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A green and yellow motorized rickshaw zips through the streets of Delhi, India.

Since the World Bank’s International Finance Corporation first coined the term emerging markets in 1981, the characteristics and composition of the markets have evolved significantly. Past concerns regarding the resilience of emerging markets during a crisis led some investors to struggle with the merits of including a direct allocation. However, with the rise of China and its leadership of global economic growth, investors are increasingly considering a dedicated allocation to emerging markets. This article reviews the evolution and the general case for investing in emerging markets.

The key attributes supporting the case for global emerging markets have been evident for some time and include:

Greater growth	In the latest Global Economic Prospects report by The World Bank Group, emerging and developing economies are forecast to grow more than double that of advanced economies in 2023 and 2024.
Drivers of Innovation	Many emerging markets companies have become leaders of innovation in important sectors such as internet-related technologies, electric vehicle battery manufacturing, and computer chip manufacturing.
Household names	Many emerging market companies are household names such as Samsung and Hyundai, while other less recognized companies have acquired well-known global brands.
Rising returns	As emerging markets shift from manufacturing to more value-added industries, there is an expectation for the ability to generate superior returns to rise.
Alpha opportunities	Emerging markets are less researched by the analyst community compared with large cap developed equity markets, which creates opportunities for excess returns from independent research by active managers.

Background

Emerging markets are characterized as countries with growing economies and a growing middle-class population. Many of these markets continue to have high rates of poverty, and often they are still experiencing significant social and political change. But despite such headwinds, the growth prospects of emerging markets can provide a strong base for investors to be rewarded.

The market capitalization of emerging markets was US$ 90,456 billion as of December 31, 2022, representing a little over 11% of the world equity capitalization. Yet many institutional investors have no direct exposure to emerging markets. Instead, investors often rely on their international and global equity managers to selectively invest in emerging markets, which can result in the allocation falling well short of its representation of the world equity market capitalization. With emerging markets representing the highest growth area of global stock markets, there is a case for investors to benefit from at least a market representation.

The MSCI Emerging Markets Index is comprised of over 1,300 stocks in 24 countries. Countries are normally grouped into three regions, Emerging Markets Asia, Emerging Markets Latin America and Emerging Markets Europe, Middle East and Africa, with the Asian region representing almost 80% of the market index.

Evolution

For the longest time emerging markets were considered similar to the Canadian equity market, with a heavy bias to commodities. Today, the combined weighting in energy and materials for emerging markets is less than 13% of the index market capitalization, compared to 30% of the Canadian equity market. Instead, emerging markets have evolved to offer opportunities different to the Canadian equity market. For example, emerging markets have experienced a steady rise in the information technology and health care sector allocations, which together represent over 20% of the market index (Figure 1). Not only that, but within the information technology sector there has also been a radical change in its composition with large and successful companies, such as Alibaba and Tencent making up an important component of the sector.

Figure 1: Index Sector Allocations

Global Industry Classification (GIC) Sector	MSCI Emerging Markets (%)	S&P/TSX Composite (%)
Energy	5.0	18.1
Materials	7.6	12.0
Industrials	19.4	13.3
Consumer Discretionary	12.5	3.7
Consumer Staples	4.7	4.2
Health Care	10.7	0.4
Financials	14.3	30.8
Information Technology	10.8	5.7
Communication Services	2.8	4.9
Utilities	3.2	4.4
Real Estate	8.9	2.6

Source: Thomson Reuters Datastream. Data as of December 31, 2022. Due to rounding, column percentages may not total 100%.

The financial sector represents around 14% of the index and offers a further differentiation versus developed markets, where the loan-to-deposit ratios in emerging market companies are generally lower.

However, the biggest change to the emerging market index has been with respect to country allocation, and the growing dominance of China in the index. It was not long ago that large cap China A shares represented less than 1% of the MSCI Emerging Markets Index. At the end of 2022, China accounted for over 32% of the index (Figure 2).

Figure 2: Region and Larger Country Allocations

Region and Country	MSCI Emerging Markets Index (%)
Emerging Markets Asia	78.3
China	32.3
India	14.4
Taiwan	13.8
Republic of Korea	11.3
Emerging Markets Europe, Middle East & Africa	13.2
Saudi Arabia	4.1
United Arab Emirates	1.4
Qatar	1.0
Kuwait	0.9
South Africa	3.7
Emerging Markets Latin America	8.5
Brazil	5.3
Mexico	2.3

Understanding the Risks

It is important to appreciate risks associated with investing in emerging markets. While active managers can mitigate some of these risks through research and careful selection of individual stocks, investors should recognize the following.

Political and social risk: Political and social changes taking place in emerging market countries can lead to uncertainty due to corruption, regulations not always being rigorously enforced, or governments exhibiting an unwanted influence. The uncertainty contributes to market volatility. For example, Beijing’s actions to limit the influence of Hong Kong-listed technology companies, combined with a real estate sector crisis and the zero-COVID policies that witnessed longer strict pandemic controls relative to most other governments, contributed to a tough and volatile 2021-2022 for emerging market equities.
Information and liquidity risk: Although the quality of data has vastly improved, obtaining good, complete and timely information can still be challenging in emerging markets. Currency controls remaining in a small number of markets also may create liquidity concerns.

Recognizing the potential benefits

While the countries are classified as emerging, nearly all the companies in the MSCI Emerging Markets Index have a market capitalization greater than US$ 1 billion, which compares to 209 Canadian companies with a market value above US$ 1 billion. Increasingly, emerging market companies are becoming household names, whether on their own merits, or through acquisition of global branded companies, such as Samsung, Hyundai Motor and the Indian conglomerate, Tata, which is the owner of brands such as Jaguar, Land Rover and Tetley Tea.

The key benefits offered by emerging markets include:

Growth opportunity: The drivers of growth are wide ranging and include demographics, economic development, technology, innovation, infrastructure development, and capital market developments. While global growth is expected to moderate from 2021 levels, emerging and developing countries are expected to account for a significant component of world gross domestic product (GDP). The World Bank forecasts emerging and developing markets to grow at an average annual rate of 3.4% in 2023 and 4.1% in 2024, compared to expansion of only 0.5% and 1.6%, respectively for advanced (developed) economies.¹ A significant proportion of developed market company earnings are also linked to emerging market growth, further underlining its importance.
Drivers of innovation: Innovation in emerging markets has contributed to its evolution, as well as China becoming an important component of the market. Innovation has allowed several emerging market countries to leapfrog the developed world in terms of business models. For example, while many farmers in India have no access to computers and landlines, smart phones have created an information and business environment that allows buyers and sellers to interact, as well as enabling e-payments.
Rerating opportunity: Ordinarily, high-growth assets are priced at a premium. Emerging market stocks have traditionally traded at a discount to developed world valuations, but the economic fundamentals for emerging markets as a whole have improved.
Improving returns: Many emerging market companies are shifting away from manufacturing for Western companies and looking to develop their own identity and growth success. To achieve this they are tapping into higher value-added areas using brands and technology, recognizing that branded firms with loyal followers can achieve more than double the margins of non-brand firms. Return on invested capital (ROIC) should rise for emerging market companies as they develop world-class brands.
Growing universe of opportunities: The growth of China in the emerging market index has also witnessed a growth in the universe of investment opportunities. Today, there are as many China A shares that meet the typical liquidity and market capitalization criteria as there are in the United States (US) equity market. Similarly, the number of opportunities for emerging markets excluding China is not too different from the number of opportunities for the global developed market, excluding the US.
Style offset opportunity: The growing opportunity set has witnessed a growth in systematic (quantitative) fund offerings, where the managers use technology to gain a breadth of understanding on a large universe of companies, compared to the depth of understanding associated with fundamental managers focused on selecting a smaller portfolio of companies. As for other equity markets, investors who can accommodate multiple managers in an asset class can benefit from the complementary approaches of systematic and fundamental styles.
Alpha opportunity: The external analyst community generally undertakes less research of emerging market companies compared to global developed companies. Active managers have been able to benefit from independent research with over 86% of managers in the emerging market equity universe outperforming the MSCI Emerging Market Index over the 10 years ended December 31, 2021 (based on the eVestment database).

Environmental, Social and Governance Considerations (ESG)

Despite the political and social challenges associated with emerging market countries, companies are increasingly recognizing the importance of ESG considerations. Helping this cause has been the expansion of ESG coverage of emerging markets companies by third-party providers. The importance of each ESG component varies from one country, industry or company to another. However, like the developed world, corporate governance tends to be the most material issue, followed by the steps being taken to manage the environmental impact of companies in the emerging markets.

The Case for Emerging Markets

Many investors are underweight emerging markets relative to its representation in world equity markets, yet global growth is expected to be led by emerging and other developing markets.

Canadian investors have historically shied away from emerging markets, partly due to the historical commodity bias. Today, emerging markets offer a very different opportunity set due to innovation that has seen a transformation in the type of companies and opportunities, including a significant growth in the information technology sector.

As emerging market companies shift from manufacturing to higher value-added interests using brands and technology, the number of emerging market household names will increase, and help to grow margins and ultimately the return potential from emerging markets.

¹ Source: World Bank Global Economic Prospects, January 2023

Japanese monetary trends continue to argue that current inflation is “transitory” and there is no case for BoJ policy tightening.

Broad money M3 rose by just 0.1% in January, pulling annual growth down to 2.3%, below a 2010-19 average of 2.6%. Annual M1 growth is also below its corresponding average – see chart 1.

Chart 1

M3 showed little growth on the month despite BoJ net JGB purchases reaching a record ¥20.3 trillion, equivalent to $155 billion or 1.3% of the stock of M3 – chart 2. The modest M3 increase pushes back against claims that BoJ JGB buying has “pumped liquidity into markets”.

Chart 2

A counterparts analysis of M3 is not yet available for January but the lack of impact of QE is probably explained by the BoJ transacting mainly with commercial banks. A purchase from a bank involves a JGB / reserves swap with no effect on deposits held by non-banks.

A further technical point is that Japanese money definitions exclude holdings of non-bank financial institutions, so purchases from such institutions also have no direct effect on M3.

Chart 3 shows the contributions to annual M3 growth of selected credit counterparts through December. A substantial positive contribution from QE (domestic credit to government from BoJ) was offset by weakness in domestic credit to other sectors and negative contributions from commercial bank JGB sales (domestic credit to government from other banks) and net external flows. The latter drag partly reflects BoJ intervention to support the yen in late 2022.

Chart 3

The weakness of credit expansion to non-government domestic sectors in the M3 counterparts analysis contrasts with a recent pick-up in annual growth of loans and discounts by major, regional and Shinkin banks – chart 4. The explanation for the divergence is that the M3 credit measure encompasses lending to non-bank financial institutions, including by the BoJ. Such lending surged during the pandemic but has contracted recently.

Chart 4

Annual all-items consumer price inflation rose to 4.0% in December, the highest since 1981, and may have reached 4.5% in January, based on Tokyo data. Core inflation adjusted for the impact of major policy changes was 1.7% in December and may have increased to 2.0-2.1% in January. The recent pick-up partly reflects yen weakness, which may be reversing – chart 5.

Chart 5

Annual cash earnings growth surged to 4.8% in December as winter bonuses reflected recent strong profits. Scheduled earnings growth of 1.8% is a better guide to trend but also represents a multi-decade high.

The reversal of the 2020-H1 2021 M3 growth surge suggests that inflation and earnings growth are at or near a peak and will return to pre-pandemic levels in 2024-25.

African American Business Data Analyst Woman Using Computer, global map and data on screen

Investors globally have embraced global small cap equities as a source of equity diversification. Despite the name, the universe is largely comprised of companies with a market capitalization greater than US $1 billion and includes a growing number of household names in many of the local markets and some having a global brand recognition.

Key merits of global small cap

Not that small	Over 2,600 global small cap companies have a market capitalization greater than US $1 billion
Breadth and depth	Largest stock is only 0.2% of the index and there is broader sector diversification compared to other major market indices
Alpha opportunities	Global small cap markets are less researched by the analyst community compared with large cap developed equity markets, which creates added value opportunities for independent research by active managers

Background to global small cap

Global small cap stocks offer investors the ability to benefit from a unique opportunity set. The MSCI World Small Cap Index captures small cap representation across 23 developed market countries. Compared to a domestic context, the global small cap opportunities are not that small; there are 2,643 companies with a market capitalization greater than US $1 billion at December 31, 2022. There were only 209 such companies in the S&P/TSX Composite Index.

The largest individual stock in the global small cap index represents only 0.2% of the index. In contrast, the largest individual stock at the end of 2022 in the S&P/ TSX Composite Index represented 6.3% of the index.

Moreover, the largest 15 stocks in the Canadian equity market index account for 45% of the index, while the largest 15 stocks in the global small cap index represent less than 3%. It would require the largest 627 stocks to achieve 45% index representation in the global small cap index, highlighting the much broader investment opportunity set offered by the global small cap universe.

Many of the stocks in the global small cap universe are household names in their local market, and some have a global brand recognition. For example, L’Occitane, the manufacturer, marketer, and retailer of natural and organic skincare and beauty products; Samsonite, the world’s best-known and largest travel luggage company; and IWG, which offers short-term (and long-term) workspace solutions around the world, including well-known brands such as Regus.

The diversification benefits of global small cap go beyond individual stocks. While the major Canadian indices are heavily skewed to the financial, energy, and material sectors (see Figure 1), the global small cap markets provide representation across a broader range of sectors, including higher exposure to consumer discretionary (e.g., companies in the restaurant, luxury goods and travel industries) and health care.

Figure 1 – Small Cap Sector Diversification Merits

	MSCI Global Small Cap Index (%)	S&P/TSX Composite Index (%)
Energy	5.0	18.1
Materials	7.6	12.0
Industrials	19.4	13.3
Consumer Discretionary	12.5	3.7
Consumer Staples	4.7	4.2
Health Care	10.7	0.4
Financials	14.3	30.8
Information Technology	10.8	5.7
Communication Services	2.8	4.9
Utilities	3.2	4.4
Real Estate	8.9	2.6
Total	100	100

Source: MSCI and Thomson Reuters Datastream. Data as at December 31, 2022

Over the last 10 years, the global small cap index has achieved the strongest return, albeit with greater volatility (Figure 2). As with all markets, it is important to understand the investment risks.

Figure 2 – 10-Year Risk and Return (Ending Dec. 31, 2022)

Source: MSCI and Thomson Reuters Datastream. Note: Index returns are in Canadian dollars.

Understanding the risks

While active managers can mitigate some of the risks through research and careful selection of individual stocks, when it comes to global small caps, investors should recognize the following:

Liquidity risk: It can take longer to trade a small cap stock compared to large cap stocks.
Information flow: While higher insider ownership associated with small cap stocks aligns with the interests of investors, it can also lead to less transparency and flow of information common with global large cap investments.
Credit access: Small companies do not have the same access to credit markets as larger companies, which can sometimes limit a small company from realizing its potential.

Recognizing the potential benefits

Offsetting the risks are a number of potential benefits of global small cap investments:

Growth opportunity: For investors who can identify the next generation of small companies that grow faster and graduate into the large cap segment, the reward is significant.
Greater alignment of interest: Global small cap companies tend to have a more focused line of business and higher insider ownership, resulting in greater alignment of interests between the owners and shareholders.
Sector opportunity: Investors can benefit from the higher consumer discretionary and health care sector representation offered by the global small cap index. For example, consumer-spending patterns indicate the consumer discretionary sector is likely to perform well over the long term. The health care sector should also benefit from demographic aging in the developed world.
Added value opportunity: Small cap companies also tend to be less externally researched by the analyst community. As a result, active managers have a greater opportunity to outperform their index benchmark by identifying companies whose share price does not fully reflect their intrinsic value or growth prospects. Based on the eVestment database, 71% of managers in the active global small cap universe outperformed the MSCI World Small Cap Index over the 5 years ended December 31, 2022.
Style offset opportunity: At the end of 2022, over 4,425 companies were in the MSCI World Small Cap Index. The broader opportunity set has led to an increased number of global small cap strategies offered by systematic (quantitative) investment managers. With a systematic approach, an investment manager is able to benefit from a breadth of understanding on a large universe of companies, compared to the depth of understanding associated with fundamental managers, who are focused on selecting a smaller number of companies to invest in. As for other equity markets, investors who can accommodate multiple managers in an asset class can benefit from the complementary systematic and fundamental styles.

Case for global small cap equities

The last several years has witnessed increased concentration in the global large cap developed equity market index. Introducing a global small cap equity component to portfolios can provide a complimentary source of diversification, a broader opportunity set of less externally researched companies, and thereby offering the potential for delivering returns above the index through active management.

The unusually high level of job openings may be affecting the seasonality of US labour market data. An accurate read on the non-seasonal employment trend may not be possible until the spring.

The normal seasonality of US private payrolls is captured by the difference between BLS unadjusted and seasonally adjusted stock series, shown in chart 1. The seasonal effect is roughly neutral in September, rises to a peak in November, turns substantially negative in January and recovers back to neutral in May.

Chart 1

The normal pattern of employers shedding jobs on a large scale in January but rehiring into the spring / summer could change when the labour market is unusually tight, as currently. Firms may prefer to hold onto workers as seasonal activity slackens, anticipating difficulties refilling jobs later in the year. Laid-off employees may find alternative work more rapidly than in a normal year.

A change of behaviour may explain the blockbuster January payrolls rise, i.e. the seasonal adjustment may have significantly overestimated the seasonal drop in employment this year.

An alternative approach to assessing the underlying jobs trend is to compare months when the seasonal effect is neutral. As noted, September and May are neutral months, while seasonal deviations are significant over October-April. The average change in unadjusted payrolls over September-May should be an undistorted measure of employment growth.

If the suggestion of a seasonal distortion is correct, headline payrolls growth numbers for February-May could understate the underlying trend, compensating for January’s (possible) overstatement.

Suppose, for illustration, that monthly growth in unadjusted payrolls turns out to average 150,000 between the two seasonally neutral months of September 2022 and May 2023. (This equates to an annualised growth rate of 1.4%, in line with the reported expansion of the labour force in the year to January, i.e. the assumption is consistent with a stable unemployment rate.)

Such growth would imply a payrolls level of 132,686,000 in May 2023, with no significant seasonal element. This compares with a currently reported seasonally adjusted level of 132,684,000 for January. The headline payrolls measure, on these assumptions, would show negligible growth over February-May.

A post in October gave a hopeful view of Chinese prospects, noting that “excess” money had accumulated and could flow into equities and the economy if policy-makers signalled a commitment to expansion.

The consensus is now optimistic, believing that property market support measures and the removal of pandemic control restrictions will result in strong economic acceleration through 2023. Yet the latest money / credit data signal caution.

Globally, Chinese reopening is expected to be reflationary. Reopening, however, will release supply as well as demand. The former effect could dominate, resulting in additional downward pressure on Chinese export prices.

Six-month growth of true M1 peaked in July 2022, falling back to its March level in December – see chart 1. This suggests a slowing of underlying nominal GDP momentum from Q2. The levels of nominal and real narrow money growth are modest by historical standards.

Chart 1

Broad money trends are stronger, with six-month growth of the favoured measure here – M2 excluding deposits of non-bank financial institutions – ending 2022 near the top of its range in recent years. Money, however, needs to shift from time deposits into M1 to signal rising confidence and spending intentions.

Broad money growth may have been inflated by a switch out of wealth management products and other bank liabilities into deposits. The total stock of bank funding has been growing less strongly, with minimal acceleration since 2021 – chart 1.

Many analysts follow the “credit impulse” – the rate of change of credit growth, usually expressed relative to GDP. This often gives the same message as narrow money trends (but is judged here to be less reliable) and also suggests a loss of economic momentum – chart 2.

Chart 2

Bulls argue that excess household savings will fuel a consumption boom, drawing parallels with G7 experience following reopenings. Chinese households did not receive stimulus checks or direct wage support and the excess is likely to be considerably smaller, implying less pent-up demand.

Supporting this view, household real M2 deposits in December were 8% above their pre-pandemic trend (and may have been inflated by the early timing of the Chinese New Year) – chart 3. US household real M3 holdings reached a peak 24% overshoot of the comparable trend in March 2021 – chart 4.

Chart 3

Chart 4

Fed policy remained expansionary as pandemic drags faded. The PBoC, by contrast, appears concerned about inflationary risks from rapid reopening and has engineered or at least tolerated a significant rise in term money rates. The increase in late 2022 was universally dismissed by China specialists as a year-end phenomenon unrelated to any policy shift but a minor fall in early January has since given way to another rise – chart 5.

Chart 5

The view here is that the reopening boost to domestic demand will be modest and biased towards services. For goods, supply expansion due to reduced disruption may outweigh the lift to demand.

Global trade moved into contraction in late 2022, partly reflecting an accelerating downswing in the global stockbuilding cycle. With supply constraints easing, Chinese exporters are likely to cut prices to increase market share, especially given the super-competitive level of the RMB – chart 6.

Chart 6

Recent Bank of England signals have been deemed to be less hawkish than those of the Fed and ECB, contributing to a view that UK policy tightening is less likely to prove excessive, in the sense of causing greater economic damage than necessary to return inflation to target.

Monetary trends do not support this hope.

It should be remembered that the Bank embarked on rate hikes and QT before the Fed and has raised rates by 340bp versus the ECB’s 250 bp.

“Shadow” rate estimates attempt to incorporate the impact of unconventional monetary policy measures. The Wu-Xia shadow rate for the UK has risen by 1250 bp from its 2021 low versus increases of 650 bp and 980 bp respectively in the US and Eurozone – see chart 1.

Chart 1

UK real narrow money (i.e. non-financial M1 deflated by consumer prices) contracted by more than comparable US / Eurozone measures in the six months to November – chart 2. The decline is historically extreme and suggests a severe recession – chart 3.

Chart 2

Chart 3

UK nominal broad money (non-financial M4) grew by just 1.3% at an annualised rate in the six months to November – chart 4. The comparable Eurozone measure rose at a 5.0% pace. US broad money contracted but is correcting a much larger increase in 2020-21.

Chart 4

Real broad money holdings of UK households have retraced almost all of the pandemic-related surge, falling to the lowest level since May 2020 – chart 5. Far from “excess” money balances supporting spending, a real money squeeze is now likely to magnify consumption weakness.

Chart 5

Bank of England communications may be becoming less hawkish but the damage has been done. Officials ignored the monetary signal that a 2021-22 inflation spike would reverse with modest policy restraint. The economic consequences of overkill are likely to be at least as bad as in the US / Eurozone.

The BoJ’s decision to widen the fluctuation band of the 10-year JGB yield around the zero target follows an apparent withdrawal of monetary policy support by the PBoC in recent weeks.

Three-month SHIBOR has risen by 75 bp since late September and is now only 15 bp below its start-of-year level – see chart 1. Upward pressure has been partly market-driven but the PBoC has chosen not to accommodate increased demand for liquidity.

Chart 1

The PBoC’s Q3 monetary policy report, issued in November, expressed concern about medium-term inflation risks, stressing the importance of avoiding excessive monetary growth. An apparent hawkish shift may have been reinforced by the shock abandonment of the zero covid policy, which officials may view as likely to boost near-term price pressures via a faster demand recovery and / or an increase in supply bottlenecks.

The Japanese / Chinese policy moves are worrying because monetary trends in the two economies have been providing a modest offset to significant US / European weakness – chart 2. That support could now fade.

Chart 2

A rise in Japanese six-month narrow money growth in November was accompanied by a further pick-up in bank lending, consistent with stronger credit demand expectations in the BoJ’s Q3 loan officer survey – chart 3. The hope is that firmer bank loan growth / money creation will survive a modest policy adjustment.

Chart 3

Global six-month real narrow money momentum is estimated to have risen for a fifth month in November but remains negative – chart 3. Allowing for the usual lag, the suggestion is that global manufacturing PMI new orders will bottom by next spring but remain in recessionary territory into Q3.

Chart 4

The recovery in real money momentum continues to be driven by a slowdown in six-month CPI inflation, with nominal money growth languishing – chart 5. The inflation decline will extend but overly hawkish central banks risk pushing nominal money momentum to new lows.

Chart 5

The global manufacturing PMI new orders index was little changed in November, the six-month rate of change of the OECD’s G7 leading indicator has hooked up and cyclical sectors have been outperforming defensive sectors in the recent equity market rally. Do these developments signal a bottoming of global economic momentum and a prospective H1 2023 recovery?

Monetary trends argue not. Global (i.e. G7 plus E7) six-month narrow money momentum rose slightly for a fourth month in October but remains in negative (i.e. recessionary) territory. All previous recoveries through the 50 level in global manufacturing PMI new orders were preceded by real money momentum rising above 2% – see chart 1.

Chart 1

The June low in real narrow money momentum will probably hold but a corresponding PMI new orders low is unlikely before Q1 2023. There was a 10-month lag between the most recent real money growth peak (July 2020) and the matching PMI top (May 2021).

There are additional negative considerations. The rise in real money momentum since June has been due to an inflation slowdown, with nominal money growth weakening further – chart 2. Previous PMI recoveries were preceded by nominal as well as real money accelerations.

Chart 2

The rise in global real money momentum reflects the E7 component, with G7 momentum still weakening – chart 3. China, India, Mexico and Brazil have contributed to the E7 recovery but the increase has been exaggerated by a nominal money surge and inflation drop in Russia – chart 4. The latter may be of limited global relevance given Russia’s partial economic isolation.

Chart 3

Chart 4

The six-month rate of change of the OECD’s G7 leading indicator rose slightly for a third month in November, according to calculations here. This appears to be a hopeful signal – bottomings historically have usually been followed by sustained recoveries, as chart 5 shows. The uptick is also consistent with recent better relative performance of cyclical equity market sectors.

Chart 5

Initial indicator readings, however, are often revised significantly and previous sustained recoveries in the six-month rate of change from negative territory were accompanied or more usually preceded by a revival in G7 real narrow money momentum – chart 6. With the latter yet to bottom, the uptick in indicator momentum may be either revised away or reversed.

Chart 6

A “monetarist” UK recession probability model used here signalled a 70% likelihood of a recession in 2022 back in March. Coincident data suggest that contraction began in the summer. The model now indicates that the recession will last through Q2 2023, at least.

Monthly GDP figures have been affected by holiday distortions and are often revised significantly but current data show a peak in May and a 0.9% drop by August.

Employment is a lagging indicator so further growth in the PAYE jobs measure (also subject to large revisions) through September does not preclude a recession having begun*. Job vacancies, by contrast, are coincident. The ONS vacancies series peaked in May, falling steadily through September.

The published ONS series is a three-month moving average but single-month numbers are available on a non-seasonally-adjusted basis, to which an adjustment procedure can be applied. The resulting total vacancies series peaked in April, falling modestly through July before plunging in August / September– see chart 1. The suggestion is that economic conditions worsened sharply at the end of Q3.

Chart 1

The decline in total vacancies reflects a larger fall in private sector openings, which were down by 13% in September from a May peak, offset by a further rise in the public sector driven by health and social care.

The official vacancies numbers are from a survey of employers but the ONS also compiles weekly indices of online job adverts from data supplied by Adzuna. These indices have a short history and are not seasonally adjusted but the year-on-year change in total job adverts mirrors that of total vacancies – chart 2.

Chart 2

Inputs to the recession probability model include real money measures, interest rates, credit spreads, share prices, house prices and the effective exchange rate – see previous post for more details. The model looks out three quarters and the probability estimate stood at 79% at end-Q3, suggesting that the economy will still be in recession in Q2 2023 – chart 3.

Chart 3

House price strength was a moderating influence on the model reading until recently but coming weakness may contribute to the probability estimate remaining in recession territory.

*The Labour Force Survey measure of employees in employment fell between May and July but recovered in August.

Bank of England Chief Economist Huw Pill has suggested that fiscal policy easing in the mini-Budget and the reaction in markets warrant a “significant monetary policy response”. Why?

UK monetary trends continue to weaken and are consistent with a medium-term return of inflation to target, if not below.

Annual growth of non-financial M4 – the preferred broad aggregate here, comprising holdings of households and private non-financial firms – was unchanged at 3.7% in August, below an average of 4.4% over 2015-19. The three-month rate of expansion fell further to just 0.8% annualised – see chart 1.

Chart 1

Should the Bank tighten to offset the inflationary impact of exchange rate weakness? The “monetarist” view is that currency movements can delay or speed up the transmission of monetary changes to prices but have no longer-term inflation impact as long as money growth is stable.

The sterling effective rate index was down by 10% on a year before at last week’s low point but the annual change reached -25% during the GFC and -19% after the Brexit referendum. The index hasn’t (yet) broken below its GFC low – chart 2.

Chart 2

The greater concern here is that increased government borrowing will be financed significantly through the banking system, resulting in another boost to money growth. This could occur via voluntary purchases of gilts by commercial banks in response to higher yields or because the Bank is forced to offer sustained support to a dysfunctional market.

Such a scenario, however, is possible rather than likely. Any monetary boost from deficit financing could be offset or outweighed by a further weakening of private sector credit trends as banks pass on higher funding costs and widen spreads.

The Bank would have made better recent decisions if it had paid attention to monetary trends: it wouldn’t have expanded QE in November 2020, would have raised rates earlier in 2021 and wouldn’t have embarked on QT. Current monetary weakness argues against policy tightening. The Bank may judge it necessary to hike rates to bolster its credibility, and that of the wider UK policy-making framework. Bank officials, however, should avoid inflating market expectations and be prepared to reverse increases if markets calm and – as seems likely – money trends remain soft.

CC&L Financial Group Ltd.

Identifier: Global and international