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Markets were mildly disappointed by December US payroll numbers released on Friday, showing a monthly fall of 85,000, but the Conference Board’s employment trends index (ETI) continues to signal a labour market recovery.

The ETI is designed to lead turning points in payrolls and has eight components: consumers’ assessment of job availability, initial unemployment claims, small firm unfilled vacancies, temporary employment, involuntary part-time working, job openings, industrial production and business sales. It bottomed in June last year, edging higher into the autumn before rising strongly in November and December. All eight components contributed to last month’s gain – more details here.

Historically, the index has led troughs in payroll employment by between one and four months – see chart. The June bottom was, therefore, consistent with a low in payrolls by October. They increased marginally in November before slipping back in December. The ETI suggests that last month’s decline will be either revised away or more than offset by a rise in early 2010.

The OECD’s leading indices are designed to predict industrial production and typically lead by three months or so. November figures released on Friday show further large gains across major developed and emerging economies. A combined G7 plus “E7” indicator suggests that output will continue to recover rapidly in early 2010 – see first chart.

Further evidence of resurgent industrial activity is provided by recent Asian trade data. The second chart shows combined dollar exports and imports of China, Korea and Taiwan, adjusted for seasonal variation. Both surged in December, with imports surpassing their July 2008 peak. 

The annual increase in the British Retail Consortium (BRC) shop price index – a measure of goods price inflation – jumped by two percentage points to 2.2% in December. The BRC index is a narrower measure than the official consumer price index for goods but this increase bodes ill for the December CPI report to be released on 19 January.

The chart compares the BRC indices for food and non-food goods with roughly-comparable CPI definitions. BRC food inflation tracks the CPI measure reasonably closely and climbed from an annual 2.8% to 3.7% in December. This represents an unfavourable surprise since the increase cannot be explained by the VAT effect – most food items are not VAT-able.

The annual change in the BRC non-food index rose from -1.2% to 1.4% in December, largely reversing a 2.8 percentage point decline in December 2008 due to the VAT cut. The annual change in the CPI for “non-energy industrial goods” fell by 2.2 percentage points in December 2008; a similar reversal would imply a rise from 1.3% to more than 3% last month.

Overall CPI inflation, including services as well as goods prices, fell from an annual 4.1% to 3.1% in December 2008. Higher BRC food inflation, the jump in the non-food measure and an unfavourable petrol price base effect suggest a similar-sized increase in December 2009. The forecast in an earlier post of a rise in annual CPI inflation from 1.9% in November to 2.6-2.7% last month may prove conservative.

Retail investors continued to pile into unit trusts and OEICs in November, buying a net £2.4 billion, according to Investment Management Association figures released today. Inflows are on course to reach a record £26 billion for 2009 as a whole – the previous highest annual total was £17.7 billion in 2000.

The November performance was particularly impressive given strong competition from National Savings, which attracted £2.8 billion, mostly into now-withdrawn “guaranteed growth and income bonds” offering a premium yield. Equity funds again enjoyed the strongest inflow (£930 million), followed by property (£420 million) and balanced (£250 million). Bond fund sales slumped to a 13-month low (£190 million), probably reflecting the National Savings effect.

Retail mutual fund inflows amounted to 1.2% of M4 excluding money holdings of “other financial corporations” in the six months to November. With investors reallocating portfolios away from cash, the sum of money growth and mutual fund flows is probably a better guide to liquidity support for the economy than M4 itself. This indicator – the green line in the chart – continues to revive, supporting recovery hopes. 

Investors are fearful that the coming election will produce a hung parliament and a weak minority government unable to tackle the gaping hole in the public finances.

They are right to be worried. The peculiarities of the electoral system mean that the Conservatives need to win a much larger share of the vote than Labour to obtain a majority of seats in the House of Commons. In addition, the economy – a key electoral battleground – is currently less unfavourable for Labour than is widely assumed.

The scale of the Conservative challenge is illustrated by “swingometer” calculators that project numbers of seats based on voting intentions. Assuming a uniform national swing, the Tories need to win at least 40% of the vote and lead Labour by 10 percentage points to achieve a Commons majority. Labour, by contrast, requires only a one percentage point advantage for an outright victory.

Recent polls have been volatile but on average show a narrowing of the Conservative lead since the autumn. The last four ICM polls since October, for example, have reported Tory/Labour differences of 17, 13, 11 and nine percentage points respectively.

Based on historical analysis of influences on voting intentions, Labour’s mini-revival is no fluke but reflects better economic trends. The Tory lead, moreover, could be cut further over the near term, magnifying worries about a hung parliament.

The boost, however, is likely to be temporary, with the economy turning against the government again from early 2010. This suggests that Labour’s chances of frustrating the Tories will diminish the longer an election is delayed.

With gross domestic product (GDP) yet to recover after a 6% plunge, it is controversial to claim that the economy has become less of drag for Labour. Voters, however, focus on influences on their personal finances rather than abstract concepts such as GDP.

Historically, support for the governing party relative to the main opposition has benefited from rises in pay growth and house price inflation while suffering when general inflation, interest rates and unemployment increase.
 
In early 2009, Labour support was eroded by a sharp rise in jobless numbers, widespread pay freezes and falling house prices. The damage, however, was limited by Bank of England interest rate cuts and a big decline in inflation, partly due to last year’s VAT reduction. More recently, the increase in unemployment has slowed sharply and house prices have recovered.

Based on current economic readings, the surprise is not that the Tory lead has eroded but that it remains at about 10 percentage points. The historical analysis predicts a much smaller gap, consistent with Labour being the largest party in a hung parliament.

On one view, Labour’s failure to rally by more reflects the party’s core unpopularity, implying dismal electoral prospects. The polls, however, may simply be reacting with a longer lag to economic changes, suggesting a further narrowing of the gap.

The trouble for Labour strategists is that the current economic boost is likely to prove short-lived. Rising inflation, in particular, threatens to undermine government support in early 2010.

The annual rate of change of the Retail Prices Index has already moved up from a low of minus 1.6% in June to plus 0.3% in November. It is likely to climb to about 4% by spring 2010 as a result of the VAT reversal and higher energy and housing costs.

Labour has a window of opportunity. The party’s strategists must aim to narrow the gap between its poll rating and current economic “fundamentals” and – if successful – call an early election. The arithmetic gives Labour a good chance of leading a minority government with only a modest further recovery in its support.

Delaying until May, however, is likely to prove fatal. Poor trade figures supposedly lost Harold Wilson the 1970 election. Could surging inflation do the same for Gordon Brown in 2010?
 
An edited version of this article appeared in today’s Daily Mail.

November monetary statistics are consistent with an ongoing economic recovery. Corporate liquidity and mortgage approvals for house purchase continue to strengthen while narrow money is growing solidly. Broad money remains weak but this is of limited concern currently because low interest rates and reviving risk appetite have depressed the demand to hold money by households and financial institutions.

• Broad money (M4) holdings of private non-financial corporations (PNFCs) rose by 4.8% in the year to November – the fastest annual growth rate since February 2008. Real corporate money expansion is a leading indicator of business investment and hiring – see chart. Bank lending to PNFCs is down by 2.2% over the last year but rose in November, suggesting that credit demand is stabilising as the economy recovers.

• Household M4 growth slowed further to an annual 2.4% in November but this is likely to reflect a voluntary shift of funds into other savings vehicles. Mutual fund inflows probably remained strong in November – figures are released tomorrow – while National Savings attracted a bumper £2.8 billion, mostly into now-withdrawn “guaranteed growth bonds” offering a premium interest rate.

• The number of mortgage approvals for house purchase rose by a further 5% in November for a 123% annual gain. The housing recovery is focused on more expensive homes – the average value of morgages approved increased an annual 16% in November.

• Narrow money M1 rose by 12% annualised in the three months to November. A shift of cash into more liquid forms often precedes a rise in spending or financial investment; expressed differently, the M1 pick-up is consistent with an increase in the velocity of circulation of broad money.

• The Bank of England’s preferred broad money aggregate – M4 excluding money holdings of “intermediate other financial corporations” – surged by 0.9% in November following declines of 0.6% and 0.9% in October and September. As explained last month, the volatility largely reflects the Bank’s seasonal adjustment procedure for money holdings of “non-intermediate” financial firms.

• A sustained contraction in broad money would be concerning but recent weakness is explicable by portfolio shifts and has not prevented a recovery in corporate liquidity. Firmer credit trends should support M4 in early 2010 – banks expect stronger demand for business loans, house-purchase mortgages and unsecured consumer lending, according to last week’s Credit Conditions Survey.

World industrial production – proxied by the combined output of the Group of Seven (G7) major countries and seven large emerging economies (the “E7”) – resumed rapid growth in November. Based on data for six countries accounting for nearly two-thirds of the G7 plus E7 total, output rose by more than 1% after a 0.2% October decline.

G7 plus E7 production has now recovered by 9% since its February 2009 low, retracing more than half of the 16% decline from the peak in February 2008.

The rebound in G7 plus E7 output continues to mirror the recovery in G7 production following the 1974-75 recession – see first chart. (G7 output is an acceptable proxy for world production in the 1970s, when emerging economies were less significant.) This comparison suggests further solid growth in 2010 but with momentum slowing as the year progresses.

The implication of a momentum peak in the first half of 2010 is supported by monetary trends – annual growth in G7 real M1 appears to have topped in August 2009 and typically leads output expansion by about six months. E7 real M1, however, is still accelerating, suggesting that emerging economies will continue to lead the recovery – second chart.

Yesterday’s GDP figures, showing a 0.2% decline in the third quarter, disappointed economists expecting a more substantial upward revision to the previously-estimated 0.3% fall. The report’s details, however, support recovery hopes and were reinforced by today’s October services output number.

• A monthly GDP estimate derived from data on services and industrial output indicates that the third-quarter decline was due to a blip lower in August – see first chart. GDP is on course to post a solid gain in the fourth quarter, with the October estimate 0.3% above the third-quarter level.

• Last quarter’s contraction was mainly due to lower North Sea output – GDP excluding oil and gas extraction fell by just 0.04%. This measure has declined by less than during the 1979-81 recession – 5.6% since the first quarter of 2008 versus 6.4% between the second quarter of 1979 and first quarter of 1981.

• An expenditure-based measure of GDP is more upbeat than the “official” series, which relies heavily on gloomy output data. Excluding statistical adjustments, expenditure GDP rose by 0.5% in the third quarter – second chart. This measure also suggests a later start-date to the recession, peaking in the second rather than first quarter of 2008.

• Destocking was again heavy in the third quarter, implying a substantial GDP boost as it subsides. Meanwhile, household finances have improved more rapidly than expected: the saving ratio is at an 11-year high while the debt to income ratio has fallen by 18 percentage points from its peak – third chart.

• As in the US, non-financial companies continue to run a large financial surplus (i.e. retained earnings are far ahead of capital spending) – typically a precursor of more expansionary behaviour. Excluding reinvested foreign earnings, the surplus amounted to 2.4% of GDP last quarter versus 1.3% in the US. Excess free cash flow, rather than credit supply constraints, is the main driver of the ongoing repayment of bank borrowing by companies.

In its October World Economic Outlook, the IMF forecast a rise in consumer price inflation in the advanced economies from 0.1% in 2009 to 1.1% in 2010. The increase is likely to be much larger barring renewed commodity price weakness.

The first chart shows the annual change in the consumer price index (CPI) for the Group of Seven (G7) major countries – a proxy for advanced economies – together with the 12-month movement in the IMF’s world commodity export price index. The latter is projected forward assuming that commodity prices stabilise at their October level (the latest reading of the IMF index). The relationship suggests a rise in G7 annual inflation to at least 2% in early 2010 and an average for the year well above the IMF’s 1.1% forecast.

Its projections for emerging and developing countries are also questionable. Spare capacity is limited in many emerging economies and consumer price indices typically assign a higher weight to commodities than in developed countries. Yet the IMF forecasts a decline in average CPI inflation for the group to 4.9% in 2010 from 5.5% in 2009.

Projected falls in Chinese and Indian inflation – to 0.6% and 7.4% respectively in 2010 – are particularly implausible. Chinese prices are likely to accelerate in the wake of 30% growth in the M2 money supply in the year to November while the Indian forecast implies a sharp reversal of the current rising trend – second chart – despite still-loose monetary policy.

The premise of this journal is that the supply of money can diverge from the demand to hold it and the difference – “excess” or “deficient” liquidity – is a key driver of markets and economies.

Implementing the approach, however, requires an estimate of the demand for money, which is unobservable. A starting-point is to assume that underlying demand depends on the level of nominal economic activity. This implies that excess or deficient liquidity expansion will be related to the gap between the growth rates of the real money supply and output.

The chart shows an index of the return on developed-market equities in US dollars relative to the return on dollar cash (three-month eurodollar deposits). The index rises from 100 at the start of 1970 to 249 at the end of November 2009. In other words, equities outperformed cash by 149% over the forty years, or 2.3% per annum.

The shaded areas in the chart define periods when annual growth in Group of Seven (G7) real money supply – on the narrow M1 measure – exceeded the rate of expansion of industrial output, suggesting excess liquidity. Equities have tended to outperform cash during such periods while underperforming when real money lagged output.

On average, equities returned 11.1% per annum more than cash when there was excess money expansion and 5.8% less when liquidity was deficient. A strategy of switching between equities and cash depending on liquidity conditions would have yielded a cumulative excess return of 873% (5.9% per annum) versus the 149% (2.3%) from a buy-and-hold policy.

Interestingly, the results are less impressive when a broad rather than narrow money measure is used to identify the liquidity environment. On average, equities outperformed cash by 6.3% per annum when G7 real broad money was rising faster than output while underperforming by 1.8% at other times.

Changes in liquidity conditions sometimes bypass developed-market equities and have their main impact on other asset classes. For example, money growth shortfalls in 1994-95 and 1997 were associated respectively with G7 bond market weakness and the Asian crisis. Conversely, excess liquidity in 2001-02 propelled property rather than equity markets higher.

Based on partial data, G7 real M1 is likely to have risen an annual 8% in November versus a 6% fall in industrial output, implying still-favourable conditions. Real money, however, has fallen short of output growth over the last six months and the annual rates of change are likely to converge by next spring as economic recovery proceeds and headline inflation rebounds.

A tide of liquidity has lifted most boats this year but is beginning to ebb. This does not preclude a further rally in equities in 2010 but the ride is likely to be bumpier than in 2009 while a sustained advance may depend on cash shifting out of other asset classes, whose prices may suffer corresponding weakness.