“Gangbusters” UK GDP growth of 0.6% in Q1 may partly reflect inadequate adjustments for the leap year and early timing of Easter. In any case, the bigger story in recent national accounts data is nominal deceleration.

Nominal GDP rose at an annualised rate of 2.1% in Q4 and Q1 combined, down from 6.3% in the prior two quarters. With output momentum recovering slightly, the slowdown reflected a sharp fall in the rate of increase of the GDP deflator, from 6.6% annualised to 1.5% – see chart 1.

Chart 1

Chart 1 showing UK Nominal & Real GDP (% 2q annualised)

The drop in two-quarter nominal GDP momentum was signalled roughly a year ahead by falls in six-month broad and narrow money momentum into negative territory – chart 2. Money momentum has recovered since Q3 2023 but on both measures remains weaker than during the 2010s, when the GDP deflator rose at an average 1.8% pace.

Chart 2

Chart 2 showing UK Nominal GDP & Narrow / Broad Money (% 2q & % 6m annualised)

As an aside, the latest Monetary Policy Report contains a lengthy discussion of monetary developments and their relevance for policy. The strategy, as usual, is to damn with faint praise. While “broad money growth and inflation appear to have moved together over long cycles … it is harder to take an unambiguous signal about inflationary pressures from growth in the aggregate money data in isolation over shorter, policy-relevant, horizons.”

Really? Study chart 2. A directional leading relationship in rates of change is obvious. Except around the initial Covid lockdown, there are no examples of money momentum giving a seriously misleading message about future nominal GDP developments. As well as signalling the 2021-22 inflation surge, money trends warned of economic weakness / falling price pressures in 2008-09 and 2011-12, while contradicting recession forecasts following the Brexit referendum result. “Monetarists” were on the right side of the policy debate on all these occasions.

The income analysis of GDP allows movements in the GDP deflator to be attributed to changes in labour costs and broadly defined profits per unit of output. How has the recent sharp slowdown been achieved given supposedly sticky wage pressures?

According to the national accounts numbers, employee compensation per unit of output rose at an annualised rate of 1.8% in Q4 / Q1, down from 6.9% in the prior two quarters – chart 3. This slowdown is consistent with official earnings data and reflects a combination of 1) a moderation in regular earnings momentum, 2) a fall in bonus payments and 3) a pick-up in productivity (i.e. output per worker) as employment fell.

Chart 3

Chart 3 showing UK GDP Deflator & Income Components (% 2q annualised)

Profits and other “entrepreneurial” income per unit of output, meanwhile rose by only 1.1% annualised in the latest two quarters, versus 6.3% in Q2 / Q3 2023.

Domestic cost developments, therefore, are compatible with the inflation target while money growth, although recovering, remains too low. The “monetarist” view is that the MPC is behind the curve – again.

post in February argued that US Treasury plans to reduce reliance on bills to fund the deficit implied weaker monetary expansion from Q2, with possible negative implications for markets and economic prospects. This scenario remains on track.

The Treasury last week confirmed a reduction in the stock of Treasury bills in Q2 while signalling small-scale issuance in Q3.

Deficit financing via bills rather than coupon debt tends to boost the broad money stock because bills are mostly bought by money-creating institutions, i.e. banks and money funds. Their purchases are usually associated with expansion of their balance sheets, with a corresponding increase in monetary liabilities.

Broad money also tends to rise when the Treasury finances the deficit by running down its cash balance at the Fed.

Both effects were in play in 2023 / early 2024, resulting in a large monetary boost from Treasury operations that more than offset the Fed’s QT – see chart 1.

Chart 1

Chart 1 showing US Broad Money M2+ (6m change, $ bn) & Fed / Treasury QE / QT (6m sum, $ bn)

The latest Treasury estimates, however, imply a small negative impact in Q2 / Q3 combined. The earlier post argued that the Fed would need to halt QT to offset this shift. Last week’s taper announcement was insufficient, implying that the combined Treasury / Fed influence is likely to turn significantly contractionary – chart 2.

Chart 2

Chart 2 showing US Broad Money M2+ (6m change, $ bn) & Sum of Fed & Treasury QE / QT (6m sum, $ bn)

Will a revival in bank lending neutralise the Treasury / Fed drag? The Fed’s April senior loan officer survey was less negative but demand and supply balances remain soft by historical standards, arguing against a strong pick-up – chart 3.

Chart 3

Chart 3 showing US Commercial Bank Loans & Leases (% 6m annualised) & Fed Senior Loan Officer Survey Credit Demand & Supply Indicators* *Weighted Average of Balances across Loan Categories

April monetary statistics will be released in late May but weekly numbers on currency, commercial bank deposits and money funds are consistent with emerging weakness  – chart 4.

Chart 4

Chart 4 showing US Broad Money M2+ & Weekly Proxy* ($ trn) *Currency in Circulation + Commercial Bank Deposits + Money Funds

The Fed’s preferred core price measure – the PCE price index excluding food and energy – rose by an average 0.36% per month, equivalent to 4.4% annualised, over January-March.

The FOMC median projection in March was for annual core inflation to fall to 2.6% in Q4 2024. This would require the monthly index rise to step down to an average 0.17% over the remainder of the year – see chart 1.

Chart 1

Chart 1 showing US PCE Price Index ex Food & Energy

The judgement here is that such a slowdown is achievable and could be exceeded, based on the following considerations.

First, such performance was bettered in H2 2023, when the monthly rise averaged 0.155%, or 1.9% annualised, i.e. the requirement is within the range of recent experience.

Secondly, the monetarist rule of thumb of a two-year lead from money to prices suggests a strong disinflationary impulse during H2 2024. From this perspective, any current “stickiness” may reflect the after-effects of a second pick-up in six-month broad money momentum in 2021, following the initial surge into mid-2020– see chart 2.

Chart 2

Chart 2 showing US PCE Price Index & Broad Money (% 6m annualised)

Momentum returned to a target-consistent 4-5% annualised in April 2022, subsequently turning negative and recovering only from March 2023, with the latest reading still sub-5%. Allowing for the usual lag, the suggestion is that six-month price momentum will move below 2% in H2 2024, remaining weak through next year.

A third potential favourable influence is a speeding-up of the transmission of recent slower growth of timely measures of market rents to the PCE housing component. Six-month momentum of the latter was still up at 5.6% annualised in March but weakness in the BLS new tenant rent index through 2023 is consistent with a return to the pre-pandemic (i.e. 2015-19) average of 3.4% or lower – chart 3. With a weight of 17.5%, such a decline would subtract 3 bp from the monthly core PCE change.

Chart 3

Chart 3 showing US PCE Price Index for Housing (% 6m annualised) & BLS Tenant Rent Indices (4q ma, % 6m annualised)

UK house prices were an estimated 52% expensive relative to history at the end of 2023, based on a comparison with rents and the real yield on index-linked gilts, a competing inflation-protected asset.

The degree of overvaluation is below previous extremes and does not imply that house prices need to fall by an equivalent magnitude, or even at all – the deviation could be eliminated by rental growth and a reversal of the recent rise in real yields.

The ratio of the average house price to average earnings is conventionally used to assess valuation. Chart 1 shows an economy-wide version of this ratio – the estimated value of the housing stock divided by aggregate household disposable income.

Chart 1

Chart 1 showing Ratio of UK House Prices to Household Income* *Value of Housing Stock Divided by Gross Disposable Income of Households

The secular rise in the ratio is usually ascribed to such factors as increasing credit availability, population growth and undersupply due to planning and other constraints.

The use of earnings as a yardstick is questionable: it would be odd to assess the valuation of an equity market by reference to the income of investors. A better approach is to compare house prices with the value of services provided – proxied by rents – using an appropriate discount rate.

A simple valuation metric based on this approach is the gap between the rental yield on housing and the real yield on longer-term index-linked gilts. Index-linked rather than conventional bonds are the appropriate reference because housing is expected to provide inflation protection over the longer term.

The rental yield series, shown in chart 2, is derived from national accounts data by dividing the sum of actual and imputed rents by an estimate of the value of the housing stock*. The measure, therefore, is comprehensive, including owner-occupied and public housing as well as private rented accommodation.

Chart 2

Chart 2 showing UK Housing Rental Yield & 5y+ Index-Linked Gilt Yield

The index-linked yield series starts in 1983 – the first such gilt was issued in 1981 – so the rental / index-linked yield gap has 41 years of history. In contrast to the house price to income ratio, the gap appears to be stationary / mean-reverting. The average (mean) gap over this period was 4.96 pp. The deviation from this average is the basis of the estimate of over- / undervaluation in a particular year.

The gap indicates that housing was undervalued as recently as in 2021 but only because index-linked yields had fallen to a record negative.

The drop in the yield gap to an estimated 3.27% at end-2023 – implying housing overvaluation of 52% – was driven by index-linked yields returning to positive territory. The rental yield was little changed between 2021 and 2023.

Current overvaluation compares with prior extremes of 74% in 2007 and 105% in 1988 – chart 3. These extremes marked peaks of the 18-year housing cycle, with another top due around 2025.

Chart 3

Chart 3 showing Ratio of UK House Prices to Implied Fair Value* *Based on Rental Yield / Index-Linked Yield Gap

The suggestion is that, unless index-linked yields revert to negative, housing will perform poorly relative to history over the longer term, although prices may be supported over the next 1-2 years as the housing cycle upswing crests.

*The current series for actual and imputed rents begin in 1985; earlier numbers were estimated by linking to previous vintages. The value of the housing stock was calculated by adding the value of dwellings and an estimate of the value of associated land. The latter estimate was derived by applying the ratio of land value to dwellings value for households to the value of dwellings owned by all sectors. The resulting series begins in 1995; earlier numbers were estimated by linking to a previous vintage series for the value of the residential housing stock including land.

A modest upside inflation surprise in March has been portrayed as confirming that inflationary pressures remain sticky, warranting further delay in policy easing.

The stickiness charge is bizarre in the context of recent aggregate data. The six-month rate of change of core consumer prices, seasonally adjusted, has fallen from a peak of 8.4% annualised in July 2023 to 2.4% in March – see chart 1.

Chart 1

Chart 1 showing UK Consumer Prices & Broad Money (% 6m annualised)

Six-month momentum, admittedly, has moved sideways over the last four months. This mirrors a pause in the slowdown in six-month broad money growth in early 2022, with the relationship suggesting a resumption of the core downtrend from around May.

Claims of stickiness focus on measures of core services momentum. Such measures gave no forewarning of the inflation upswing and are unsurprisingly also lagging in the downswing.

“Monetarist” theory is that monetary conditions determine trends in nominal spending and aggregate inflation, with the goods / services split reflecting relative demand / supply considerations.

Global goods prices have been under downward pressure because of rising supply and falling input costs (until recently), resulting in a diversion of nominal demand and pricing power to services.

So a monetarist forecast is that a recovery in goods momentum is likely to be associated with faster services disinflation within a continuing aggregate inflation downswing.

A subsidiary argument to the sticky inflation view is that the MPC can afford to be cautious about policy easing because the economy is regaining momentum.

Monetary trends have yet to support a recovery scenario. Of particular concern is a continued contraction in corporate real money balances, which chimes with weakness in national accounts profits data and suggests pressure to cut investment and jobs – chart 2.

Chart 2

Chart 2 showing UK Business Investment (% yoy) & Real Gross Operating Surplus of Corporations / Real PNFC* M4 (% yoy) *Private Non-Financial Corporations

The latest labour market numbers hint at negative dynamics. LFS employment (three-month moving average) fell sharply in December / January and is now down 346,000 from a March 2023 peak. Private sector weakness has been partly obscured by solid growth of public sector employment – up by 140,000 or 2.5% in the year to December.

Ugly unemployment headlines have been avoided only because of a sharp fall in labour force participation. The unemployment rate of 16-64 year olds would have risen by 1.2 pp rather than 0.3 pp over the last year if realised employment had been accompanied by a stable inactivity rate – chart 3.

Chart 3

Chart 3 showing UK Unemployment & Inactivity % of Labour Force, 16-64 Years

Claims of labour market resilience rest partly on the HMRC payrolled employees series but this fell for a second month in March, although numbers are often revised significantly. (A previous post argued that this series has been distorted upwards by rising inclusion of self-employed workers in PAYE.)

A recent revival in housing market activity, meanwhile, could prove short-lived unless mortgage rates resume a downtrend soon. The latest Credit Conditions Survey signalled that banks plan to expand loan supply in Q2 but the balance (seasonally adjusted) expecting stronger demand fell back sharply – chart 4. Majorities continue to report and expect higher defaults, consistent with gathering labour market weakness – chart 5.

Chart 4

Chart 4 showing UK Mortgage Approvals for House Purchase (yoy change, 000s) & BoE CCS Future Demand for / Availability of Secured Credit to Households

Chart 5

Chart 5 showing UK Unemployment Rate (3m change) & Net % of Banks Reporting Increase in Default Rate on Secured Credit to Households

Woman visiting beautiful town in Cinque Terre coast, Italy.

Despite ongoing macroeconomic uncertainties and some softness in business activity, financial results published from our holdings for 2023 reassured us. On average, both margins and earnings held up relatively well. Here are two examples of holdings that contributed positively during the first quarter of 2024.

Sopra Steria Group:

Sopra has historically managed mid-single digit organic growth in addition to consistent quality M&A to enhance topline growth. Its historical margins, however, have lagged larger peers like Accenture or CapGemini due to the acquisition of Steria in 2014 which was dilutive to margins [Steria was 350 basis points (bps) below Sopra’s margin], as well as some segments and geographies where management has somewhat sacrificed margins for growth. In 2023, despite additional margin dilution from recent acquisitions, Sopra achieved a 9.4% operating margin, its highest since 2011, and much closer to the 10% to 12% expectation for a major European IT service firm. This was driven by increased pricing, operational efficiencies and scale. We expect Sopra to reach and maintain this improved margin profile in the next couple of years, while maintaining a defensive end-market profile than peers. As such, we remain optimistic on the name.

Melia Hotels International:

After the initial collapse of travel in 2020, when Melia saw its sales drop 70% year over year, the resort hotel operator enjoyed explosive revenue growth due to what analysts coined “revenge travel.” While 2023 saw more normalized 14% topline growth after two years of high double-digit growth, there is still plenty of room for sustainable growth on both the top and bottom line. Despite reaching peak EBITDA from 2018, margins remain a full 200 bps before pre-COVID and there is no reason to believe pre-COVID margins cannot be reached again as the inflationary environment normalizes. Furthermore, the company announced earlier this year the sale of 38% of three of its hotels to Santander for €300 million, strengthening Melia’s balance sheet through deleveraging, while highlighting the bank’s confidence in Melia’s growth prospects. Overall, the company appears quite confident in its 2024 outlook. Despite concerns that inflation could impact discretionary spending including travel and lodging, Melia expects low double-digit RevPAR growth driven equally by price and occupancy, which seems supported by strong January and February data.

Over the next weeks, European companies will start publishing their Q1 revenues, and with it, their outlooks for 2024. The comparison basis with Q1 of 2023 could prove challenging, but we are still projecting companies to generate positive earnings growth for this calendar year. Here are some observations that tend to support our view that the economic improvement could continue:

Real wage growth and savings rates are supportive: After experiencing negative mid-single digit growth in 2022, the Eurozone and the UK are now back to positive real wage growth. As a result, saving rates have started to climb and the gap with the US has widen. As shown below, EU and UK gross savings rates are very supportive compared to the US. The economic activity could react positively to a scenario where households decide to shift a portion of that disposable income into consumption.

Savings rates across the US, the UK and the Eurozone

Chart 1: Line graph showing EU, UK and US gross savings rates, 2015 to 2024.
Source: Berenberg.

European optimism is growing: Business surveys and confidence indices are showing early signs of recovery, as indicated by the latest release on the German business outlook. Although it may not immediately translate into new orders, it could play an important role in how the second half of this year develops.

The housing market is stabilizing: Mortgage approvals in the UK bounced back in February to a level not seen since September 2022. A similar picture can be observed in Germany after two years of excessive contractions. Although corporate loans were still declining in the first quarter of 2024, we are starting to see credit conditions easing for mortgages, a first since 2021.

The destocking cycle is coming to an end: The destocking cycle that started in early 2023 has contributed to a very low level of stocks. Some industries might even carry too low a level of stocks in the event that pent-up demand returns in the second half. Any uplift in order intake would require a higher level of stocks, which would revitalize the manufacturing sector.

Valuation discount: The wide valuation gap that exists between Europe and Global could be narrowing as economic indicators and confidence improve. As shown by the 12-month forward earnings index below, small and mid-cap stocks are still trading at discount vis-a-vis Global. A potential rate cut, expected in June, combined with a reacceleration of demand, would likely drive small and mid-cap companies.

Forward 12-month earnings for European companies vs. the Global market

Chart 2: Line graph showing 12-month forward earnings index for Europe and Global small, mid- and large-cap indicies, 2019 to 2024.
Source: Berenberg.

In a world where the unexpected has become the norm, our holdings’ resilience through last year’s ups and downs offers a sense of stability and growth potential amid uncertainty – and an opportunity to think beyond the immediate to what could be on the horizon.

The quarterly commentary in mid-2023 noted that the cycle and monetary analyses were giving conflicting signals. The stockbuilding cycle appeared to be tracing out a low, a development usually associated with stronger performance of equities and other cyclical assets. However, greater weight was accorded to continued weakness in global real narrow money momentum, which suggested downside risk to economic activity and insufficient liquidity to support market gains.

The cycle signal has so far proved the correct one, with cyclical assets rallying strongly over the past five months. Monetary conditions have been more permissive than expected, probably reflecting continued deployment of “excess” money balances left over from the 2020-21 monetary surge, as well as unusual US deficit-financing operations.

What now? Valuations of some cyclical assets appear already to discount a solid and sustained economic upswing. Global real narrow money momentum has recovered slightly but remains negative, while the level of money balances may now be below “equilibrium”. Until money growth normalises, the risk is that an initial stockbuilding cycle recovery will prove disappointingly weak or even fail, with a retest of the 2023 low. A monetary revival, meanwhile, may have been pushed back by major central banks’ caution in reversing 2022-23 policy restriction, although an easing trend is under way in EM.

Commentaries in 2022 argued that the stockbuilding cycle was likely to bottom in 2023, probably in H2, based on the cycle’s 3.33-year average length and the prior low having occurred in Q2 2020. The possibility of an earlier trough was considered, on the view that the current cycle could be shorter than average to compensate for a longer prior cycle (4.25 years).

The key indicator used to monitor the cycle – the annual change in the stockbuilding share of G7 GDP – appears to have reached a major low in Q1 2023. A secondary indicator based on business surveys confirmed this trough in July – see chart 1.

Chart 1

Chart 1 showing G7 Stockbuilding as % of GDP (yoy change) & Business Survey Inventories Indicator

Stockbuilding cycle lows historically were usually associated with nearby major or minor lows in cyclical asset prices. Chart 2 shows the relationship with the relative performance of equity market cyclical sectors, excluding IT and communication services. A cyclical rally gathered pace from April 2023, consistent with a H1 cycle trough.

Chart 2

Chart 2 showing G7 Stockbuilding as % of GDP (yoy change) & MSCI World Cyclical ex Tech* Relative to Defensive ex Energy Sectors *Tech = IT & Communication Services

Why was a scenario anticipated in 2022 sadly underplayed in commentaries last year? The difficulty was that stockbuilding cycle lows historically were preceded by an upturn in global real narrow money momentum – chart 3. A marginal recovery in annual momentum occurred between February and June last year but a relapse to a lower low ensued. With no monetary improvement, and major central banks continuing to tighten into H2, it seemed unlikely that economic news and fund flows would support outperformance of cyclical assets.

Chart 3

Chart 3 showing G7 Stockbuilding as % of GDP (yoy change) & Global* Real Narrow Money (% yoy) *G7 + E7 from 2005, G7 before

One explanation for the disconnect is that real money momentum, while a reliable indicator historically, failed to capture the availability of money to support activity and markets because of an overhang of “excess” balances created by earlier monetary strength. The ratio of the stock of global real narrow money to industrial output at end-2022 was still 4% above its steeply rising pre-pandemic trend – chart 4.

Chart 4

Chart 4 showing Ratio of G7 + E7 Real Narrow Money to Industrial Output* & 1995-2019 Log-Linear Trend *Index, June 1995 = 1.0

The strength of US equities may also have partly reflected the US Treasury’s decision, following the suspension of the debt ceiling in June, to “overfund” the federal deficit via issuance of bills, which were purchased mainly by money-creating institutions. This had the effect of more than offsetting the monetary drag from the Fed’s QT, while low coupon issuance created space in investors’ portfolios for additional purchases of credit and equities.

Support from these influences should be at or close to an end. The ratio of global real narrow money to industrial output returned to its March 2020 level in mid-2023, moving sideways since and now 4% below the pre-pandemic trend – chart 4. The Treasury’s financing plans, meanwhile, envisage a reduction in the bill float in Q2, raising the possibility of renewed monetary US weakness unless the Fed swiftly tapers QT.

Global real narrow money momentum has firmed again since Q3 2023 but remains negative, in both annual and six-month terms. A revival could, in theory, continue even if major central banks delay policy easing: rising economic confidence could be reflected in a switch out of time deposits and money funds into demand / overnight deposits, while EM money trends may improve further in response to recent policy easing. More likely, a normalisation of money growth will require a significant reversal of 2022-23 DM policy rate hikes.

Without a further rise in real money momentum, the initial stockbuilding cycle recovery may prove disappointingly limp or even fizzle altogether, revisiting the H1 2023 low. Such a scenario would pose a major risk to some cyclical assets now apparently discounting solid / sustained economic growth, such as the DM cyclical equities sector basket – chart 5.

Chart 5

Chart 5 showing MSCI World Cyclical ex Tech* vs Defensive ex Energy Sectors Valuation Z-scores *Tech = IT & Communication Services

How could investors sharing the latter concern and favouring a defensive bias hedge against the possibility that a stockbuilding cycle upswing unfolds normally, implying economic acceleration into 2025? Some cyclical assets have lagged, including industrial commodity prices, the DM materials sector and EM cyclical sectors, which – unlike in DM – are at a low valuation versus defensive sectors relative to history.

Chart 6 shows six-month real narrow money momentum in major countries. The US remains above Europe but the gap has narrowed, while, as argued above, the US recovery could go into reverse into Q2. The UK, meanwhile, has crossed above the Eurozone, suggesting improving relative economic prospects following GDP underperformance in the year to Q4.

Chart 6

Chart 6 showing Real Narrow Money (% 6m)

China was a significant contributor to the recent rise in global real narrow money momentum, following record PBoC lending to banks in Q4. Such lending, however, contracted in January / February and a decline in term money rates has stalled, raising concern that the recovery in money growth will falter.

Other notable features include a pick-up in Australia, continued relative weakness in Switzerland and a relapse in Sweden. The suggestion is that the Australian economy will outperform, delaying rate cuts; by contrast, the Swiss National Bank has already embarked on easing, with the Riksbank expected to follow in Q2.

G7 inflation has continued to moderate in line with a simplistic monetarist forecast based on the profile of broad money growth two years earlier. A note in November 2022 suggested that annual consumer price inflation (GDP-weighted average), then at 7.8%, would fall below 3% by December 2023. The latest reading, for February, was 2.9%.

US annual core inflation on the Fed’s favoured PCE measure was 2.8% in February or 2.2% excluding lagging rents. Market concerns about inflation remaining “stubborn” are based on a rebound in shorter-term momentum measures but this has been mainly due to an outsized January gain, possibly reflecting residual seasonality (which could also explain unexpected weakness in late 2023), i.e. these measures are likely to fall back sharply as the January effect drops out.

G7 annual broad money growth continued to decline into April 2023, suggesting that the primary inflation trend will remain down into H1 2025. The reduction to date, however, was accelerated by post-pandemic normalisation of supply chains and weakness in commodity prices – the former effect is over and commodity prices usually rise during stockbuilding cycle upswings. The baseline view here remains that inflation rates will return to target by H2 2024 with significant risk of a subsequent undershoot and no sustained rebound before H2 2025.

US economic “resilience” in 2023, recent inflation stabilisation and buoyant risk asset markets raise the question of whether the current level of policy rates is restrictive.

A “neutral” level of rates, according to the monetarist view, is one that results in monetary growth consistent with target inflation. Based on 2010s experience, US broad money expansion of about 5% pa could reasonably be expected to yield medium-term inflation of 2%. (“Broad money” here refers to an expanded M2 measure – “M2+” – incorporating large time deposits at commercial banks and institutional money funds.)

The six-month rate of change of broad money recovered from negative territory in early 2023 to 3.7% annualised in January, remaining at this level in February – see chart 1. This might be taken to suggest that the economy is adjusting to the higher level of rates and the current deviation from “neutral” is modest.

Chart 1

Chart 1 showing US Broad / Narrow Money (% 6m annualised)

Money growth over the past year, however, was boosted by unusual deficit financing operations, which more than offset monetary destruction due to the Fed’s QT. The Treasury’s plans to scale back bill issuance imply a sharp reversal in Q2, as previously discussed.

Put differently, the “neutral” level of rates may have been temporarily lifted by the Treasury’s financing operations but a relapse is now likely.

Could a recovery in bank lending offset a near-term drag on money growth from less expansionary Treasury operations and ongoing QT? Six-month growth of commercial bank loans appears to have bottomed in late 2023 but was only 2.1% annualised in February, while the last Fed loan officer survey remained downbeat – chart 2.

Chart 2

Chart 2 showing US Commercial Bank Loans & Leases (% 6m annualised) & Fed Senior Loan Officer Survey Credit Demand & Supply Indicators* *Weighted Average of Balances across Loan Categories

The suggestion that “neutral” is significantly lower than the current level of policy rates is supported by narrow money trends. (“Narrow money” = M1A = currency in circulation plus demand deposits.) Six-month momentum also recovered during 2023 but peaked at only 1.7% annualised in December, easing to 1.2% in February – chart 1.

Narrow money may be re-entering contraction – monthly changes were negative in January and February.

The latest US data support concern that a minor recovery in global six-month real narrow money momentum is about to go into reverse.

Meanwhile, weakness in US “hard” economic data for January / February has, perhaps, received less attention than it deserves. Average levels of retail sales, industrial production, durable goods orders and household survey employment were lower than in Q4 – chart 3. March data could change the story but joint quarterly declines were historically characteristic of recessions.

Chart 3

Chart 3 showing US Activity Indicators (% qoq)

Global six-month real narrow money momentum – a key leading indicator in the forecasting approach employed here – has recovered from a low in September 2023 but remains negative and could be stalling. Allowing for the typical lead, this suggests a slide in economic momentum into mid-year with limited subsequent revival.

Monetary trends, therefore, cast doubt on the current market consensus view that a global cyclical upswing is under way.

The real money / economic momentum relationship is primarily directional, i.e. involving turning points rather than levels. Chart 1 highlights related troughs in six-month rates of change of global (i.e. G7 plus E7) real narrow money and industrial output since 2000. The average lead time at these lows was eight months, with a range of four to 14.

Chart 1

Chart 1 showing G7 + E7 Industrial Output & Real Narrow Money (% 6m)

So the September 2023 low in real money momentum could be associated with an output momentum low any time between January and December 2024.

The directional relationship was briefly disrupted during the pandemic but has since been reestablished: a trough in real money momentum in June 2022 was followed by an output momentum low in December 2022, with subsequent peaks in December 2022 and October 2023 respectively.

Six-month output growth in January was the slowest since May.

While the directional relationship is intact, output momentum in 2022-23 was much stronger than suggested by prior levels of real money momentum. As previously discussed, this is probably attributable to a monetary “overhang” from rapid growth in 2020-21. The ratio of the stock of global real narrow money to industrial output returned to its March 2020 level in September last year and has since moved sideways, arguing for a normalisation of the levels relationship of real money and economic momentum.

The recovery in real money momentum between September 2023 and January 2024 was broadly based across countries but the US pick-up reversed in January – see previous post – while Chinese / Japanese momentum declined in February – chart 2. So the global revival could be stalling with momentum still negative. (A February update will be provided following release of US / Eurozone monetary data next week.)

Chart 2

Chart 2 showing Real Narrow Money (% 6m)

How do monetary signals compare with messages from the yield curve?

Chart 3 shows a longer-term history of six-month rates of change of global industrial output and real narrow money, along with the differential between GDP-weighted averages of 10-year government bond yields and three-month money rates. (The chart splices together G7 data through 2004 with subsequent G7 plus E7 numbers.)

Chart 3

Chart 3 showing Global* Industrial Output (% 6m), Real Narrow Money (% 6m) & Yield Curve *G7 + E7 from 2005, G7 before

The directional leading relationship between real money and economic momentum is equally convincing pre-2000, with a similar average lead time.

The yield curve has broadly mirrored trends in real money momentum, with a slight tendency for money to lead. However, the curve predicted fewer output momentum turning points, particularly in recent years, i.e. monetary signals have been more informative and reliable.

Continued yield curve inversion is consistent with still-negative real money momentum. An increase in inversion since October, moreover, contrasts with the recent monetary recovery, supporting concern that the latter may be stalling.

Combinations of negative real money momentum and an inverted curve were always followed by global recessions. The longest interval between a joint signal and recession onset was in 1989-90: real money momentum and the yield curve were both negative in April 1989, with a recession judged to have started in November 1990*.

The most recent joint signal occurred in October 2022, when the yield curve moved into inversion. Based on history, a recession would be expected by May 2024 at the latest. Are markets premature in sounding the all-clear? Assuming no downturn through May, should the signal be disregarded? Do I feel lucky?

*The recession bands in the chart begin when the six-month change in industrial output turns negative ahead of a fall to below -1.25% (not annualised).

The Fed’s quarterly financial accounts provide information on sector money trends and funds flows. Several features of the Q4 accounts, released last week, are noteworthy.

First, net retirement of equities by non-financial corporations (via buy-backs and cash take-overs) reached a record dollar amount ($270 billion) in Q4, confirming that corporate buying was a key driver of the year-end rally – see chart 1.

Chart 1

Chart 1 showing US Non-Financial Corporations: Net Retirement of Equities ($ bn)

The rise in equity purchases followed strong growth of non-financial business broad money holdings in the year to end-Q3, discussed in a previous post. Such holdings, however, contracted slightly in Q4, pulling annual growth down from 10.6% to 6.2% – chart 2.

Chart 2

Chart 2 showing US Broad Money Holdings by Sector (% yoy)

Financial business money holdings had surged in the year to end-Q1 2023, perhaps partly reflecting cash-raising related to equity market weakness in 2022. These balances were run down during H2, though still finished the year slightly higher than at end-2022.

The recent weaker trends in non-financial and financial business money suggest less buying support for equities and other risk assets going forward.

Household broad money, by contrast, rose solidly in Q4, resulting in the annual change returning to positive territory. The ratio of money holdings to disposable income recovered slightly following six consecutive quarterly declines, remaining above its pre-pandemic trend, in contrast to shortfalls for corresponding Eurozone and UK ratios – chart 3.

Chart 3

Chart 3 showing Household Broad Money to Disposable Income Ratios

The Q4 financial accounts also contain initial estimates of corporate profits and gross domestic income (GDI). Profits after tax adjusted for stock appreciation and economic depreciation rose at a 2.5% annualised rate last quarter and remain below a peak reached in Q3 2022 – chart 4, blue line. The range-bound movement is consistent with S&P 500 earnings data and questions perceptions of economic / profits strength.

Chart 4

Chart 4 showing US National Accounts Corporate Profits & S&P 500 Aggregate Earnings ($ bn)

GDI is an alternative estimate of GDP and has consistently lagged the headline expenditure-based measure in recent quarters – see previous post. It did so again in Q4, rising at a 1.9% annualised rate versus headline GDP growth of 3.2% – chart 5. GDI grew by just 1.2% in the year to Q4.

Chart 5

Chart 5 showing US GDP / Gross Domestic Income (% qoq annualised)