revival before 2024. 

A marginal decline in global manufacturing PMI new orders in May reflected a notable weakening of the DM component offset by stronger EM results. EM resilience is consistent with recent stronger E7 real money momentum (broad as well as narrow) – chart 2. 

Chart 2

Chart 2 showing G7 + E7 Real Narrow Money (% 6m)

Charts 3 and 4 show six-month real narrow money momentum and manufacturing PMIs in selected major economies. Russia, China and India top the real money momentum ranking with weakness focused on Europe – particularly Switzerland and Sweden. The latest PMI results mirror the real money ranking (rank correlation coefficient = 0.85), with recessionary readings in the Eurozone, Switzerland and Sweden contrasting with Indian / Russian strength. 

Chart 3

Chart 3 showing Real Narrow Money (% 6m)

Chart 4

Chart 4 showing Manufacturing Purchasing Managers’ Indices