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MENA equity markets had a strong third quarter of 2024 with returns of 6.7% (for the S&P Pan Arabian Index Total Return) but trailed the MSCI Emerging Markets Index, which was up 7.8% in the same period. For the first nine months of 2024, MENA equity markets are up 5.4% compared to 14.4% for the MSCI EM Index.

Our team spent time in Saudi Arabia recently and came back feeling positive about the Kingdom’s medium-term prospects. The impact of the bold socioeconomic reforms that the country pursued in the last few years is visible not just in economic activity (and bad Riyadh traffic), but also in the sentiment expressed and captured in interactions we had with company executives, government officials, Uber drivers and hotel and restaurant staff. One can make the case that Saudi women have been the group that benefited the most from the country’s reform program. The elimination of the religious police establishment and lifting of the driving ban led to freedoms and mobility that Saudi women had not experienced before in their own country. This resulted in remarkable growth in their labour force participation, with data from the World Bank showing it had increased from 20% in 2018 to 35% in 2023. Much has been written about the changes that have been taking place in the Kingdom in the last few years, and we will not expand further on that here. However, we believe Saudi Arabia is in the early innings of a major societal and economic transformation project that will generate multi-year growth in profit pools in certain sectors like financial services, healthcare, education, entertainment, tourism, real estate and technology. Some of the profit pool growth will come at the expense of sectors that are not prioritized under the government’s Vision 2030 program or are not as geared to the evolution in consumer behaviour and evolving regulatory environment. These include brick and mortar retailers or companies that over-earned on government contracts, and which can be found in several sectors including construction and engineering.

Of course, not all is rosy in the Kingdom. While significant progress was made on diversifying the economy, nearly three quarters of the budget is still funded from oil revenue. If it stays, the current combination of low oil prices, production curtailment and high government spending is likely to weigh on growth or raise the risk of fiscal imbalances in the long term. The economic viability of some of the giga projects is difficult to determine and so poses additional capital allocation and fiscal risk. Positively, the country is preparing for this reality and has been actively diversifying its sources of funding from debt and equity capital markets. According to Fitch Ratings, Saudi Arabia was the largest US dollar debt issuer in emerging markets (ex-China) in 1H 2024. The listing of Saudi Aramco and the dividends that the government will receive from that will also continue to support the budget.

Additionally, inflationary pressures are building up in the system – specifically in Riyadh as demand- and supply-side factors collide in areas of housing and transport. This is resulting in downward pressure on household disposable incomes and is manifesting itself in downtrading and increased household debt. Unsurprisingly, many consumer companies are observing down trading in their revenue mix, and many are reacting through aggressive discounting to preserve market and wallet share. Consumers are embracing buy-now-pay-later financing to maintain or extend their purchasing power and this channel is becoming increasingly more prominent in the revenue of many consumer-facing businesses. Furthermore, consumer pressure in Saudi Arabia has the potential to delay further necessary reforms and regulations that can open new profit pools as the government looks to strike a balance between diversifying the economy and protecting consumer purchasing power.

The strategy has had good success investing in Saudi Arabia from identifying growing profit pools early on and investing in companies that were best positioned to grow their share of them. Those include companies we have previously discussed in our letters such as Saudi Dairy & Foodstuff Co. (SADAFCO) in 2018, National Company for Learning and Education (NCLE) in 2019, and The Company for Cooperative Insurance (TAWUNIYA) in 2023. However, there are several challenges that have impeded our ability to express a fuller position in some of the sectors mentioned above. Firstly, we view the quality of certain companies in sectors like real estate and tourism as relatively poor and place some of those in the over-earners group we describe above. The other dynamic that has been increasingly challenging to navigate is the valuation environment, especially with regards to growth stocks. In the last two years, the market moved well ahead of earnings expectations, creating an unfavourable risk-reward set-up for companies the strategy owned and prospected. Using the MSCI Midcap Saudi Index to proxy growth companies in Saudi Arabia, we find that the price-to-earnings (P/E) ratio in 2023 was 38 times, more than double the 2022 levels and above levels we believe reflect cost of capital and growth dynamics on the majority of stocks in that index. Of course, we have made exceptions where we maintain ownership of a few high P/E ratio companies only when we believe their quality and growth potential justify such valuations. While we strongly believe in momentum as a factor for driving returns and outperformance, valuation is the ultimate determinant of our capital allocation reflexivity.

Fortunately, there are three factors working for the strategy at the moment. Firstly, there are growing profit pools resulting from reforms and demographics which is critical to our investing style – growth. Secondly, in the last two months, the market has begun the long-awaited process of recalibrating its expectations of earnings to levels that we deem realistic and interesting – reasonable valuations. Lastly, the strategy has already begun shifting the portfolio to areas where there is a healthy combination of growth, risk-reward and low investor positioning. One particular area where the strategy has been net buying in is the Saudi conventional banks, where we believe technical overhangs have largely suppressed price discovery year-to-date. The set-up for next year looks particularly attractive as those headwinds become less pronounced and bank earnings continue to compound.

We look forward to continuing to update you on the strategy in the next letter.

Eurozone money trends are improving but remain too weak to support economic optimism, while country details highlight French stress.

A post in June noted that six-month real narrow money momentum was still significantly negative, suggesting that a minor economic recovery in H1 2024 would give way to a H2 “double dip”. The PMI composite output index fell from 50.9 in June to a flash reading of 48.1 in November.

Six-month real money momentum has risen further since June but was still barely positive in October. It has, however, crossed above Japan and narrowed a shortfall with the US, implying improving relative prospects – chart 1.

Chart 1

Consensus gloom about Germany may be overdone. Six-month nominal narrow money momentum has swung into positive territory since mid-year, catching up with Spain / Italy – chart 2.

Chart 2

French momentum, by contrast, remains negative, with a recovery stalling in September / October.

French narrow money weakness appears to reflect low confidence and spending intentions rather than deposit flight (so far). Annual growth of all bank deposits slowed sharply in September / October but is still on a par with in Germany – chart 3.

Chart 3

France’s deficit in the TARGET system rose by €34 billion in September to a record €175 billion, which could signal a capital outflow related to the political / fiscal crisis. There has, however, been no corresponding increase in Germany’s surplus, for which an October number is available – chart 4.

Chart 4

A pull-back in US narrow money momentum casts doubt on post-election economic optimism.

Six-month growth of M1A (comprising currency in circulation and demand deposits) eased to 5.7% annualised in October, down from an August peak of 10.0% – see chart 1.

Chart 1

Growth of the broad M2+ measure, by contrast, rose to 5.1% annualised, the fastest since March 2022. (M2+ adds large time deposits at commercial banks and institutional money funds to the official M2 measure.) Narrow money, however, has a better record of signalling turning points in economic momentum.

Six-month expansion of official M1 is weaker, at 2.9%. M1 is no longer a narrow money measure, following its redefinition in 2020 to include savings accounts.

A post in September expressed doubt that a pick-up in M1A growth would be sustained, partly because it had occurred before any rate cuts. In addition, the rise had been driven solely by the demand deposit component, with currency momentum unusually weak.

Six-month growth of currency has recovered but was still only 1.7% annualised in October – chart 1.

A further consideration, noted in a post last month, is that narrow money growth has tended to rise ahead of presidential elections but reverse shortly before or after the poll date – chart 2. (1984 and 2000 were notable exceptions.)

Chart 2

The pull-back to date has been modest but could become more serious, especially if the Fed delays further rate cuts.

Broad money growth, however, could be supported by increased monetary financing of the fiscal deficit, based on Treasury plans for higher bill issuance in Q4 and Q1 (given that these are mostly purchased by money funds and banks).

Narrow / broad money divergences can reflect shifts in confidence and spending intentions affecting broad money velocity. (Such shifts are associated with movements between low-velocity broad money components and high-velocity narrow money.) Relative narrow money strength into the summer was a positive signal for the economy; the reversal suggests fading prospects.

The current stockbuilding cycle may be approaching its mid-point, which typically marks a shift from “risk-on” to a neutral or negative market environment.

The stockbuilding (or inventory or Kitchin) cycle is usually described as ranging between 3 and 5 years. The dating here suggests a normal band of 2.5 to 4.5 years, with an average of about 3.5.

A key indicator used to inform judgements about cycle dates is the annual change in G7 stockbuilding, expressed as a percentage of GDP. Chart 1 shows a long history of this indicator, along with suggested cycle low dates.

Chart 1

There were 16 complete cycles, measured from low to low, between Q2 1967 and Q1 2023, a period of 55.75 years. This implies an average cycle length of 3.5 years or 42 months.

The cycle described in a 1923 article by Joseph Kitchin averaged 40 months. Kitchin analysed data on bank clearings, commodity prices and interest rates and did not explicitly link his cycle with inventory fluctuations. His average was based on 9 cycles spanning 30 years, i.e. a smaller data set than shown in chart 1.

An average of about 3.5 years harmonises with the longer-term housing cycle, with an accepted average length of 18 years. Five stockbuilding cycles “nest” within each complete housing cycle, implying an average length of 3.6 years (43 months).

The most recent stockbuilding cycle trough is judged to have been reached in Q1 2023. Assuming a starting point in the middle of the quarter, November 2024 is month 21 of the current cycle.

The annual change in G7 stockbuilding was still negative in Q3 and usually becomes significantly positive at peaks, suggesting that the cycle remains an expansionary influence on economic momentum currently.

The cycle is as important for markets as the economy (as shown by Kitchin’s reliance on commodity price and interest rate data). The first half of the cycle (starting from a trough) is typically favourable for risk assets and cyclical exposure. Bear markets and crises have historically been concentrated in cycle downswings.

Table 1 compares movements in various assets since the Q1 2023 trough – third column – with average performance in the first 21 months of the prior 8 cycles (stretching back to the mid 1990s) – first column. The second column shows average performance over the remainder of those 8 cycles.

Table 1

The current cycle has so far largely conformed to the historical pattern, with strong performance of equities, cyclical sectors, precious metals and credit. The suggestion is that remaining upside potential is limited in these areas, with weakness likely over the next 1-2 years as a cycle downswing unfolds.

Could the current cycle prove to be longer than average, extending the risk-on phase? A longer cycle is plausible both because the previous one was short (2.75 years) and to align with the business investment cycle, for which the dating here implies a low in 2027 or later.

A delayed entry to the downswing phase could imply catch-up potential for areas that have lagged relative to history, including non-US / EM equities and commodities.

Cycle timings, however, could be affected by accelerated stockbuilding in anticipation of tariff wars, which could bring forward the cycle peak, although this would not necessarily imply an earlier trough.

The overall message is cautionary. A previous post argued that the “excess” money backdrop for markets is now neutral / negative in stock as well as flow terms. Cyclical considerations reinforce the monetary message.

Crestpoint is excited to announce the appointment of Lindsay Stiles as Crestpoint’s new co-Chief Operating Officer (co-COO). With over 20 years of experience in the commercial real estate industry, Lindsay brings a wealth of knowledge and expertise in operations, asset management, finance, leasing, and brokerage.

Lindsay has held several senior roles throughout her career, including COO of Slate Office REIT and Managing Director at Colliers International. Reporting directly to our President and CEO, Kevin Leon, and working alongside our current COO, Colin MacKellar, Lindsay will focus on operations and business systems, compliance, human resources, and client service. Lindsay’s addition to our team will help us maintain focus, agility, and effective execution as we continue to grow.

Long-distance running is an endurance sport that offers lessons that resonate with investing. In Born to Run, Christopher McDougall illustrates how elite ultrarunners thrive through discipline, adaptability and a love for the journey. These traits align closely with successful investing, where endurance, process consistency and risk management are key. As Rick Mears, an American racecar driver, famously said: “In order to finish first, first you must finish.” This principle underscores the importance of survival in both running and investing, as staying in the race is a prerequisite for achieving long-term success.

Compounding endurance and wisdom

Unlike sprint running where youthful energy and explosiveness dominate, endurance running demonstrates that experience often wins over youth. Research by Pimentel et al. (2003) found that well-trained older runners (average age 61) perform as efficiently as much younger runners (average age 26), despite having lower overall aerobic capacity.

Similarly, in investing, knowledge compounds over time. Building and expanding one’s circle of competence is crucial. Each market cycle and every business studied enrich an investor’s knowledge library, deepening expertise and sharpening judgment. In both running and investing, there’s wisdom in pacing. As the saying goes, “to go faster, you need to slow down.” Long-distance runners balance high- and low-intensity sessions to build endurance gradually, much like disciplined investors adhere to a sound strategy and steady capital allocation to achieve long-term success. Small, consistent efforts, whether in running or investing, compound over time to deliver meaningful outcomes.

Staying in the race

Runners know that pushing too hard early in the race often leads to injury or burnout. When dealing with investments, aggressive risk-taking can lead to permanent loss of capital, a risk that prominent investors, including Warren Buffett and Howard Marks, frequently caution against. A focus on capital preservation ensures that investors remain in the race long enough to benefit from compounding returns, much like runners who pace themselves to reach the finish line strong.

Mental toughness and adaptability

Long-distance running is as much a mental challenge as a physical one. Runners frequently encounter unexpected obstacles such as tough weather, grueling terrain or moments of self-doubt. Success comes from adaptability and mental resilience, staying focused on the goal despite temporary setbacks. Challenges like these arise in investing during periods of market volatility and uncertainty. Fear and greed often drive extreme behaviour of Mr. Market, but those who remain adaptable and focused on long-term objectives are better equipped to navigate through the storm.

Humility and ego management

Runners quickly learn that the course has a way of humbling even the most confident athletes. Whether it’s underestimating a hill or pushing too hard on a hot day, overconfidence can lead to setbacks. Respecting the journey and staying humble is key to consistent performance. As with running, overconfidence when investing can be costly. Successful investors recognize the limits of their circle of competence, acknowledging mistakes and making necessary adjustments to achieve superior outcomes.

Recovery and rebalancing

Hydration and nutrition during the race are critical, but equally important is post-run recovery to avoid injury and maintain peak condition. Periodic system checks – evaluating whether there’s any discomfort, signs of dehydration or creeping fatigue – are part of a successful runner’s routine. Attribution analysis, risk reassessment, and rebalancing serve a similar purpose in investing. They ensure that portfolios remain aligned with long-term goals and avoid overexposure to excessive or unintended risk.

Embracing and trusting the process

Experienced runners often speak of finding joy in the act of running itself, rather than focusing solely on finishing times. The Tarahumara people, as McDougall describes, run for the love of it, finding fulfillment in the process. This philosophy resonates in investing, where the process is deeply rewarding. However, focusing on the process serves a higher purpose: delivering superior value. Even the best strategies will face periods of underperformance. Endurance runners trust their training, knowing that results come over time. A well-crafted investment strategy is also like this in that it delivers superior value over the full cycle. The real risk lies in abandoning a sound strategy during temporary setbacks, which can lead to irreversible mistakes.

Both running and investing are endurance activities. Success comes to those who stay committed to their process, manage risks thoroughly and adapt to challenges. Beyond the parallels, there are also synergies between endurance running and investing. Running helps nurture and enhance one’s discipline, humility, patience and mental toughness. It also offers a unique mental space for reflection. The steady rhythm of a long run on a quiet sunny morning creates the perfect environment to think deeply about market developments or investment strategies. And finally, as Born to Run highlights, staying active is crucial to maintaining vitality: “We don’t stop running because we get older; we get older because we stop running.” It’s a reminder that endurance, whether in life or investing, is about staying engaged and embracing the journey.

A look at the potential impact of President Trump’s policies on emerging markets, the risks of rising trade tensions with China and the resilience of China’s domestic market

US politics has shifted to the right with an unexpected red sweep of the presidency, Senate and House. Gloomy prognostications for emerging markets abound on expectations for a stronger dollar, stickier inflation and a less dovish Fed. Yet there is very little to go on in terms of hard policy. For example, would President Trump risk a tit-for-tat tariff spiral with China and the EU, or will he pursue deals which incentivise foreign exporters to build manufacturing assets in the US to secure exemptions or reductions? The EU has done something similar with Chinese carmakers.

On inflation, increased deficit spending may be inflationary from 2026 onwards, but our broad money signals suggest the current backdrop is still disinflationary and likely to force a flat-footed US Fed into playing catch-up in its cutting cycle in the short term. This should be weighed against the assumption that Trump means a strong dollar. Further out, with mid-term elections occurring in November 2026, the re-election of the House and a third of the Senate could provide a check on the fiscal agenda.

Should risks of rising trade tensions materialise, this may make EM countries with large domestic markets (i.e., China and India) relatively more attractive versus smaller, open, trading economies in ASEAN.

Overall, our instinct is to avoid knee-jerk repositioning on speculation, at the risk of being whipsawed down the road should events differ from expectations. The reality is that the anti-tyranny checks embedded in the US constitution mean that the president has less power than we commonly think. Our view is that it will pay to remain focused on the cyclical and structural factors at play in shaping return prospects across equities and other asset classes.

Stock picking in a China bull market

Chinese equities took off in the final week of September, rising around 25% in USD terms as announcements of incoming and meaningful monetary and fiscal stimulus blew away traders shorting H-shares and sparked significant domestic inflows. Foreign investors remained on the sidelines.

China equities flows: Domestic vs. foreign investors

Source: EPFR

The rally was so big that Chinese stocks are virtually level-pegging US equities as at the end of October.

Source: NS Partners; LSEG Datastream

This spurt, led by beaten-down names including property developers and domestic insurers (with high property exposure), is likely the first leg of this rally. We see the pullback in recent weeks as an opportunity to reposition more aggressively at the margins (from a defensive equal weight). While stimulus won’t be a bazooka on the level of 2008-09, the imprimatur for the measures from Xi Jinping himself suggests they will keep coming until we see at least stabilisation in the Chinese economy.

While the threat of tariffs looms for exporters, China has a huge domestic economy with a deep equities market. Direct exports of goods to the US account for only 2.6% of Chinese GDP, less than for Japan and Germany.

With stocks still trading only slightly above their lows of around 10x CAPE, there is an opportunity for deep fundamental analysis to unearth high quality and growing names that have been knocked by investor revulsion for Chinese equities.

Source: NS Partners; LSEG Datastream

For those interested, a short primer on our stock picking approach below – skip ahead for our coverage of current stock opportunities in China.

Our approach to stock picking – focus on economic value added (EVA)

Made famous by Stern Stewart & Co., the approach homes in on the spread between the rate of return on a company’s invested capital and its cost of capital; economic value added, or EVA for short.

Why? We know that over the medium to long term, EVA is directly tied to the intrinsic value of any company and the fuel that fires up a company’s stock price.

Stock prices reflect how successfully a company has invested capital in the past and how successful it is likely to be at investing new capital in the future. EVA is the best methodology to measure the value that management has added to, or subtracted from, the capital it has employed over time.

How can management create value?

Bennett Stewart in his book The Quest for Value boils it down to three drivers:

The rate of return earned on the existing base of capital improves; that is, more operating profits are generated without tying up more funds in the business.
Additional capital is invested in projects that return more than the cost of obtaining new capital.
Capital is liquidated from, or further investment is curtailed in, substandard operations where inadequate returns are being earned.

We are looking for companies that can be expected to generate high or improving returns on the capital employed in their businesses. These are companies run by management teams laser-focused on making investments that earn more than the cost of capital, and undertaking all positive net present value projects, while rejecting or withdrawing from all negative ones.

Menu of investment opportunities available within a single company.
Source: Bennett Stewart (1991), The Quest for Value

Understand what drives returns

Value creation is not enough for long run success. We need to know whether it can be sustained. Our process is focused on identifying the drivers of these returns and assessing:

whether there are historic changes or potential catalysts for improved value creation that are yet to be reflected in market prices; and
the sustainability of those returns – are there enduring competitive moats that will protect excellent returns on invested capital?

Our approach identifies highly productive and capital-efficient companies pursuing value creation in a variety of ways. It also focuses on whether that value creation is sustained via competitive moats.

Moats can take a number of forms, from differentiation via proprietary tech, brands or prime locations, to high switching costs, network effects, cost leadership, economies of scale or minimum efficient scale.

Investment edge

This strategy got its start just as the Asian Financial crisis of 1997 unleashed havoc across the region before spilling over into Latin America and Eastern Europe. We know firsthand through several cycles that emerging markets expose investors to both great opportunity but also the potential for downside shocks. Investors have endured a torrid decade in EM equities, but the signals we track suggest an improving outlook. We aim to capture that opportunity through a combination of identifying robust and growing companies compounding ROICs coupled with liquidity and macro analysis – the heart of an all-weather approach that has delivered outperformance over the long run.

Eastroc – The domestic energy drink champion

The potential for China’s economy to stabilise on stimulus efforts could feed the next bull market in China. While China looks cheap across the board, our view is that laggard quality growth names look particularly attractive.

Source: NS Partners; LSEG Datastream

Eastroc Beverage fits the bill as a fast growing, highly profitable and yet attractively valued domestic energy drink champion.

P/E has drifted lower while earnings have held up

Source: Bloomberg

There is plenty of headroom for growth in the segment, with energy drink consumption by volume in China at only 58% of Japan, 32% of the US, and 23% of the UK (Source: Bank of America). Growth drivers include the expansion of the gig economy, along with new consumption channels in music concerts, e-sports and parties. While major cities are posting healthy consumption growth of c.10% CAGR, peripheral markets are growing rapidly at c.35-40%.

Red Bull stumbles

Eastroc is mounting a fierce challenge to incumbent Red Bull, growing market share from 5% in 2012 (with Red Bull at 80%) to nearly 30% in 2023. Not only has Eastroc been effective in building its distribution network out from its Guangdong home base in Southern China, it has also been able to capitalise on strategic missteps from the incumbent. A fallout over a lapsed distribution agreement between Red Bull’s Thai and Chinese operators has spiralled into open warfare over the market. The bickering sister companies are fighting each other in provincial courts, launching rival marketing campaigns and even different pricing strategies. Eastroc offers distributors higher margins and pricing stability, making them more willing to stock the challenger’s inventory. In addition, Eastroc offers value at around half the price per 500 ml of Red Bull, so benefiting from consumers trading down in a weak economy.

Source: Eastroc Beverages 2022

Optionality through new product lines

What we find particularly interesting is the potential for new growth drivers outside its flagship energy drink. Healthier and plant-based energy drinks targeted at women, electrolyte drinks targeted at sporting activity and sugar-free teas can are all large and fast growing segments.

Source: Eastroc Beverages 2024

Eastroc already has a strong distribution network to sell these new lines into, meaning the investment to drive this growth will be relatively small, boosting returns on capital.

Our kind of business – EVA, cash flow and Du Pont tests (charts and data below from Bloomberg)

Growth requires capex to build out the distribution network, and yet Eastroc looks like a cash machine.

Overheads look contained as it expands.

This business scales well.

Paid by customers early while pushing out payables.

Margins are resilient.

Unsurprisingly, the EVA (ROIC/WACC spread) is high and set to rise over the next 2-3 years.

Opportunity among the quality names in China

Eastroc is the fast-rising challenger to Red Bull in China and enjoying strong growth tailwinds in the energy drink segment. The company is able to squeeze more value from its established network in Guangdong without tying up significant capital. The capital that it does invest is used to expand carefully into new territories that promise returns that far exceed the cost of capital.

Eastroc is the type of stock we would expect to outperform should this upward move in Chinese equities mature into a wider bull market. CCP stimulus efforts are not yet enough to shift consumer sentiment meaningfully, but valuations are compelling and the growth is there for companies like Eastroc to perform regardless.

In recent years, tariffs have become a central component of US trade policy, impacting international relations and economies worldwide. The resurgence of tariffs, particularly those aimed at China and specific industries, reflects a strategic move to protect US industries and reduce its trade deficits.

A second round of tariffs under the next US administration could fuel inflationary pressures, affecting both US and international economies. A universal 10% tariff on imports, as proposed, would directly raise prices for consumers, making imported goods more expensive. This price increase could reduce domestic purchasing power and may lead to reciprocal tariffs from trading partners, further escalating costs and reducing trade flows. Additionally, these trade policies might destabilize global trade by disrupting established supply chains, potentially leading to short-term job creation in the US, but creating a long-term economic inefficiencies.

At the time of Trump’s election in 2016, the US trade deficit in goods was close to 3.9% of GDP with nearly half coming from trade with China. Starting in 2018, tariffs were added to an increasingly wide range of Chinese products. The average tariff on imports from China was 3.1% in 2017. It was raised in waves, exceeding 20% by the end of 2019, before a deal was reached in which China committed to increase its purchases of American products. Tariffs were also imposed on specific products from other countries, such as steel.

Surprisingly, the goods trade deficit for 2023 remained close to 3.9% of GDP. Although the share attributable to China was reduced to 25%, imports from other countries like Vietnam, India, South Korea and Germany increased.

A potential revival in tariffs would be detrimental to certain industries. Asia and Germany’s automotive and machinery industries are particularly vulnerable due to their high dependence on US demand. Such tariffs would likely reduce Asian and German exports and might encourage companies to adjust their supply chains or relocate production to the US.

As a potential response, countries could retaliate on targeted goods or offer trade concessions to diffuse the tension. During the first Trump presidency, the EU agreed to lower their tariffs on some US products and made concessions on the import of beef and soybeans. The EU may again offer to import more goods from the US such as armaments, liquified natural gas (LNG) and agricultural products. We believe that offering trade concessions and reaching bilateral trade agreements would be more favourable than imposing blanket tariffs on a large selection of goods.

In summary, enhanced tariffs could lead to increased consumer prices, hurt international relations, and potentially shift production and trade in the most vulnerable industries. These economic shifts would challenge the international economies, especially if retaliatory actions escalate to a trade conflict.

Japanese money trends remain ominously weak, suggesting poor economic / market prospects and a return of inflation to unacceptably low levels.

Annual growth rates of broad money M3 and narrow money M1 fell to 0.7% and 1.5% respectively in October, well below 2010-19 averages of 2.6% / 5.1% and the lowest since the GFC – see chart 1.

Chart 1

Record f/x intervention resulted in monetary contraction in Q2 but a subsequent recovery has been minor, partly reflecting BoJ policy tightening. M3 and M1 grew at annualised rates of 0.5% and 0.1% in the three months to October – chart 2.

Chart 2

Japanese economic prospects represent another test of “monetarist” vs. consensus forecasting approaches. The BoJ / consensus view is that above-potential economic growth, a tight labour market and a gradual rise in adaptive inflationary expectations will result in annual CPI inflation – on both the targeted ex. fresh food measure and the BoJ’s core index also excluding energy – remaining close to the 2% target in FY 2025 and FY 2026. The BoJ views risks as skewed to the upside, warranting a tightening bias.

The “monetarist” view, by contrast, is that 2022-23 inflation resulted from a temporary spike in money growth in 2020, with the effects extended by a big fall in the yen. With money growth well below the 2010-19 average, CPI inflation is heading back to, or beneath, its corresponding average of 0.5%, unless the exchange rate suffers a further collapse.

Headline CPI numbers have been affected by changes in energy and travel subsidies but six-month core momentum (on the standard international definition excluding all food as well as energy) has fallen back below 2% annualised, consistent directionally with the earlier slowdown in money growth – chart 3. The level of core momentum still incorporates the effects of yen weakness.

Chart 3

Chart 4 shows the contributions of the “credit counterparts” to annual M3 growth, with data available through September. Comparing with growth a year earlier, the largest drag has been a shift in domestic credit to government from expansion to slight contraction, reflecting the impact of f/x sales (which reduce government borrowing needs) and the BoJ moving from QE to QT.

Chart 4

A slowdown in domestic credit to other sectors has also exerted a negative influence. The measure shown is significantly broader than the BoJ’s series for loans and discounts by commercial banks but growth in the latter has also moderated recently, while the latest senior loan officer survey reported weaker expectations for credit demand – chart 5.

Chart 5

Is there still an overhang of money from the 2020 surge sufficient to sustain nominal economic expansion despite current low M3 growth? This can be answered using the “quantity theory of wealth” – the idea that asset prices and incomes adjust such that a geometric average of wealth and nominal GDP rises in line with broad money over the medium term.

Chart 6 shows that, using Q4 2018 as a base, a nominal GDP undershoot relative to broad money (i.e. a fall in conventionally defined velocity) has been offset by a wealth overshoot, resulting in the average moving slightly ahead of the level implied by the money stock in Q2 2024.

Chart 6

The suggestion is that an “excess” money reserve has been exhausted and, unless asset prices fall, current low money growth will be reflected in nominal economic weakness.

Global “excess” liquidity has surged to a level breached only twice over the last half-century, implying a favourable backdrop for risk assets, according to a Bloomberg article. The assessment here, by contrast, is that excess money conditions are neutral / negative.

Actual growth of the money stock can exceed or fall short of the rate of increase of money demand for economic and portfolio purposes. Deviations are reflected partly in changes in demand for financial / real assets and associated price movements.

The rate of increase of (real) money demand is unobservable. Two proxies are 1) the current rate of (real) economic expansion and 2) a long-term average of real money growth, this being assumed to capture the trend rise in money demand.

Accordingly, the approach followed here historically has relied on two flow indicators of excess or deficient money:

The gap between real narrow money and industrial output momentum (six-month rates of change preferred).
The deviation of real narrow money momentum from a long-term average (12-month rate of change preferred).

Chart 1 shows a cumulative return index of global equities relative to US dollar cash together with the two indicators. The indicators have been lagged to allow for reporting delays, i.e. the readings for a particular month would have been known at the time (ignoring revisions). Shaded areas denote double-positive readings. Equities outperformed cash significantly on average during these periods (i.e. averaging performance in the month following each monthly signal). They underperformed on average under mixed or double-negative readings.

Chart 1

The first indicator is hovering around zero while the second remains negative.

The excess liquidity indicator referred to in the Bloomberg article is described as measuring how much real money growth outperforms economic growth, suggesting that it should resemble the first indicator above. Like here, narrow (M1) money is used in the calculation. Coverage, however, is restricted to the G10 developed markets and growth rates may be measured over 12 rather than six months.

Chart 2 shows a G7 version of the real narrow money / industrial output momentum gap calculated on a 12-month basis, which should be a close substitute for a G10 measure. This indicator turned positive in July but is far from historical highs.

Chart 2

What explains the much more bullish Bloomberg reading? The guess here is that the Bloomberg indicator is a deviation of the real money / economic growth gap from some measure of trend, rather than its absolute level. The current gap, for example, is significantly higher than a 24-month moving average, also shown in chart 2.

In this case, the Bloomberg indicator would be better described as a measure of excess money acceleration rather than growth. The current high reading would reflect a recovery in excess money momentum from deep negative to slightly positive.

Conceptually, it is unclear why the demand for assets should be related to the second derivative of excess money rather than its growth or level. The Bloomberg indicator correctly signalled the strength of equity markets this year, though not in 2023. Backtesting indicates that the sign of an acceleration measure would have underperformed that of the level of excess money growth in signalling whether equity market returns were above or below cash rates historically.

Why did the measures shown in chart 1 “miss” the strength of equity markets in 2023-24?

Excess or deficient money need not affect all markets similarly. Treasuries, commercial property and commodities may have borne the brunt of a money flow shortfall.

Preference for equities has been boosted by the AI boom and associated strength in a small number of large cap stocks. The MSCI World equal-weighted index has underperformed US dollar cash since the excess money indicators in chart 1 turned negative around end-2021.

The key reason for the disconnect with market performance, however, is that the flow measures were, on this occasion, an insufficient guide to the excess money backdrop, failing to take account of a still-large stock overhang left over from the 2020-21 money growth surge.

The “quantity theory of wealth”, explained in posts in 2020, is a suggested modification of the traditional quantity theory recognising that (broad) money demand depends on wealth as well as income and proposing equal elasticities. Nominal income is replaced on the right-hand side of the equation of exchange MV = PY by a geometric mean of income and wealth.

Chart 3 applies the “theory” to US data since end-2014.

Chart 3

The combined income / wealth variable closely tracked moderate growth of broad money over 2015-19. Wealth rose faster than income, so traditionally-defined velocity fell. The velocity of the combined income / wealth measure was stable.

The policy response to the covid shock resulted in possibly unprecedented monetary disequilibrium. Asset prices responded swiftly to the excess, causing wealth to overshoot broad money in 2021. Excess money flow indicators turned negative around end-2021 and wealth corrected sharply in 2022.

The combined income / wealth measure was still well below the level implied by broad money even before this correction. Deployment of the excess stock fuelled a second surge in wealth from late 2022 while sustaining economic growth despite monetary policy tightening.

Asset price gains, goods / services inflation and real economic expansion resulted in the income / wealth measure finally converging with broad money at end-Q2, with an estimated small overshoot at end-Q3. So the velocity of the combined measure has returned to its end-2019 level.

Stock as well as flow considerations, therefore, suggest that the excess money backdrop is now neutral at best.