Identifier: Inflation

The surge in global broad money last spring and summer was expected here to result in a major inflation rise in 2021-22. A post in September presented reasoning supporting a forecast of 4-5% average G7 inflation in the two years to Q4 2022.

Recent data appear consistent with this forecast but monetary developments suggest that medium-term inflation risks are diminishing.

The latter assessment rests on three considerations. First, six-month growth of global (i.e. G7 plus E7) broad money has moved back towards its pre-pandemic pace. Growth was 4.2% in April, or 8.6% at an annualised rate, versus an average increase of 6.6% pa in the 10 years to end-2019.

G7 broad money growth remains elevated relative to the 2010s but E7 growth is at the bottom of its range, with Chinese weakness a key driver – see chart 1.

Chart 1

Secondly, G7 bank loans to the private sector have contracted following a brief spurt last spring, contrary to forecasts that government guarantee programmes and central bank incentives would spark a lending boom – chart 2.

Chart 2

Sustained high inflation in the 1970s reflected strong broad money growth driven by bank lending. Last year’s money surge, by contrast, was due to monetary financing of ballooning fiscal deficits and additional QE.

Bank lending is a coincident / lagging economic indicator and is likely to revive as economic activity continues to recover. “Excess” household and corporate liquidity, however, may delay and / or damp a pick-up in credit demand, while the impact on broad money may be neutralised by reduced monetary deficit financing / QE as fiscal positions improve and central banks taper.

A third reason for thinking that monetary inflation risks may have diminished is that a portion of the excess liquidity created last year has been absorbed – at least for the moment – by higher asset prices.

A simplistic quantity theory approach posits that the demand to hold money varies proportionately with nominal GDP. Money, however, is held as a store of wealth as well as to support transactions in goods and services.

Posts here last year described a modified quantity theory model in which nominal GDP and gross wealth have equal roles in driving broad money demand, with an additional impact from real bond yields. This model is consistent with G7 data over the last 50+ years and explains the secular decline in conventionally-defined broad money velocity as a consequence of a rising trend in the ratio of wealth to GDP and a fall in real bond yields.

The current stock of G7 broad money is 20% higher than at end-2019. G7 gross wealth – i.e. the aggregate value of equities, bonds and stocks – is also up by about 20% since then, while real bond yields, on the measure calculated here, are little changed. According to the model, the rise in wealth will have boosted broad money demand by 10%. So markets may have “absorbed” about half of the additional liquidity created since end-2019, implying a smaller excess to be reflected in goods and services prices.

The implication of the model that buoyant asset prices are disinflationary is controversial – it suggests, for example, that inflation prospects would worsen if markets were to crash. That was, however, the experience following the GFC – G7 inflation rose sharply in 2010-11 after the 2008-09 collapse in asset prices. High inflation in the 1970s was associated with weak markets, with equities volatile but directionless and a trend decline in bond prices.

The suggestion that the medium-term inflation outlook has improved at the margin is based on current information and will be revised if any of the inputs discussed above change.

Medium-term inflation expectations in markets are correlated with swings in global industrial momentum – chart 3. The forecast here that the global manufacturing PMI new orders index will decline through late 2021 suggests that expectations will stabilise or moderate near term.

Chart 3

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

Marketing Communication.

Additional country releases in recent days confirm that global six-month real narrow money growth fell further in April, to its slowest pace since January 2020 – see chart 1. The decline from a peak in July 2020 is the basis for the forecast here of a significant cooling of global industrial momentum during H2 2021.

Chart 1

The April fall reflected both slower nominal money growth and a further pick-up in six-month consumer price momentum – chart 2. The latter is probably at or close to a short-term peak and the central scenario here remains that real money growth will stabilise and recover into Q3. The risk is that nominal money trends continue to soften – the boost to US numbers from disbursement of stimulus payments may be over and this year’s rise in longer-term yields may act as a drag.

Chart 2

Six-month growth of real broad money and bank lending also moved down in April, with the former close to its post-GFC average and the latter considerably weaker – chart 3. Forecasts last year that government guarantee programmes would lead to a lending boom have so far proved wide of the mark; monetary financing of budget deficits, mainly by central banks, remains the key driver of broad money expansion.

Chart 3

Charts 4 and 5 shows six-month growth rates of real narrow and broad money in selected major economies. The UK remains at the top of the range on both measures, supporting optimism about near-term relative economic prospects, although slowing QE and a sharp rise in inflation promise to erode the current lead.

Chart 4

Chart 5

Eurozone real money growth, by contrast, is relatively weak: monetary deficit financing has been on a smaller scale than in the US / UK, while six-month inflation is higher than in the UK / Japan. Bank lending has been expanding at a similar pace in the Eurozone and UK. The recent step-up in ECB PEPP purchases could lift Eurozone broad money growth although the change is modest and could be offset by an increased capital outflow – see previous post.

China remains at the bottom of the ranges and monetary weakness was expected here to trigger PBoC easing by mid-year. Policy shifts usually proceed “under the radar” via money market operations and directions to state-run banks. The managed decline in three-month SHIBOR continued this week, while the corporate financing index in the Cheung Kong Graduate School of Business survey stabilised in April / May after falling over October-March, which could be a sign that banks have been instructed to increase loan supply.

The PBOC’s quarterly bankers’ survey, due for release later this month, could provide further corroboration of a policy shift: the differential between loan approval and loan demand indices leads money growth swings – chart 6. Monetary reacceleration in China remains the most likely driver of a rebound in global six-month real narrow money growth – required to support a forecast that H2 industrial cooling will represent a pause in an ongoing upswing rather than a foretaste of more significant weakness in 2022.

Chart 6

A post in November presented a “monetarist” forecast that CPI inflation would rise to more than 3% by late 2021. This forecast appears on track.

The Bank of England’s central projection for Q4 2021 was 2.1% in November. This was lowered to 1.9% in February but raised to 2.5% in May.

A key element of the November forecast was a significant inflation boost from energy prices, reflecting a view that a strong global industrial recovery would push up oil and other commodity prices. This has played out: the CPI energy component rose by 7.5% in the year to April, contributing 0.5 percentage points (pp) to annual CPI inflation of 1.5%.

The energy effect explains the upward revision to the Bank of England’s forecast. The Bank now expects the contribution of energy prices to annual inflation to rise further to 0.75 pp by Q4 – similar to the view here, which assumes an additional 5% increase in the Ofgem price cap in October.

The forecast that CPI inflation will exceed 3% by year-end is driven by three additional factors:

  • The planned increase in VAT in the hospitality and tourism sectors from 5% to 12.5% in October, with a return to 20% scheduled for April 2022.
  • A pick-up in food price inflation, partly reflecting recent strength in global food commodity prices.
  • A rise in underlying core inflation (i.e. excluding the VAT effect as well as energy / food contributions) in lagged response to faster broad money growth.

Taking these in turn, the forecast assumes that there will be 35% pass-through of the VAT rise to prices, implying a 0.2 pp boost to the monthly change in the CPI in October. The Bank and consensus, by contrast, appear to assume a negligible impact. This is surprising: firms face rising costs and the withdrawal of government support while economic reopening should ensure strong demand – why would they allow margins to take the full hit from the VAT hike?

Food prices have so far been weaker than assumed in the November forecast here, falling by 0.5% in the year to April. Producer output prices of food products, however, were up by 2.3% over the same period, the largest annual rise since 2018 – see chart 1.

Chart 1

The pick-up in producer output prices appears to have been driven by higher input costs of home-produced food. Imported food materials, by contrast, have cheapened, partly reflecting sterling appreciation. This is about to change: the FAO global food commodity price index rose by 17% in sterling terms in the year to April – chart 2.

Chart 2

The forecast here continues to assume that annual CPI food inflation will rise to 2.0% by December.

The final element of the forecast is an expected further rise in underlying core CPI inflation. Actual core inflation (i.e. excluding energy, food, alcohol and tobacco) was 1.3% in April but the assumption of 35% pass-through of the VAT cut in hospitality and tourism implies a significantly higher underlying rate, of 1.9%. The underlying rate has risen from a low of 1.2% in May 2020.

Research previously reported here found a consistent directional leading relationship between broad money growth and underlying core inflation, albeit with a variable lead time influenced particularly by exchange rate movements – chart 3. The surge in annual broad money growth, as measured by non-financial M4, from 3.6% at end-2019 to a likely peak of 16.1% in February suggests further upward pressure on the underlying core rate in 2021 -22 – the assumption here is that it will rise to 2.1% by December.

Chart 3

Chart 4 shows forecasts for headline, core and underlying core CPI Inflation through end-2021 based on the above assumptions. The headline rate finishes the year at 3.1% – slightly lower than in the November forecast because of the Budget decision to postpone full reversal of the VAT cut until 2022.

Chart 4

Chinese money trends continue to give a negative message for economic prospects. The PBoC could be moving towards easing policy despite a surge in producer price inflation.

Monthly changes in money and lending aggregates were notably weak in April. Six-month growth rates of narrow money, broad money and broad credit fell again, sustaining a downward trend since Q3 2020 – see chart 1.

Chart 1

Trends are weaker in real terms because of a recovery in six-month consumer price inflation. Six-month real narrow money growth is the lowest since February last year – chart 2.

Chart 2

The monetary slowdown was the basis for a forecast that the economy would lose momentum in H1 2021. Q1 GDP growth was below consensus and PMIs have moderated since late 2020. Further monetary weakness suggests that that the slowdown will extend through Q3, at least.

There is little reason to expect money / credit trends to revive. Average interest rates on bank loans have moved sideways since Q3 2020 – chart 3. The PBoC’s Q1 bankers’ survey reported a fall in loan approvals, consistent with a decline in the Cheung Kong Graduate School of Business corporate financing index – weaker readings imply less favourable credit conditions.

Chart 3

The expectation here was that the PBoC would reverse its H2 2020 policy tightening in response to softer economic data and an ongoing money / credit slowdown. The central bank, however, was concerned about housing market strength in early 2021 and withdrew liquidity to reverse a decline in money market rates into late January.

Many continue to expect the next PBoC move to be a tightening, a forecast seemingly supported by a recent surge in producer price inflation. The latter, however, has been driven by raw material costs, with little pass-through to date into producer prices of consumer goods – chart 4.

Chart 4

Core consumer price inflation has recovered from early year weakness but remains low – chart 5.

Chart 5

The weak April money / credit numbers could be the trigger for a PBoC rethink. Three-month SHIBOR has been allowed to drift slightly below its January low – chart 6. A further decline would support the view that a policy shift is under way.

Chart 6

The forecast here at the start of the year was that the global manufacturing PMI new orders index – a key indicator of industrial momentum – would reach a peak in early 2021 and fall into the summer. The index declined slightly between November and February but rose to a new recovery high in March, with flash data last week and today’s Chinese results indicating a further significant increase in April. What has gone wrong?

The expectation of an early 2021 peak and subsequent relapse was based on a fall in global six-month real narrow money growth from an extreme peak in July 2020 – real money growth has led turning points in PMI new orders by 6-7 months on average historically. Six-month real narrow money momentum continued to weaken into March, so the monetary signal for PMI direction remains negative – see first chart.

Chart 1

There was meaningful variation around the 6-7 month historical average lead time. An April PMI new orders peak, were it to be confirmed, would imply a nine-month lead, which would be within one standard deviation of the average. So the further rise into April is not yet an unusual departure from the norm.

The most likely explanation is that the PMI upswing has been extended by US fiscal stimulus – particularly the third round of payments to households – along with initial moves towards economic reopening in the US, UK and other countries showing progress in virus containment. A 9.3% monthly surge in US retail sales in March may have been a key driver of stronger March / April new orders.

“Economic impact payments” authorised by the American Rescue Plan Act were $318 bn in March and $51 bn through 28 April for a total $369 bn, representing the bulk of a programme costed at $411 bn by the Congressional Budget Office.

New York Fed analysis of data collected in its monthly survey of consumer expectations indicates that households have spent or plan to spend 25% of the windfall, similar to the proportion in the first and second rounds, with remainder used to increase savings (42%) or pay down debt (34%). Rounding the $369 bn received to date up to $400 bn, this suggests additional consumer outlays of about $100 bn.

Assume that half of this amount is spent on goods, which could be an overestimate given that services account for two-thirds of total consumption. That would suggest additional retail sales – a rough proxy for goods spending – of about $50 bn. Monthly sales jumped by $47 bn between February and March. The suggestion is that the bulk of the boost to goods spending has already occurred and sales will fall back sharply into the summer.

Chart 2

An additional technical explanation for the March / April rise in PMI new orders is a positive base effect from the slump in the index to a low in April 2020. Survey respondents are asked to draw a comparison with the previous month but there is evidence that some replies take into account the level of business in the same month a year earlier – understandable in cases where there is a strong seasonal pattern in demand.

Specifically, a regression of the global manufacturing PMI new orders index on its one- and 12-month lagged values finds a small but statistically significant negative coefficient on the latter*. The coefficient suggests that a 13.7 point plunge in the index in March / April 2020 contributed 0.8 of a point to the estimated 3.0 point increase in March / April 2021 – third chart. This boost will reverse by June, reflecting the recovery in the index after April last year.

Chart 3

With global real narrow money growth still moderating, the US fiscal boost probably passing its maximum and China still on a slow growth path pending PBoC easing, the forecast here of a PMI pullback through late Q3 is maintained.

Chart 4

*The same result is obtained using US ISM manufacturing new orders data over a much longer sample.

Global six-month real narrow money growth appears to have edged lower in March, continuing a downtrend since last summer. This suggests that an expected relapse in global industrial momentum will extend through late Q3 / early Q4.

The global manufacturing PMI new orders index reached a new recovery high in March, consistent with a surge in six-month real narrow money growth into July / August 2020, allowing for the historical average 6-7 month lead time. More recent national surveys hint that March will mark a top – see chart 1.

Chart 1

The March real money growth estimate is based on information for the US, China, Japan, India and Brazil, together accounting for 70% of the G7 plus E7 aggregate tracked here. The US component is estimated from weekly data on currency in circulation and commercial bank deposits – official March money numbers are released next week and the Fed no longer provides weekly updates.

Global six-month real narrow money growth appears to have eased further to its lowest level since February 2020, reflecting stable nominal growth and another rise in six-month CPI inflation – charts 2 and 3.

Chart 2

Chart 3

Chart 4 shows the early reporting countries individually. US six-month real narrow money growth is estimated to have edged lower despite disbursement of $318 bn of stimulus payments to households – these were made in the second half of the month and may have a larger impact in April (the money numbers are month averages).

Chart 4

Six-month growth also eased slightly further in Japan and China, with a small rise in India. Brazil moved into contraction although this needs to be placed in the context of an extraordinary surge last summer – 12-month growth is still strong.

Markets could be starting to offer corroboration of the scenario of a global manufacturing PMI new orders peak and pull-back, with Treasury yields stalling and equity market cyclical sectors no longer outperforming – chart 5.

Chart 5

Will global six-month real narrow money growth recover? Six-month CPI inflation is likely to rise slightly further in April / May but could fall back in H2 as commodity prices move sideways or correct.

Fiscal stimulus is acting to push up US nominal money growth but there may be an offsetting drag across the G7 from recent bond yield rises – chart 6.

Chart 6

A revival in Chinese narrow money growth probably requires a PBoC policy shift. The view here has been that policy was overtightened in H2 2020 and the economy would slow in H1 2021. This scenario appears to be playing out, with Q1 GDP disappointing and industrial output falling in March. Core CPI inflation (i.e. ex. food and energy) is at 0.3% and a surge in PPI inflation reflects input cost rises that are squeezing downstream margins. The PBoC has allowed three-month SHIBOR to drift back to its January low, consistent with a switch to an easing bias – chart 7.

Chart 7

The assessment in the previous quarterly commentary was that the monetary backdrop for markets had deteriorated at end-2020. This was arguably reflected in weak bond market performance during Q1 but global equities rose further as earnings expectations were revised higher. The monetary indicators followed here continue to give a cautionary message for markets while suggesting that global industrial momentum will slow into late Q3. A summer growth “scare” could trigger a correction in equities and a recovery in defensive sectors.

The market assessment relies on two indicators of “excess” money, which, according to the “monetarist” view, is a key influence on demand for financial assets: the difference between global six-month real narrow money and industrial output growth, and the deviation of 12-month real money growth from a long-term moving average. The entire outperformance of global equities relative to US dollar cash since 1970 occurred during periods when both indicators were positive. Equities underperformed cash on average when either or both were negative.

Allowing for data publication lags, the indicators gave a joint positive signal at end-April 2020. The MSCI All Country World Index (ACWI) returned 33.9% in US dollar terms between then and end-2020, reflecting both a recovery in earnings expectations and a rerating of markets. The “buy” signal, however, was rescinded at end-December following a cross-over of real narrow money growth beneath industrial output growth – see chart 1.

Chart 1

Global equities derated during Q1 – the ACWI 12-month-forward PE ratio fell by 4.2% – but the index nevertheless returned 4.7% as forecast earnings rose by a further 8.6%. Earnings optimism was boosted by confirmation of additional large-scale US fiscal stimulus, which also contributed to continued outperformance of cyclical sectors. The view here, however, is that global industrial momentum is peaking and will slow through late 2021. This would be a shock to the consensus and could trigger an unravelling of recent market trends.

The slowdown forecast rests on the relapse of global six-month real narrow money growth from its July-August 2020 peak – turning points have led those in industrial output growth by nine months on average historically. The lead time on the global manufacturing purchasing managers’ index (PMI) is slightly shorter, suggesting that a new high in the index reached in March will mark the peak of the current upswing – chart 2.

Chart 2

China’s industrial recovery has already decelerated, with the Markit / Caixin manufacturing PMI falling to an 11-month low in March. Chinese monetary policy was less stimulative than elsewhere in H1 2020 and retightened in H2, explaining relatively weak money trends – chart 3. China’s PMI has led the global measure since the GFC – chart 4.

Chart 3

Chart 4

Global six-month real narrow money growth continued to subside in February. A recovery could unfold into the summer as US money numbers are boosted by disbursement of fiscal stimulus and if the PBoC relaxes policy in response to softer economic data. Such a scenario could result in another “excess” money buy signal by mid-year while suggesting industrial reacceleration from late 2021. A money growth rebound, however, is likely rather than guaranteed and the judgement here is that the focus for now should be on downside economic / market risks.

An industrial slowdown could be offset in GDP terms by services strength if covid developments allow economic reopening. This could, however, contribute to industrial deceleration by reversing last year’s substitution by consumers of goods for services spending. Industrial trends are likely to be more important for markets, partly reflecting a stronger correlation with equity earnings. Services-driven GDP strength could make central banks less inclined to offer support in the event of industrial / market weakness.

Global CPI inflation rates are spiking higher in reflection of recent commodity price moves and base effects but inflation worries could be near a short-term peak if the above industrial scenario unfolds – another reason for doubting that the cyclical / value rally will extend in Q2. Input price components of business surveys will fall away into the summer barring another surge in oil and other industrial commodities – chart 5. Cyclical sectors may be fully discounting “reflation”, judging by valuation relative to defensive sectors – chart 6.

Chart 5

Chart 6

The March rise in the global manufacturing PMI was driven by European components, with the US PMI little changed and China’s – as noted – easing further. Eurozone strength is consistent with a real money growth spike last summer but a subsequent slowdown argues against current levels being sustained – chart 7.

Chart 7

UK money trends, by contrast, are diverging positively from other majors, signalling a relatively bright economic outlook and possible support for UK equities – chart 3. Money growth strength reflects larger-scale monetary deficit financing than in other countries, which may continue given PM Johnson’s big spender bias and a supine Bank of England. “Excess” money could partly flow overseas, suggesting downside risk for sterling, in which speculators appear to have accumulated a significant long position.

The forecasting approach here uses cycle analysis as a cross-check of the monetary analysis and to provide longer-term perspective. The previous assessment, which is maintained, was that the stockbuilding and business investment cycles bottomed in Q2 2020, while the long-term housing cycle remains in an upswing. The suggestion that all three cycles were turning supportive for the global economy and markets reinforced the positive message from monetary trends in mid-2020.

The next scheduled low is in the short-term stockbuilding cycle. Based on an average historical cycle length of 3.5 years, this could occur in late 2023, with the downswing into the low starting 12-18 months earlier, i.e. in mid- to late 2022. Risk markets tend to weaken in the 18 months leading up to a cycle trough – major equity bear markets have usually occurred during this time window.

The suggestion is that the primary trend in the global economy and markets will remain up through H1 2022. Stockbuilding cycle upswings, however, typically unfold in a zig-zag pattern, with an initial upthrust followed by a corrective phase before a final move higher into the peak. The judgement here is that the initial phase is ending and cycle momentum will diminish into H2, consistent with the monetary forecast of an industrial slowdown. The view that the initial phase is mature is supported by the business survey inventories indicator in chart 8.

Chart 8

Market moves since Q2 last year, moreover, have in most cases matched or exceeded averages during 18-month periods following previous stockbuilding cycle lows – see table 1. Developed market equities, cyclical sectors and commodity prices, in particular, have performed strongly, suggesting limited further upside even though a stockbuilding cycle downswing may be a year or more away.

Table 1

Source: Refinitiv Datastream, own calculations

A further consideration is that the current stockbuilding cycle could be shorter than average. The covid shock appears to have extended the previous cycle to 4.25 years. If the current cycle were to display an offsetting deviation from the average 3.5 years, the next low would occur in early rather than late 2023 (i.e. 2.75 years from the Q2 2020 trough). This, in turn, would imply that the 18-month negative period for markets ahead of the low would start in H2 2021.

The latter possibility, it should be emphasised, is not the central case here and would require confirmation from a further fall in global six-month real narrow money growth during H1 2021 rather than the US-led rebound suggested earlier.

The comparison of recent returns with stockbuilding upswing averages, as well as supporting the case for reducing cyclical sector exposure in favour of defensive sectors, suggests relative value in emerging market equities, quality and gold, and scope for a further rally in the US dollar. Stronger EM equity performance, however, may be conditional on a recovery in Chinese money growth, probably requiring a prior PBoC policy shift.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

Marketing Communication.

UK money numbers continued to show absolute and relative strength in February, suggesting a coming domestic demand boom with unfavourable balance of payments and inflation consequences.

Charts 1 and 2 compare six-month growth rates of real narrow and broad money across economies. The UK tops both rankings, with recent monetary reacceleration contrasting with ongoing slowdowns elsewhere (although US growth is turning up again as stimulus payments enter bank accounts).

Chart 1

Chart 2

The preferred UK broad money measure here – non-financial M4, comprising money holdings of households and private non-financial corporations (PNFCs) – grew by 16.0% in nominal terms in the year to February. The comparable Eurozone measure – non-financial M3 – rose by 12.5%. Annualised growth rates in the latest three months were 14.4% and 9.5% respectively.

The Bank of England’s M4ex broad money measure grew by a slightly lower 15.2% in the year to February, with its annualised rate of increase slowing to 9.7% in the latest three months. M4ex also includes money holdings of financial institutions, which have fallen over the last three months* but are of limited significance for near-term demand prospects.

UK broad money strength reflects the large fiscal deficit and its entire financing by money creation, i.e. net sterling lending to the government by the banking system, including the Bank of England – chart 3**.

Chart 3

In 1985 then Chancellor Nigel Lawson introduced the “full funding” rule, which required deficits (and any increase in foreign exchange reserves) to be financed by net debt sales to the UK non-bank private and overseas sectors, implying no public sector contribution to broad money growth. According to this concept there has been zero funding over the last 12 months – domestic and overseas “savers” made no contribution to financing the deficit, which has been mirrored pound-for-pound by an increase in the broad money stock.

In terms of the “credit counterparts” arithmetic, monetary financing accounted for 15.4 percentage points (pp) of the 16.0% growth of non-financial M4 in the year to February. A positive contribution of 3.6 pp from sterling lending to households and PNFCs was offset by a 3.1 pp drag from other counterparts*** – chart 4.

Chart 4

The chart shows that official money creation made an even larger contribution in 2009-10, reflecting the Bank of England’s post-GFC QE programme. This was, however, needed to offset private money destruction as banks attempted to meet regulatory demands to boost their capital ratios rapidly by contracting their lending and shedding other assets. The net result was low broad money growth and inflation. There is no actual or potential monetary shortage to counteract now, and hence no monetary justification for QE on the current scale.

Broad money growth would have been even faster but for a diversion of liquidity into sterling bank deposits of overseas residents – monetary aggregates include deposits of domestic residents only. Overseas deposits grew by £49 bn in the year to February, equivalent to 2.6% of non-financial M4. The recent rise is the largest since before the GFC, when liquidation of the overhang of foreign balances triggered a sharp fall in sterling – chart 5.

Chart 5

Strong domestic demand prospects typically imply upward pressure on the exchange rate as expectations for monetary policy adjust. With central banks now committed to prolonged interest rate suppression, this linkage has been broken. Instead, the prospect of unchecked demand strength suggests a bigger current account deterioration and falling real rates as inflation accelerates. Central banks may be rehabilitating the monetary theory of exchange rate determination, according to which a rise in the relative supply of a currency (in this case sterling) results in depreciation.

The consensus appears complacent about balance of payments risks: the average current account deficit forecast in the Treasury’s monthly survey is £80 bn in 2021 and £84 bn in 2022, essentially unchanged from £74 bn in 2020 (£79 bn excluding trade in precious metals). The view here remains that a major blow-out is possible, based on the historical relationship with broad money growth – chart 6 – and a Brexit hit to the UK’s global export share.

Chart 6

*Due to reductions in sterling bank deposits of fund managers, insurance companies and securities dealers.
**The deficit definition referred to here is public sector net borrowing excluding public sector banks (PSNB ex). The public sector net cash requirement (PSNCR) includes financial transactions and was larger than PSNB ex in the 12 months to February (£330 bn vs £286 bn), mainly reflecting Bank of England lending schemes and the student loan programme. Monetary financing accounted for 90% of the PSNCR over this period.
**Net sterling lending to UK financial institutions plus net overseas and foreign currency lending minus capital and other net non-deposit liabilities.

Global six-month real narrow money growth is estimated to have fallen further in February, based on monetary data covering 70% of the G7 plus E7 aggregate calculated here. The decline from a July 2020 peak suggests a slowdown in industrial momentum extending through Q3 2021.

Turning points in six-month real narrow money growth have led turning points in the global manufacturing PMI new orders index by 6-7 months on average historically. The July money growth peak, therefore, suggested a new orders peak in January-February. The current high point of the orders index is November 2020 but this may have been surpassed in March. These are details: the key point is that the index appears to be reaching a peak on schedule, with money trends suggesting a significant relapse by end-Q3.

Chart 1

Cooler consumer goods demand is consistent with a coming industrial slowdown. Global retail sales fell between October and January, with early data suggesting another decline in February – chart 2.

Chart 2

Industrial output growth appears to have been sustained by a continued recovery in investment goods demand and – probably more importantly – a rebuilding of depleted inventories. Restocking, however, will have been accelerated by softer consumer goods demand and the associated output boost may be peaking.

A key point, often neglected, is that the level of industrial output is related to the rate of change of inventories. These are probably still lower than desired and restocking should continue. A slowdown in the rate of increase, however, is sufficient to exert a negative impact on the level of output.

A normalisation of US six-month real narrow money growth has been a key driver of the slowdown in the global measure, although smaller declines have occurred elsewhere – chart 3. US money growth should rebound strongly in March / April as the Treasury transfers cash to households from its account at the Fed (i.e. helicopter money).

Chart 3

A US rebound could drive a pick-up in global six-month real narrow money growth, signalling industrial reacceleration in late 2021 / H1 2022. This isn’t guaranteed, however: a further inflation rise will drag on real money growth near term, while nominal money trends elsewhere may continue to cool.

Analysis of US narrow money trends has been complicated by banks reclassifying some savings accounts as transactions accounts following a Fed decision to lift restrictions on the former. This artificially boosted the old M1 measure in 2020, particularly later in the year, when its six-month growth rate rebounded strongly – chart 4. The numbers used here attempt to correct for this distortion but the suggestion of a significant slowdown was disputed by some readers.

The debate has now been resolved by the recently released Q4 financial accounts – these contain M1 flow data adjusted for reclassifications and other discontinuities. The fall in six-month growth of the break-adjusted M1 series during H2 2020 was similar to that of the corrected measure calculated here.

Chart 4

A global industrial slowdown in Q2 / Q3 may not be reflected in GDP data because of services reopening. The latter, indeed, could contribute to industrial softening as consumer demand switches back from goods to services. The judgement here is that industrial trends are a better guide to underlying economic momentum and a more important driver of markets, partly reflecting a stronger correlation with equity market earnings.

A simple rule for switching between global equities and US dollar cash discussed in previous posts holds cash when six-month growth of global real narrow money is below that of industrial output. A negative cross-over occurred in October 2020 and – allowing for data publication lags – resulted in the switching rule recommending a move to cash at end-2020.

Real money growth was below industrial output growth in January and early indications are that this remained the case in February – chart 5. The rule, therefore, will continue to recommend cash in April and, probably, May. The rule is currently about 4% offside since the end-December switch. Such a drawdown is not unusual and compares with a 32% gain when the rule was in equities between end-April and end-December 2020.

Chart 5

Chinese money trends have been signalling an economic slowdown in H1 2020. This appears to be playing out but the PBoC has kept policy tight and narrow money growth has fallen further in early 2020. A Chinese slowdown could derail current global reflation optimism.

Covid base effects are distorting year-on-year growth rates of coincident economic indicators so a two-year comparison is more informative. Retail sales and fixed asset investment slowed sharply in January / February but industrial output gained further momentum – see chart 1.

Chart 1

Output strength is probably explained by additional working days due to covid travel restrictions that shortened workers’ holidays and reduced factory idling – this suggests payback in March / April. The NBS PMI manufacturing new orders index peaked in November and fell to its lowest since June last month.

An economic slowdown had been signalled by money trends: six-month growth rates of narrow and broad money peaked over May-July 2020 at modest historical levels, moving lower during H2 – chart 2.

Chart 2

Six-month broad money growth stabilised in early 2021 but is below the post-GFC average, while narrow money growth has fallen further. Sectoral detail shows weaker expansion of both household and enterprise narrow money holdings, consistent with the joint slowdown in retail sales and private investment.

China has retained its bottom place in a ranking of six-month real narrow money growth across major economies despite falls elsewhere – chart 3.

Chart 3

The expectation here had been that the PBoC would respond to early economic slowdown signs by partially reversing its H2 2020 policy tightening. Instead, it withdrew liquidity before the holiday to protest an easing of money market rates in December / January. Three-month SHIBOR has backed up to 2.7%, almost double its low in April / May 2020.

The suggestion that monetary policy is restrictive is supported by a flat yield curve – chart 4 – and weak core inflation: consumer prices ex. food and energy were unchanged in February from a year before.

Chart 4

China led last year’s economic recovery and the expectation here has been that a Chinese slowdown would presage a loss of global industrial momentum into Q3 2020. Assuming that this scenario plays out, a key question is whether new US fiscal stimulus will drive a growth rebound during H2. This will hinge on the extent to which another deficit blowout in Q2 / Q3 is reflected in US money trends. Growth of the weekly broad money series calculated here has firmed slightly – chart 5 – and a significant pick-up is likely in late March / April as households receive stimulus payments.

Chart 5