International Equity Archives - CC&L Financial Group Ltd.

Never a dull moment.

Just as people were beginning to expect a return to normalcy after COVID, unexpected events, such as inflation and war in Ukraine, left investors wondering how to adjust. Then, on March 17, Silicon Valley Bank (SVB) became the second-largest bank in U.S. history to go bankrupt, quickly followed by Signature Bank. This caused panic selling across financial companies worldwide, ultimately leading to the demise of Credit Suisse and its forced merger with UBS. Many quality articles already exist that explain these events in detail so we will instead focus on their impact on Global Alpha portfolios.

Our Investment team had already decided to be cautious on banks and take profits on some of the names we owned at our year-end review in December 2022. Our rationale was that net interest margins would be compressed by rapid rate hikes and the need to remain competitive on lending rates to retain customers. We certainly did not expect the impact to be this immediate.

Our portfolios performed well during this period, offering downside protection due to our underweighting of banks and financials as well as our quality bias. None of our holdings were materially impacted by SVB’s or Signature Bank’s collapse. We have made no material weight adjustments to our financial names and have reached out to their management teams for more information on their situation. We remain confident in the business models and growth prospects of all our financial sector holdings.

On the macro front, the European Central Bank raised rates by 50 basis points (bps) on March 16 and reassured investors that it has ample tools to manage price and financial stability separately without needing a trade-off. The US Federal Reserve Board appeared to follow the same line of thought with its 25 bps increase a week later.

In Japan, a new Bank of Japan governor, Kazuo Ueda, was chosen to replace Haruhiko Kuroda. Ueda is expected to slowly pave the way to a normalization of the Bank’s ultra-accommodative policy over his tenure. We see this as a net positive in the medium to long term given the unsustainability of the current policy in this global inflationary environment.

On a positive note, China’s reopening seems well underway, with retail sales for January and February up 3.5% year over year, providing a net tailwind to the global economy in the short term.

BACK TO INTERNATIONAL SMALL CAP

During the first quarter, the MSCI EAFE Small Cap Index underperformed the MSCI EAFE Large Cap Index, but outperformed the MSCI Emerging Markets Index.

Within the MSCI EAFE Small Cap Index, information technology, which represents 9.9% of the Index, was the strongest-performing sector, delivering a 11.1% return. Real estate was the worst-performing sector, returning -2.4% for the quarter, with an Index weight of 10.3%.

PERFORMANCE HIGHLIGHTS

Over the same timeframe, our International Small Cap composite delivered a 9.1% gross return, outperforming the MSCI EAFE Small Cap Index by 4.3% (gross).

Our top performer for the quarter was Sopra Steria (SOP FP), a France-based IT services company providing digital consulting services and software development to help clients with digital transformation, ranging from changes to business models to revamping information systems and internal processes.

Since Sopra acquired of Steria in 2014 to accelerate growth outside of France, the company has seen significant success and is now the second-largest IT provider in the country, with over 6% share in a highly fragmented market.

So, what drove the stock up?

Sopra has some defensive characteristics that made it an attractive investment in the volatility seen in the early part of the quarter. Indeed, a large percentage of Sopra’s revenues are recurring in nature, while also deriving 30% of its revenue from the public or semi-public sector.

Amidst this environment, Sopra announced strong 2022 results in February with revenue topping the revised guidance due to a strong end of year, citing an upbeat market for digital services. Sopra then closed the quarter with a meaningful acquisition, announcing a €517 million offer for Ordina, one of its peers in the Netherlands that possesses a similar profile to Sopra with its exposure to the public sector above 40%. The deal offers clear synergies and is immediately accretive to Sopra, reinforcing our confidence in Sopra’s management.

Another top contributor last quarter was Meliá Hotels International (MEL SP), a leading European hotel group that owns and manages more than 326 luxury and mid-scale hotels and resorts in 33 countries, mainly in the Americas and Europe. Meliá’s brand recognition and strong positioning in less competitive regions, such as Latin America, remain key differentiators compared to its peers.

Despite being penalized at the start of COVID due to global travel restrictions, Meliá saw a resurgence of interest from investors as a reopening play thanks to its strong operational resilience and undervalued assets, outperforming its competitors since the pickup in international travel.

What drove the stock up?

Meliá rallied in early January along with the overall stock market, as fears about the extent of a recession eased. Optimism was high for the hotel sector to outperform in 2023. Indeed, given the strong end to 2022, momentum was expected to continue, especially with China easing travel restrictions and Meliá’s revenue per available room (RevPAR) being above its 2019 levels in many regions.

Meliá supported this positive outlook with solid Q4 results, with revenue and EBITDA coming in better than expected. The company noted that travel demand remained resilient despite fears of inflation and economic downturn. Booking numbers showed 25% growth compared to 2019, and there was also a positive outlook for corporate travel and conferences. Melia remains one of the highest-conviction picks in our portfolio.

Our top detractor for the quarter was L’Occitane (0973 HK). A French company listed in Hong Kong, L’Occitane manufactures, markets and retails natural and organic skincare and beauty products. The company has over 3,400 retail locations in 90 countries. Its main brand, L’Occitane en Provence, represents the majority of its sales and is well-known for its quality at an affordable price.

The global beauty market is estimated at US$240 billion and growing between 3% and 5% per year, driven by demand in Asia. L’Occitane benefits disproportionately from this trend as its brand recognition in China outshines many of its Western competitors.

What drove the stock down?

The company saw its same-store sales growth decline in the quarter ending December 2022 due to weaker than expected sales in China and the strategic decision to reduce sales to promotional web partners in the U.K. As a result, the company lowered its full-year guidance for both sales growth and margin.

However, L’Occitane benefitted from China’s reopening in January and we remain confident in the company’s medium-term outlook. Growth in the next fiscal year will be supported by the recovery in travel retail, Elemis product launches and entry into new markets, and channel expansion for its emerging brands.

NEW POSITION

We finished the quarter with a new position in Concordia Financial Group (7186 JP). It is Japan’s third-largest regional bank in terms of loans and deposits, with large exposures to the Tokyo and Kanagawa regions, which account for 60% of listed companies and 18% of the population. The group consists of 205 branches, including Bank of Yokohama and Higashi-Nippon Bank.

We have been monitoring Japan-based banks for some time, but were waiting for a catalyst given the ultra-low-rate environment in Japan. With the Bank of Japan now expecting to shift away from its extremely accommodative monetary policy following the nomination of Kazuo Ueda, we anticipate improved profitability for the banking industry. Concordia Financial Group has a higher ratio of variable rate loans than other regional banks and should therefore benefit disproportionately. Additionally, even without the expectation of rate hikes, Concordia provides best-in-class management with one of the lowest overhead ratios and a history of efficient operations.

Despite the negative press from their U.S. counterparts in March, Japan’s regional banks’ fundamentals remain solid. As their stock prices corrected during the SVB saga, we saw an opportunity to initiate a position in a quality name at a discount.

OTHER NEW BUYS AND SELLS

During the quarter we also initiated a new position in Allkem Ltd. (OROCF) while we sold our holdings in Biffa, M&A Capital Partners, LINTEC Corp., Dometic Group and Schweiter Technologies.

WHAT IS OUR EAR-TO-THE-GROUND APPROACH TELLING US?

Global Alpha has been back on the road with company meetings and conferences. Across the multiple regions we cover, we found mixed signals from management teams in various industries in the first quarter. Despite the alleviation of supply chain pressures and the resurgence of the Chinese consumer, concerns around persistent inflation, the impact of rate hikes on liquidity and continued geopolitical tensions persist.

Even amidst the speculative and risk-on sentiment earlier in the year, our quality bias benefitted us during the quarter as March saw a flight to safety and quality throughout the SVB and Credit Suisse saga.

In this macro-driven environment, we are focusing on companies with little debt and strong cash flow generation, as well as well-defined secular trends that will drive growth for years to come. We believe this new volatile environment will provide active asset managers with opportunities to add value.

We are not making significant sector or country adjustments to the portfolio based on these expectations. Instead, we are maintaining a diversified list of holdings with defensible business models that are trading at a discount to their intrinsic value. Our portfolio remains well-diversified across the many countries, currencies and industries that comprise our benchmarks.

The Global Alpha team

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Never a dull moment.

Photo is aerial view of Tokyo cityscape with Fuji mountain

On a positive note, China’s reopening seems well underway, with retail sales for January and February up 3.5% year over year, providing a net tailwind to the global economy in the short term.

BACK TO INTERNATIONAL SMALL CAP

During the first quarter, the MSCI EAFE Small Cap Index underperformed the MSCI EAFE Cap Index but outperformed the MSCI Emerging Markets Index.

Within the MSCI EAFE Small Cap Index, information technology, which represents 9.9% of the Index, was the strongest-performing sector, delivering a 11.2% return. Real estate was the worst-performing sector, returning -2.2% for the quarter, with an Index weight of 10.3%.

PERFORMANCE HIGHLIGHTS

Over the same timeframe, our International Small Cap composite delivered a 9.2% gross return (9.0% net), outperforming the MSCI EAFE Small Cap Index by 4.3% gross (4.1% net).

So, what drove the stock up?

Another top contributor last quarter was Meliá Hotels International (MEL SP), a leading European hotel group that owns and manages more than 326 luxury and mid-scale hotels and resorts in 33 countries, mainly in the Americas and Europe. Melia’s brand recognition and strong positioning in less competitive regions, such as Latin America, remain key differentiators compared to its peers.

Despite being penalized at the start of COVID due to global travel restrictions, Melia saw a resurgence of interest from investors as a reopening play thanks to its strong operational resilience and undervalued assets, outperforming its competitors since the pickup in international travel.

What drove the stock up?

Melia rallied in early January along with the overall stock market, as fears about the extent of a recession eased. Optimism was high for the hotel sector to outperform in 2023. Indeed, given the strong end to 2022, momentum was expected to continue, especially with China easing travel restrictions and Melia’s revenue per available room (RevPAR) being above its 2019 levels in many regions.

Melia supported this positive outlook with solid Q4 results, with revenue and EBITDA coming in better than expected. The company noted that travel demand remained resilient despite fears of inflation and economic downturn. Booking numbers showed 25% growth compared to 2019, and there was also a positive outlook for corporate travel and conferences. Melia remains one of the highest-conviction picks in our portfolio.

What drove the stock down?

NEW POSITION

OTHER NEW BUYS AND SELLS

WHAT IS OUR EAR-TO-THE-GROUND APPROACH TELLING US?

The Global Alpha team

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International equity markets staged a rally in the fourth quarter as data suggested that inflation had peaked and China initiated a long-awaited re-opening, ending its zero-covid policy. The MSCI EAFE index rose 8.72% in local currency and 17.34% in US dollars. The best-performing sector was financials, which gained 23.91% as investors focused on improving interest rate margins as central banks continued to tighten monetary policy. The worst performer was communications with a rise of 10.13%. The group includes telecom companies, many of which have high levels of now more expensive debt.

Global headline CPI momentum has fallen sharply with weakness in commodity prices signalling a further slowdown. Global manufacturing supply conditions are normalising and the stockbuilding downswing is accelerating. However, the US Federal Reserve will remain hawkish until the demand for labour weakens, with officials viewing an unemployment rise as necessary to slow wage growth and core services inflation.

In the Eurozone money trends suggest a worsening outlook, contradicting a recent rise in market optimism due to falling gas prices. A mild, windy winter has kept gas storage at higher than feared levels. Money trends in the UK are even weaker than in the Eurozone and the Bank of England is already softening its policy statements. The short-lived Prime Minister / Chancellor pairing of Liz Truss and Kwasi Kwarteng partly did the central bank’s job with a misjudged economic policy statement that led to a run on UK government bonds and sterling. The Conservative Party acknowledged its mistake in choice of leader replacing Truss with former Chancellor Rishi Sunak, contributing to a restoration of market calm.

In Japan the Bank of Japan surprised markets by raising the upper limit on its target government bond yield range to 50bp citing deteriorating functioning of the bond market. The shift in policy comes before the departure of central bank governor Haruhiko Kuroda in April and may be driven by the poor political ratings of Prime Minister Fumio Kishida as higher inflation and a weaker yen have impacted consumer’s spending power in an economy that has had virtually no wage growth in over 20 years despite near-full employment.

In China there has been a complete reversal of the zero-covid policy in response to public protests and the continuing damage to the economy of rolling lockdowns. Having secured an unprecedented third term in power, President Xi Jinping is resetting policy to reduce economic isolation and improve economic growth despite a costly death toll from covid, which the regime has failed to prepare for, despite three years of restrictions. The shift in policy has provided a much-needed boost to the equity market domestically and in Hong Kong.

Portfolio performance lagged the recovery in markets as growth and quality factors underperformed over the period. Sector selection was negative as defensive areas such as consumer staples and healthcare underperformed more cyclical groups such as financials and materials. Country selection was flat, helped by the underweight in Japan despite a recovery in the yen. Stock selection was notably weak in Europe where factors drove stock movements much more than individual corporate newsflow.

High quality Swiss flavourings group Givaudan (-1%) and building materials company Sika (+16%) failed to keep up with mining companies such as Rio Tinto (+30%) that rallied on the China re-opening theme in materials. Similarly business publishers such as Wolters Kluwer (+5%) and Relx (+10%) underperformed cyclical capital goods companies such as Siemens (+40%) and Rolls Royce (+42%). On the positive side Norwegian-listed salmon farmer Bakkafrost (+55%) recovered from Q3 weakness due to government tax changes on fisheries. Prudential (+34%) also recovered in response to the re-opening news in China as did Hong Kong listed insurer AIA (+32%).

In Japan performance lagged, with highly-valued quality healthcare stocks such as Terumo (-1%) and Hoya (-1%) de-rating as bond yields rose and the yen recovered. The former suffered staff shortages in the US and missed estimates for operating profit whilst the latter downgraded expectations owing to a large inventory adjustment. Defensive telecom giant NTT (+4%) gave up some of its relative gains and was sold while Olympus (-8%) was hit by the stronger yen and semiconductor sourcing issues. Elsewhere in Asia, Singapore Bank DBS (+8%) lagged the rebound in European and Japanese banks and Santos (+5%) in Australia failed to keep pace with other energy names as the gas price pulled back.

Activity over the quarter has lowered energy and healthcare exposure with some profit-taking in Norwegian gas play Equinor and a reduction in holdings of Roche and Terumo. We have switched KBC Group in Belgium and Mediobanca in Italy into Bank of Ireland and BNP Paribas, which are better positioned domestically, in a stronger economy in the case of Ireland, and likely to benefit more from higher interest rates. We have also tactically added Japanese banks Mitsubishi UFG and Sumitomo Mitsui which should benefit directly from any monetary policy shifts by the incoming governor of the Bank of Japan in April. This, and top-ups in Prudential and Hannover Re, have taken the portfolio back up to just over index weight in financials. In real estate we have re-introduced warehouse operator Goodman Group in Australia after a period of share price weakness and another long-term favourite Taiwan Semiconductor in IT. On the sell side we exited Adidas and added to Shenzhou, a more direct play in sportswear in China. We also sold the defensively orientated Computershare in IT.

Our global “excess” money indicators are likely to turn mixed in Q1 2023 which should be favourable for government bonds and less negative for equities. The expected combination of these readings has been associated with tech outperformance and energy underperformance historically. We continue to expect quality growth to outperform in tandem with falling bond yields driven by moderating inflation concerns and an increase in unemployment as the major developed economies enter recession. This analysis also leads us to prefer defensive stocks over cyclicals meaning the portfolio remains overweight consumer staples and healthcare against underweights in materials and industrials, notably capital goods. We believe that the Q4 rally in the latter in Europe will prove to be a false dawn based on an exaggerated response to lower gas prices and China re-opening. We prefer to play the Chinese covid policy change more directly through out-of-favour tech names such as Alibaba and JD.com, which have solid business models and are benefiting from an easing of regulatory pressures. We also like luxury names such as Hermes and LVMH and other China-related growth stocks such as L’Oreal and Remy Cointreau. Key underweights include autos, food retail, capital goods and miners. The latter position is under review as we assess the potential magnitude of a Chinese economic rebound.

Our investing style focuses on quality and growth companies which typically have higher valuations than the market average. In a period of rapidly rising interest rates, assets with higher trading multiples will fare worse than lower ones – this is the principal reason for our strategy’s underperformance in 2022. The companies we own typically have stable toplines with significant recurring revenue, high profit margins and low debt, implying business resilience even in the event of a severe and prolonged recession.

The Composite rose 13.37% (13.21% Net) versus a 17.34% rise for the benchmark.

The monetary forecast of global recession in late 2022 / early 2023 appears to be playing out. The latest real money data hint at a bottoming out of economic momentum around end-Q1 2023 but there is no suggestion yet of a subsequent recovery. This message dovetails with cycle analysis, with the stockbuilding cycle now turning down and unlikely to enter another upswing until H2 2023 at the earliest. Global industrial output is expected to contract sharply over the next two quarters with labour market data turning decisively weaker. Below-average nominal money growth, meanwhile, continues to signal major inflation relief in 2023-24. The monetary backdrop has improved for high-quality bonds and may turn less hostile for equities by year-end. A possible strategy is to remain overweight defensive sectors but add to quality / growth exposure on confirmation of monetary improvement. Monetary trends are relatively favourable in China / Japan and Chinese “excess” money could shift from bonds to equities if pandemic policy eases.

Global six-month real narrow money momentum remains significantly negative but appears to have bottomed in June, edging higher in July / August. Assuming that a June low is confirmed, the suggestion is that global industrial output momentum will bottom around March, based on an average nine-month lead at historical turning points. The global manufacturing PMI new orders index might reach a low a month or two earlier – see chart 1.

Chart 1

The base case here is that real money momentum will recover into year-end because of a sharp slowdown in six-month consumer price inflation, which could fall by 1-2 percentage points based on current commodity price levels.

The risk is that an inflation slowdown will be offset by a further weakening of nominal money growth in response to policy tightening. This is not guaranteed and, if it occurs, may be on a smaller scale than the inflation slowdown. Episodes of rising risk aversion are usually associated with an increase in the precautionary demand for money, reflected in a pick-up in narrow aggregates. This “dash for cash” is a negative coincident influence on markets and the economy but a subsequent release of the monetary buffer can drive recovery. (This process may explain a recent rebound in Eurozone three-month narrow money growth.)

The baseline monetary scenario would suggest a sharp global recession through Q1 2023 followed by a stabilisation in Q2 and some form of recovery in H2. Lagging indicators such as labour market data would continue to deteriorate during H2. This scenario probably represents a best case.

Similar timings with downside risk are suggested by cycle analysis. The stockbuilding cycle, which averages 3 1/3 years measured between lows, is very likely to have peaked in Q2 – the contribution of stockbuilding to G7 annual GDP growth was the highest since 2010 (a cycle peak year) and in the top 5% of historical readings. A business survey inventories indicator calculated here, which is more timely than the GDP stockbuilding data and leads slightly, plunged in July / August, strongly suggesting that a downswing is beginning – chart 2.

Chart 2

With the last cycle low in Q2 2020, the average cycle length of 3 1/3 years would suggest another trough in Q3 / Q4 2023. The previous cycle, however, was longer than average, raising the possibility of a compensating shorter cycle and an earlier low in Q2 2023. This would dovetail with the suggestion of the baseline monetary scenario of economic stabilisation in Q2 and a recovery later in 2023.

As with the monetary analysis, however, the risk is of a later trough and recovery. The concern from a cycle perspective is that the long-term housing cycle may be peaking early. This cycle has averaged 18 years historically and last bottomed in 2009, suggesting another trough around 2027. Weakness is typically confined to the last few years of the cycle but this was not always the case. This year’s interest rate shock may have brought forward the peak, if not shortened the cycle. Housing permits / starts – a long leading indicator – have fallen sharply and further weakness would suggest that a major top is in – chart 3.

Chart 3

The risk, therefore, is that housing weakness and its lagged effects on the rest of the economy will offset any recovery impetus later in 2023 from a turnaround in the stockbuilding cycle. A rapid reversal in interest rates may be necessary to avert this scenario.

An unambiguous positive message from the monetary and cycle analysis is that inflation is likely to fall sharply in 2023 and return to target – or below – by 2024. G7 annual nominal broad money growth is below its pre-pandemic average, while the correlation of commodity prices with the stockbuilding cycle suggests further falls into a possible mid-2023 trough – charts 4 and 5.

Chart 4

Chart 5

The weakness of nominal money trends argues that central banks have already overtightened policies but the timing and extent of a “pivot” will hinge on labour market data. The suggestion from consumer surveys is that a shift to weakness is imminent. The G7 indicator shown in chart 6 has moved up significantly from a December 2021 low and led unemployment by an average 6-7 months at previous major troughs. The recent unemployment rate low in July, therefore, may prove to be a significant turning point, with a rise of c.1 pp possible by H2 2023.

Chart 6

The view of market prospects here is informed by two measures of global “excess” money shown in chart 7 – the differential between six-month changes in real narrow money and industrial output and the deviation of the 12-month change in real money from a long-term average. Both measures remain negative currently, a condition historically associated with significant underperformance of global equities relative to US dollar cash.

Chart 7

The first measure, however, has recovered and – based on the above monetary / economic forecasts – may turn positive by year-end. A rise in this measure, even while still negative, has been associated with US Treasuries outperforming cash on average (a fall signalled underperformance).

The current large shortfall of 12-month real narrow money growth from its long-term average suggests that the second measure will remain negative until well into 2023. The possible combination of positive / negative readings for the first and second measures respectively has been associated with modest underperformance of equities on average, although this conceals significant variation.

Sector / style performance under this combination has been significantly different from the “double negative” regime, with tech, quality and growth tending to outperform, along with non-energy defensive sectors. The best-performing individual sector was health care with financials the worst. Energy also underperformed.

The Canadian, UK and Australian equity markets were the strongest year-to-date performers at end-Q3 – chart 8. In the case of the former two, however, sector weightings have been a key driver: both have higher-than-average exposure to financials and energy, with the UK also heavy in consumer staples – all outperforming sectors.

Chart 8

Chart 9 shows the results of recalculating performance using common (MSCI World) sector weights. Canada drops to bottom and the UK is also revealed as an underperformer.

Chart 9

The top performance of Australia is consistent with strong real money growth earlier in the year – chart 10. This support, however, has now fallen away.

Chart 10

Real money trends are relatively favourable in China and, to a lesser extent, Japan. Chinese nominal money growth has picked up, partly reflecting money-financed fiscal expansion, while inflation momentum in both countries is weaker than elsewhere. With Chinese activity depressed by pandemic policy, “excess” money has been supporting government / corporate bonds and could flow into equities if and when economic conditions normalise. A large basic balance of payments surplus, meanwhile, has partially insulated the currency from unfavourable movements in interest rate differentials: the RMB index is currently around the middle of its YTD range and stronger than over 2016-late 2021.

The ECB under former President Jean-Claude Trichet twice raised interest rates into oncoming recessions (in 2008 and 2011). The current ECB hasn’t raised rates yet but is scaling back QE much faster than was expected late last year.

The six-month rate of change of Eurozone real narrow money had turned negative before the 2008 / 2011 rate rises and subsequent recessions. It is about to do so again now.

In an eerie replay, M. Trichet yesterday gave an interview in which he opined that the Eurozone was “far from recession territory”.

The current ECB seems equally complacent. The staff forecast for GDP growth in 2022 was yesterday lowered from 4.2% to 3.7% but still incorporates quarterly increases of 1.0% in Q2 and Q3, i.e. a combined 2.0% or 4% annualised.

The “best” monetary leading indicator of Eurozone GDP, according to the ECB’s own research, is real non-financial M1, i.e. holdings of currency and overnight deposits by households and non-financial corporations deflated by consumer prices.

The six-month change in real non-financial M1 fell to zero in January and is likely to have been negative in February, based on a further increase in six-month consumer price momentum – see chart 1.

Chart 1

Chart showing Eurozone Narrow Money & Consumer Prices.

The six-month real narrow money change was negative in 18% of months between 1970 and 2019. The average change in GDP in the subsequent two quarters combined was zero. The average since the inception of the euro in 1999 was -0.8%.

Business surveys could be about to crater: the March Sentix survey of financial analysts is ominous – chart 2. The ECB and consensus may portray weakness as a temporary response to Russia’s invasion of Ukraine, drawing a parallel with past geopolitical events that had little lasting economic impact. Monetary trends suggest that a slowdown to stall speed was already in prospect and the Ukraine shock may tip the economy over into recession.

Chart 2

Chart showing Germany Ifo & Sentix / ZEW Surveys.

The ECB is in a policy bind of its own making. The view here is that it is too late to tighten and the only option is to ride out the current inflation storm. The worry for policy-makers is that inflation expectations will become “unanchored”. Fake hawkish rhetoric backed by fantasy GDP forecasts may be their attempted escape route.

Global industrial output has flatlined since early 2021, reflecting supply disruptions but also a loss of demand momentum. Output may recover into 2022 as supply problems ease but money trends signal a further weakening of underlying momentum. Second-round inflation effects, meanwhile, may force central banks to bring forward plans for stimulus withdrawal – unless markets weaken sharply. This backdrop suggests retaining a cautious investment strategy unless money trends rebound in late 2021 – possible but not a central scenario.

The ”monetarist” forecasting approach used here relies on the rules of thumb that 1) real narrow money growth directionally leads demand / output growth by 6-12 months (average 9 months) and 2) nominal broad money growth directionally leads inflation by 1-3 years (average 2+ years). Global narrow / broad money growth surged in 2020 but has slowed this year. This slowdown is being reflected in a loss of economic momentum but the inflationary impact of the 2020 bulge will continue well into 2022. Current “stagflation” concerns, therefore, are likely to persist.

Supply chain disruption is distorting economic data, complicating analysis. The presumption here is that the global manufacturing PMI new orders index is a reasonable guide to underlying industrial demand momentum. The index has fallen since May, mirroring an earlier decline in global (i.e. G7 plus E7) six-month real narrow money growth from a July 2020 peak – see chart 1. With real money growth sliding further into July / August 2021, the suggestion is that the PMI new orders index is unlikely to reach a bottom before early 2022.

Chart 1

Supply chain disruption, however, has resulted in a substantial undershoot of industrial output relative to the growth rate suggested by the PMI new orders index, implying scope for a short-term catch-up – chart 2. Market participants could wrongly interpret such a pick-up as a reversal in trend momentum. Confusing signals could lead to greater market volatility but any revival in the cyclical / reflation trade is likely to be short-lived unless monetary trends – and hence PMI prospects – improve.

Chart 2

The approach here uses cycle analysis to cross-check monetary signals and provide longer-term context. The 3-5 year stockbuilding and 7-11 year business investment cycles are judged to have bottomed in Q2 2020 and are currently providing a tailwind to the global economy, cushioning the impact of less expansionary monetary conditions.

The next cyclical “event” will be a peak and downswing in the stockbuilding cycle. Based on its average historical length of 3 1/3 years, the next cycle low could occur in H2 2023, implying a peak by H2 2022 at the latest. The business survey inventories indicator calculated here, however, suggests that the cycle upswing is already well-advanced, hinting at an early peak – chart 3.

Chart 3

The upshot is that monetary trends suggest a slowdown in global economic momentum through early 2022 while the stockbuilding cycle is likely to act as a drag from H2 2022. This leaves open the possibility of a resumption of strong economic growth in a 2-3 quarter window around mid-2022. An immediate rebound in global real narrow money growth, however, is needed to validate this scenario.

Such a rebound is possible despite the Fed and other central banks moving to wind down stimulus. It could be driven, for example, by Chinese policy easing to support a weak economy, a sharp reversal in commodity prices as industrial momentum softens (boosting real money growth via a near-term inflation slowdown) or a pick-up in bank lending (normal at this stage of stockbuilding / business investment cycle upswings). It is, however, unnecessary to speculate – it is usually sufficient for forecasting purposes to respond to monetary signals rather than try to anticipate them.

Chart 4 shows a breakdown of G7 plus E7 six-month real narrow money growth. Earlier US relative strength / Chinese weakness has been reflected in divergent year-to-date equity market performance, with DM ex. US and EM ex. China indices charting a middle course. A recent cross-over of US real money growth below the G7 ex. US average suggests reducing US exposure in favour of other developed markets.

Chart 4

Chinese real money growth, meanwhile, was showing signs of bottoming before the recent escalation of financial difficulties at property developer Evergrande. This could result in faster policy easing, an “endogenous” tightening of credit conditions, or both. The net monetary impact is uncertain but a recovery in money growth in late 2021 would argue for adding Chinese exposure in global and EM portfolios despite likely further weakness in economic data.

Investors continue to debate whether high inflation is “transitory” as central bankers naturally assert. The monetarist view is straightforward: the roughly 2-year transmission of money to prices implies no significant inflation relief before H2 2022, while a return to pre-covid levels requires a further slowdown in global broad money growth.

Inflation drivers are likely to shift, with energy and other industrial commodity prices cooling as the global economy slows but offsetting upward impulses from food, rents and accelerating unit wage costs as labour shortages and mismatches force pay rises above productivity growth.

Rising labour costs could, in theory, be absorbed by a reduction in profit margins rather than being passed on in prices. Recent profits numbers, however, overstate underlying health because of stock appreciation and pandemic-related government support. The share in US national income of an “economic” measure of corporate profits (i.e. adjusted for inventory valuation effects and Paycheck Protection Program subsidies, and to reflect “true” depreciation) is in line with its average over 2010-19, in contrast to inflated book profits – chart 5.

Chart 5

G7 annual broad money growth has fallen from a peak of 17.3% in February 2021 to 8.3% in August, with 3-month annualised growth at 6.2%. This is still high by pre-covid standards: annual growth averaged 4.5% over 2015-19. Reduced support to money growth from QE could be offset by faster expansion of bank balance sheets, reflecting strong capital / liquidity positions and rising credit demand. US commercial bank loans and leases have recently resumed growth, with the Fed’s senior loan officer survey suggesting a further pick-up – chart 6. The ECB’s lending survey is similarly upbeat.

Chart 6

Adding in the E7, annual broad money growth is closer to the pre-covid level, at 8.2% in August versus a 2015-19 average of 6.4% – chart 7. Growth is below average in China, Mexico and Russia and in line in India. Inflationary pressures are more likely to prove “transitory” in these economies, suggesting support for local bond markets.

Chart 7

Global equities held up over the summer despite weaker activity news and upside inflation surprises. A monetarist explanation is that markets were supported by “excess” money, as supply disruptions contributed to global six-month industrial output growth falling below real narrow money growth – chart 8. A temporary output catch-up as supply problems ease could reverse this crossover – a further argument for maintaining a cautious investment stance emphasising defensive sectors and quality.

Chart 8

An FTarticle lists “Five big questions facing the Bank of England over rising inflation”. The most important one is missing: will broad money growth return to its pre-covid pace?

The current inflation increase, from a “monetarist” perspective, is directly linked to a surge in the broad money stock starting in spring 2020. Annual growth of non-financial M4 – the preferred aggregate here, comprising money holdings of households and private non-financial corporations (PNFCs) – rose from 3.9% in February 2020 to a peak of 16.1% a year later.

The monetarist rule of thumb is that money growth leads inflation with a long and variable lag averaging about two years. This is supported by research on UK post-war data previously reported here – turning points in broad money growth preceded turning points in core inflation by 27 months on average.

The lead time is variable partly because of the influence of exchange rate variations. For example, the disinflationary impact of UK monetary weakness after the GFC was delayed by upward pressure on import prices due to sterling depreciation.

The exchange rate has been relatively stable recently but the rise in inflation has been magnified by pandemic effects, which may mean that a peak occurs earlier than suggested by the February 2021 high in money growth and the average 27 month lag. The working assumption here is that core inflation will peak during H1 2022.

CPI inflation, however, is likely to overshoot the current Bank of England forecast throughout 2022 – chart 1 shows illustrative projections for headline and core rates.

Chart 1

The past mistakes of monetary policy are baked in. The MPC should focus on current monetary trends in assessing how to respond to its current / prospective inflation headache.

Annual broad money growth has fallen steadily from the February peak but, at 9.0% in July, remains well above the 4.2% average over 2010-19, a period during which CPI inflation averaged 2.2%. So monetary data have yet to support the MPC’s assertion that the inflation overshoot is “transitory”.

The pace of increase, however, slowed to 4.4% at an annualised rate in the three months to July – chart 2. Household M4 rose by 5.8% with PNFC holdings little changed. In terms of the credit counterparts, bank lending to households and PNFCs grew modestly (4.1%) while a continued QE boost was offset by negative external flows, suggesting balance of payments weakness.

Chart 2

With QE scheduled to finish at end-2021 (if not before), and a temporary boost to mortgage lending from the stamp duty holiday over, money growth couldbe gravitating back to its pre-covid pace.

An early interest rate rise, on the view here, is advisable to reinforce the recent monetary slowdown and push back against rising inflation expectations. It is premature, however, to argue that a sustained and significant increase in rates will be needed to return inflation to target beyond 2022 – further monetary evidence is required.

It would be unfortunate if, having fuelled the current inflation rise by questionable policy easing, the MPC were now to raise expectations of multiple rate hikes at a time when monetary growth could be returning to a target-consistent level.

Detailed monetary data for July released yesterday suggest that recent policy easing is beginning to support money growth, in turn hinting at a recovery in economic momentum from end-2021.

A sustained slowdown in six-month narrow money growth from July 2020 correctly signalled “surprise” Chinese economic weakness so far in 2021. The expectation here was that the PBoC would ease policy in Q2, supporting economic prospects for later in 2021. Adjustment was delayed but the reserve requirement ratio cut on 9 July appeared to mark a significant shift. The hope was that July monetary data would confirm a bottom in money growth.

The headline July numbers released on 11 August seemed to dash this hope, with six-month of “true M1” falling to a new low – see chart 1*.

Chart 1

The additional data released yesterday allow a breakdown of the deposit component of this measure between households, non-financial enterprises and government departments / organisations. It turns out that the further fall in growth in July was due to the latter public sector element, which is volatile and arguably less important for assessing prospects for demand and output.

Six-month growth of “private non-financial M1”, i.e. currency in circulation plus demand deposits of households and non-financial enterprises, rose for a second month in July. So did the corresponding broader M2 measure – chart 1.

This improvement needs to be confirmed by a recovery in overall narrow money growth in August, ideally accompanied by a further increase in the private sector measure. One concern is that the rebound in the latter has so far been driven by the household component – enterprise money growth remains weak.

Increased bond issuance and fiscal easing could lift public sector money growth during H2.

The corporate financing index in the Cheung Kong Graduate School of Business monthly survey is a useful corroborating indicator of money / credit trends – a rise signals easier conditions. The index bottomed in March but has yet to improve much – chart 2. August survey results will be released shortly.

Chart 2

*True M1 includes household demand deposits, which are omitted from the official M1 measure.

The fall in UK CPI inflation in July reported this week will be of limited comfort to policy-makers – a decline had been expected because of a large base effect and will be more than reversed in August. A bigger story was the further widening of the RPI / CPI inflation gap to an 11-year high. RPI inflation could top 5.5% in Q4 2021, boosting interest payments on index-linked gilts by a whopping £15 billion relative to the OBR’s Budget forecast.

CPI inflation fell from 2.5% in June to 2.0% in July but RPI Inflation eased by only 0.1 pp to 3.8%. RPIX inflation – excluding mortgage interest – was stable at 3.9%.

The RPI / CPI inflation gap, therefore, widened to 1.8 pp, its largest since June 2010. The RPIX / CPI inflation gap of 1.9 pp is the biggest on record since the inception of CPI inflation data in 1989 – see chart 1.

Chart 1

The widening gaps mainly reflect surging house prices, driven partly by Chancellor Sunak’s stamp duty holiday. House prices enter the RPI via the housing depreciation component*, which is linked to ONS house price data with a short lag – chart 2. This component has a 9.0% weight and rose by 9.9% in the year to July, contributing 0.9 pp to RPI inflation of 3.8%. The CPI omits owner-occupier housing costs.

Chart 2

Note that the housing depreciation weight has risen from 5.8% in 2014, i.e. the sensitivity of the RPI to house prices has increased by more than 50% since then.

The RPI / CPI and RPIX / CPI inflation gaps, however, have widened by more than implied by house prices alone – chart 3.

Chart 3

A likely additional influence has been the ONS decision to depart from its normal procedure and base 2021 CPI weights on 2020 rather than 2019 expenditure data. As previously explained, this has lowered the weight of categories hit hardest by the pandemic but now experiencing a rebound in demand and prices. An alternative calculation carrying over 2020 weights (based on 2018 expenditure data) to 2021 produces an annual inflation number for July of 2.5% rather than 2.0% – chart 4.

Chart 4

The RPI has been less affected because the normal procedure was followed of basing weights on expenditure shares in the 12 months to June of the previous year. 2021 weights, therefore, reflect spending in the year to June 2020 – the impact of the pandemic was smaller over this period than in calendar 2020.

So weighting effects are likely to have had a larger negative impact on CPI than RPI inflation.

The phase-out of the stamp duty holiday is being reflected in a slowdown in housing market activity but estate agents expect a shortage of supply to support prices, according to the RICS survey. Recent strength may not yet have fed through fully to the RPI housing depreciation component – the annual rise in the latter of 9.9% in July compares with a 13.2% increase in the ONS house price index in the year to June.

Assume, as a reasonable base case, that that the annual increase in the housing depreciation component moderates to 8.0% in Q4 2021 while other influences on the RPI / CPI inflation gap are stable. This would imply a decline in the gap from the current 1.8 pp to 1.6 pp. The Bank of England’s August forecast of CPI inflation of 4.0% in Q4 would then read across to RPI inflation of 5.6%.

The OBR’s March Economic and fiscal outlook projected a 2.4% rise in the RPI in the year to Q4 2021. According to its debt interest ready reckoner, a 1% rise in the RPI boosts interest costs on index-linked gilts by £4.8 billion in the following year. The suggested Q4 overshoot of 3.2 pp, therefore, implies a spending increase of £15.2 bn – or 0.6% of annual GDP – relative to Budget plans.

*House prices also feed into the mortgage interest component, as well as estate agents’ fees and ground rent.

Monetary trends continue to suggest a slowdown in global industrial momentum in H2 2021, with a rising probability that weakness will be sustained into H1 2022 – contrary to the prior central view here that near-term cooling would represent a pause in a medium-term economic upswing. Pro-cyclical trends in markets have corrected modestly but reflationary optimism remains elevated, indicating potential for a more significant setback if economic data disappoint. Chinese monetary policy easing is judged key to stabilising global prospects and reenergising the cyclical trade.

Global six-month real narrow money growth – the “best” monetary leading indicator of the economy – peaked in July 2020 and extended its fall in May, dashing a previous hope here of a Q2 stabilisation / recovery. This measure typically leads turning points in the global manufacturing PMI new orders index by 6-7 months but a PMI peak was delayed on this occasion by a combination of US fiscal stimulus and economic reopening. A June fall in new orders, however, is expected to mark the start of a sustained decline, confirming May as a significant top – see chart 1.

Chart 1

The magnitude of the fall in global real narrow money growth and its current level suggest a move in the manufacturing new orders index at least back to its long-run average of 52.5 during H2 (May peak = 57.3, June = 55.8).

China continues to lead global monetary / economic trends, as it has since the GFC. A strong recovery in activity through 2020 prompted the PBoC to withdraw stimulus in H2, resulting in a money / credit slowdown that has fed through to weaker H1 2021 economic data. The central bank, however, has been reluctant to change course, partly to avoid fuelling house and commodity price speculation, and six-month real narrow money growth has now fallen to a worryingly low level, suggesting rising risk of a “hard landing” in H1 2022 – chart 2.

Chart 2

Real narrow money growth remains above post-GFC averages in other major economies but has also fallen significantly, reflecting both slower nominal expansion and a sharp rise in consumer price inflation. Six-month inflation is likely to fall back during H2 but nominal trends could weaken further in response to higher long-term rates and as money-financed fiscal stimulus moderates.

The suggestion from monetary trends of a deeper and more sustained economic slowdown could be argued to be inconsistent with cycle analysis. In particular, the global stockbuilding or inventory cycle bottomed in Q2 2020 (April) and, based on its 40-month average length, might be expected to remain in an upswing through early 2022, at least. This understanding informed the previous view here that a cooling of industrial momentum in mid-2020 would prove temporary.

A reassessment, however, may be warranted to take account of the distorting impact of the covid shock, which stretched the previous cycle to 50 months. A compensating shortening of the current cycle to 30 months would imply a cycle mid-point – and possible peak – in July 2021.

This alternative assessment is supported by a rise in the business survey inventories indicator monitored here to a level consistent with prior cycle peaks – chart 3.

Chart 3

The previous quarterly commentary suggested that cyclical equity market sectors and value were less attractive in the context of an approaching PMI peak, while quality stocks had potential to rally. MSCI World non-tech cyclical sectors lagged defensive sectors during Q2, with quality and growth outperforming value – chart 4. These trends could extend if the slowdown scenario described above plays out. Chinese policy easing would support the cyclical / value trade but the impact could prove temporary unless the Chinese shift resulted in an early rebound in global real narrow money growth.

Chart 4

Counter-arguments to the relatively pessimistic economic view outlined above include the following:

1. Fiscal policy remains highly expansionary and will offset monetary weakness.

Response: Economic growth is related to the change in the fiscal position and deficits, while large, are falling in most countries. Even in the US, President Biden’s stimulus package served mainly to neutralise a potential drag as earlier measures expired. The US fiscal boost peaked with the disbursement of stimulus cheques in March / April.

2. Household saving rates and money balances are high, implying pent-up consumer demand.

Response: Savings rates have been temporarily inflated by government transfers and will normalise as these fall back and consumption recovers to its pre-covid level. High money balances probably reflect “permanent” savings. US households planned to spend only 25% of the most recent round of stimulus checks, according to the New York Fed, using the rest to increase savings and reduce debt. The implied spending boost has already been reflected in retail sales, which may fall back in Q3.

3. Services strength as economies reopen will offset any industrial slowdown.

Response: The services catch-up effect is temporary and momentum is likely to reconnect with manufacturing in H2. Industrial trends dominate economic fluctuations and equity market earnings.

4. Profits are rising strongly, with positive implications for business investment and hiring.

Response: Profits are still receiving substantial support from government subsidies, withdrawal of which will offset much of the additional boost from economic normalisation. An increase in net subsidies relative to their Q4 2019 level accounted for 10% of US post-tax corporate economic profits in Q1, according to national accounts data – see chart 4.

Chart 5

5. Inventories to shipments ratios remain low, implying that the stockbuilding cycle is far from peaking.

Response: Economic growth is related to the change in stockbuilding, not its level. Stockbuilding is highest when inventories are low – the subsequent fall is a drag on growth even though stockbuilding usually remains high until inventories normalise. Low inventories to shipments ratios, therefore, are consistent with a cycle peak.

6. Industry has been held back by supply constraints – output and new orders will surge as these ease.

Response: Supply difficulties have probably resulted in firms placing multiple orders for inputs, inflating PMI readings – this effect will unwind as bottlenecks ease. Historically, manufacturing PMI new orders have fallen, not risen, following a peak in supply constraints.

7. Rising inflation will boost bond yields, supporting cyclical / value outperformance.

Response: Last year’s global money surge was expected here to be reflected in high inflation in 2021-22 but six-month broad money growth has moved back towards its pre-covid average, suggesting that medium-term inflation risks are receding. Bond yields usually track industrial momentum more closely than inflation data so would probably remain capped in a slowdown scenario even if inflation news continues to surprise negatively.

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CC&L Financial Group Ltd.

Identifier: International Equity