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Recent evidence of a liquidity thaw and easing credit conditions suggests that the probability of a V-shaped global economic recovery is rising.

Consistent with a normalisation of money flows, the spread between UK interbank and government interest rates has narrowed to its lowest level since Lehman’s bankruptcy last September – first chart.

An equivalent US measure, inverted, is shown in the second chart along with the annual growth rate of US industrial output. Historically, recessions have been signalled by the spread moving above 100 basis points. It reached a peak of 360 bp (monthly average basis) in October but is now back below 100 bp, supporting recovery hopes.

Business surveys are recovering, with yesterday’s New York Fed survey notably stronger. This improvement was foreshadowed by a slowdown in earnings downgrades by equity analysts – third chart. Assuming that the recovery in the “revisions ratio” survives the current earnings reporting season, purchasing managers’ manufacturing indices look set to revert to the breakeven 50 level, implying a stabilisation of industrial activity.

A previous post suggested a more promising outlook for corporate high-yield bonds, based on an easing of credit conditions reported in the latest UK loan officer survey and the likelihood of a similar improvement in the next US survey, due for release in early May.

Another hopeful sign for credit conditions and high-yield bonds is a recent fall in the borrowing requirement of US non-financial corporations, defined here as their “financing gap” – capital spending minus domestic retained profits – plus share purchases net of issuance. As the chart shows, this measure leads the yield spread of high-yield bonds over Treasuries.

The borrowing requirement has fallen steeply from 9.5% of GDP in the fourth quarter of 2007 to 3.6% by last year’s fourth quarter. A further decline is likely, since companies’ net share-buying was still running at 3.2% of GDP in the fourth quarter but should slow in 2009.

A sharp fall in the borrowing requirement preceded a narrowing of high-yield spreads by two years in both the late 1980s and early 2000s. Assuming a similar lag in the current cycle, high-yield spreads could decline significantly from late 2009.

The MPC-ometer predicts that Bank rate will be held at 0.5% at tomorrow’s Monetary Policy Committee meeting. A split decision is indicated, however, with one or more members – probably including arch-dove David Blanchflower – voting to lower the target for official rates to between zero and 0.25%, the currently-prevailing US level.

The MPC-ometer forecasts the outcome of each month’s MPC meeting based on the latest economic and financial indicators. The no-change prediction reflects slightly less grim news over the last month: business surveys indicate a slower decline in new orders, consumers are a bit less pessimistic, share prices have rallied and money market conditions have eased.

As well as cutting rates to 0.5%, the MPC last month announced plans to boost the money supply by buying £75 billion of gilts and other securities by early June. It is much too early to judge the success of this policy but the Bank of England had purchased £21 billion by last week, suggesting it is on course to reach the target.

The broad money supply M4, adjusted for distortions due to the financial crisis, needs to grow by 6-7% a year to support economic expansion but rose by just 3.8% during 2008, contributing to the slide into recession. The MPC should calibrate asset purchases to boost annual growth in adjusted M4 to 10% to compensate for last year’s shortfall and lay the foundations for an economic recovery.

The initial plans look sensible – £75 billion is the equivalent of 4.5% of the adjusted money supply – but the MPC will need to fine-tune its operations in the light of incoming monetary data. The Bank of England is making it more difficult for outside observers to make a judgement on this issue by refusing to publish its monthly estimates of the adjusted M4 money supply.

The Bank gave the following response to a freedom-of-information request for access to the data:

Thank you for your email dated 5 March in which you request access under the Freedom of Information Act 2000 (‘FoI Act’) to:

‘…the adjusted M4 and M4L data prepared monthly within the Bank (ie the monthly versions of the series that have been published quarterly in chart form – with underlying data available in a spreadsheet – in recent Inflation Reports)’

But in any case, the data is held by the Bank for the purposes of its monetary policy functions and is not, therefore, subject to the requirements of the FoI Act. Parts I to V of the FoI Act (including the general right of access under section 1) do not apply to information which the Bank holds for the purposes of its functions with respect to monetary policy (see section 7(1) and the Bank of England entry in Schedule 1, Part VI FoI Act).

US companies included in the S&P 500 index recorded a large aggregate loss in the fourth quarter, reflecting financial write-downs, a fall in the value of inventories due to plunging commodity prices and other recession-related charges – see first chart.

By contrast, the national accounts measure of “economic” profits was still firmly in the black in the fourth quarter. This covers all companies, excludes valuation effects and other charges, and adjusts for under- or over-depreciation in reported accounts. It is a better guide to underlying profitability.

Fourth-quarter economic profits were down by 18% from their peak in the third quarter of 2006 but 94% above the trough reached in the last recession, in the third quarter of 2001. Companies have limited damage to profitability by acting fast to shed labour and slash other costs.

The second chart shows inflation-adjusted economic profits together with a log-linear trend. At the 2006 peak, profits were 41% above the trend-line – the largest deviation since 1966. The subsequent plunge has closed the gap and profits should move below trend in early 2009.

Market valuations already discount earnings gloom. As the third chart shows, a price / earnings ratio based on trend economic profits stood at 12.6 at the end of 2008 versus a long-run average of 13.8. The P / E, however, reached much lower levels in the 1970s and 1980s.

From a liquidity perspective, market falls since late 2007 were caused by a fear-induced rise in the precautionary demand for money coupled with a withdrawal of credit from leveraged investors, resulting in forced selling of assets. Contrary to fears, the global supply of money has continued to expand but not sufficiently to offset these negatives.

As the second quarter begins, money supply trends are improving, risk aversion and precautionary cash demand appear to be moderating and investor leverage is at its lowest level for several years. This suggests support for equity markets but any rally faces hurdles from ongoing poor earnings news, a likely rise in issuance and a possible rebound in commodity prices.

A key policy development last quarter was the $1.15 trillion expansion of the Fed’s securities purchase programme, which promises to give a major boost to US and global monetary growth. Including the unutilised portion of earlier plans, the Fed could buy $1.4 trillion of assets over the remainder of 2009, equivalent to 11% of US M2+ and about 5% of our G7 broad money measure.

The demand for money is unobservable but cash hoarding is likely to diminish as fears of financial collapse abate and the economic cycle approaches a trough. Consistent with this view, measures of risk aversion have moderated recently – see chart – while narrow monetary aggregates have been rising relative to broader measures, which often precedes a pick-up in velocity.

Meanwhile, investor deleveraging appears to be well-advanced. US margin debt is back at 2003 levels while hedge fund returns have recently shown little correlation with equities, suggesting minimal market exposure. Hedge funds suffered investor withdrawals of $260 billion between November and January but outflows slowed to $17 billion in February, according to Trim Tabs.

While the liquidity backdrop for equities is improving, several factors could delay a significant recovery in markets. First, corporate newsflow may remain negative – another large fall in global GDP in the first quarter suggests the potential for downside surprises in coming earnings reports, even relative to recently-lowered expectations.

Secondly, any rally is likely to call forth an avalanche of issuance as companies seek to reduce gearing against the backdrop of high corporate borrowing costs. Balance sheet adjustment also implies that cash take-over activity and share buy-backs will remain weak for the foreseeable future.

Thirdly, “excess” liquidity resulting from a fall in money demand relative to supply could flow into commodity markets, particularly given investor concerns that unprecedented monetary and fiscal stimulus will lead to higher inflation over the longer term. A renewed commodity price surge would damage prospects for a recovery in economic activity and earnings recovery later in 2009.

Markets are assuming that interest rates will remain at unusually low levels for a sustained period. Forward rates extracted from the government yield curve imply a Bank rate of about 3.5% in five years’ time – well below its 5.1% average since the MPC’s inception in 1997. These expectations reflect the consensus view that the current deep recession will result in very low inflation, and possibly deflation, over the medium to long term. Yet this consensus may be questioned on several grounds.

One important uncertainty is the longer-term inflationary impact of the huge exchange rate decline since 2007. Many commentators argue that sterling was significantly overvalued in 2007, implying reduced inflationary repercussions from its subsequent plunge. The claim, however, is dubious: a real trade-weighted exchange rate index calculated by JP Morgan was only 7% above its 1985-2006 average at its peak in January 2007 but has since fallen 19% below it. Such a large undershoot is unlikely to be sustained and can be corrected either by a recovery in sterling or higher UK relative inflation. Suppose the real exchange rate returns to its 1985-2006 average over 10 years. If inflation were to bear the full burden of adjustment, UK manufacturing prices would have to rise by 2.2% per annum more than prices elsewhere.

A second possible weakness in the consensus view is the assumption that the recession will produce a large decline in “core” inflation. There are two issues: the prospective size of the negative “output gap” – the difference between actual and “potential” GDP – and the sensitivity of core price trends to this gap. Actual GDP is falling substantially but the credit crunch is also likely to have damaged supply potential, reflecting business failures, investment cut-backs and a possible rise in “structural” unemployment (if workers displaced from bubble sectors prove ill-equipped for employment in other activities). Meanwhile, core inflation could prove less responsive to a widening output gap than suggested by econometric models estimated on data including the inflationary 1970s and 1980s. Core price trends showed limited acceleration when actual GDP was above potential over 2006-08, raising the possibility of a similarly modest response to economic slack.

Medium-term inflation prospects will depend critically on monetary trends. The broad money supply, M4, adjusted for distortions due to the financial crisis, probably needs to grow by 6-7% per annum to be consistent with the 2% inflation target. (This assumes potential GDP growth of 2% and a decline in velocity of 2.5% per annum, in line with the average over 1992-2004, when inflation averaged close to 2%.) The Bank of England’s adjusted M4 measure rose by an annual 3.8% in December – the latest available published figure – but growth should be pushed up to the required level, or higher, by the Bank’s securities purchase programme: planned buying of £75 billion by the end of June is the equivalent of 4.5% adjusted M4 and the MPC has authority to expand the scheme by a further £75 billion. Monetary expansion should also be supported by gilt purchases by commercial banks, partly reflecting regulatory pressure to increase liquidity reserves. Bank buying totalled £26 billion between November and January, up from just £4 billion in the prior 12 months.

International influences on UK inflation will reflect global monetary trends. The Swiss National Bank has also embraced quantitative easing over the last month, while the US Federal Reserve and Bank of Japan are further expanding securities purchase operations. The Fed’s latest plans are particularly notable, involving potential buying of $1.46 trillion over the remainder of 2009 – equivalent to 18% of the M2 money supply. Annual M2 growth has accelerated from 5.5% in August last year to 9.8% by February and could reach 20% later in 2009 if these plans are implemented in full. A similar pick-up is under way in China, with annual M2 expansion rising from 14.8% in November to 20.5% in February. Based on the Friedmanite view that money leads prices by about two years, these trends suggest rising global inflation from late 2010. Friedman emphasised the variability of lags, however, and a faster transmission is possible if monetary acceleration fuels renewed commodity market speculation.

A more esoteric reason for thinking that inflation, rather than deflation, is the greater longer-term risk is historical evidence of a long cycle in prices – the Kondratyev cycle. There have been four major peaks in world prices or inflation since 1800, spaced an average of 54 years apart – see chart. With the last climax occurring in 1974, this cycle suggests inflation should have reached a major trough 27 years later in 2001, to be followed by an upswing to a new peak in 2028-29. Historically, there have been significant shorter-term variations around the long-run trend so the current inflation decline does not invalidate the hypothesis that a secular upswing is under way. The theoretical basis of the long cycle is unclear but the notion that the balance of pressures is shifting gradually to the upside is plausible, based on factors such as faster global money growth since the 1990s, rising resource demand from giant emerging economies and a prospective surge in government debt, which may weaken political support for low-inflation targeting.

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COMMENT:
AUTHOR: Ian Copelin
EMAIL: ian.x.copelin@jpmorgan.com
IP: 170.148.215.157
URL:
DATE: 03/27/2009 09:31:20 AM

What season (and where in that season) do you see us at present? Your journal chart would imply that winter finished around 2000 and therefore we are in spring. Having Googled ‘Nikolai Kondratieff’, the descriptions on the internet, imply that we are probably still in winter.

Most diagrams of the Krondratyev cycle show very clear ‘V’ shapes movements – but obviously with a 50-60 year chart it could in reality be more of a U or W bottom. From your research how quickly does the interest rate/inflation cycle turn?

Is the Krondratyev cycle applicable to equity markets, and if so, does it follow the same wave or is there a time lag?

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COMMENT:
AUTHOR: Simon Ward
DATE: 04/03/2009 02:31:12 PM

Some analysts argue that the last Kondratyev peak was in 1980, when US CPI inflation topped. I do not favour this interpretation because it would imply that the cycle has lengthened to 60 years (the previous peak was in 1920). In any case, WPI inflation peaked on schedule in 1974.

On my interpretation, the cycle trough was in 2001 (27 years or one half-cycle after 1974) and we are currently in the “spring” phase. On the alternative interpretation of a 1980 peak and a 60-year cycle, the trough is scheduled for 2010 and we are still in “winter”. However, this is difficult to square with the commodity price boom of recent years.

Kondratyev’s observation of a cycle was based on interest rates as well as prices. UK long-term yields peaked in 1974, consistent with my cycle dating. However, US yields peaked in 1981, supporting the alternative interpretation. Yields in both countries recently reached new lows, which could be evidence that we are still in “winter”. I am interpreting the decline, roughly seven years after the Kondratyev trough in 2001, as the mirror-image of the yield rise in 1981, seven years after the 1974 Kondratyev peak. Yields embarked on a secular decline in 1981; are they now on the brink of a long-term upswing?

Kondratyev himself did not refer to stock markets but other analysts have suggested that there are two equity cycles per Kondratyev cycle: spring = reflation = bullish; summer = inflation = bearish; autumn = disinflation = bullish; winter = deflation = bearish. If you accept this, the current bear market argues that we are still in winter. However, I am unsure about the linkage with stocks and prefer to date the cycle based on price data.

Central bank surveys of bank loan officers are a key gauge of the success of recent policy initiatives in easing credit conditions.

In the last US survey, conducted in January, the net percentage of banks reporting tighter credit standards on loans to firms remained close to its historic high. This indicator correlates closely with the yield spread of non-investment-grade corporate bonds over Treasuries – see first chart.

The April survey is due for release in early May. As the chart shows, however, the equivalent UK indicator from yesterday’s Bank of England credit conditions survey fell significantly between November / December and February / March. A similar drop in the US indicator would suggest better prospects for high-yield bonds.

The UK improvement may have been exaggerated by country-specific factors, such as government agreements with Lloyds Banking Group and the Royal Bank of Scotland to expand lending and the Bank of England’s purchases of corporate securities. Nevertheless, recent policy actions should contribute to at least some fall in the US indicator.

The net tightening percentage, inverted, is also a good leading indicator of the economy – see second chart – so a fall would boost recovery hopes.

The current global recession is shockingly severe. Does this imply an increased risk of “depression” or will an equally-dynamic recovery unfold later in 2009?

The first chart below updates a comparison of the current fall in industrial output in the Group of Seven (G7) economies with the three largest declines over the prior 50 years. Output is now about 18% below its peak in February 2008 – significantly greater than the biggest previous drop of 12% in 1974-75.

In the three prior cycles there was an inverse relationship between the size of the peak-to-trough output fall and the time taken to retrace it – the bigger the decline, the faster the recovery. It took 31 months for output to regain its peak level in the mid 1970s but 49 months in the early 2000s, when production fell by “only” 7%.

Commenting on an earlier post, a reader noted that the areas between the curves and the 100% horizontal line look similar. This area measures the cumulative percentage loss of output relative to its peak monthly level. This cumulative loss is shown in the second chart. The reader’s observation is correct. The loss was 186% over 1974-76, 181% over 1980-83 and 163% over 2000-04 – a remarkably narrow range.

So a bigger peak-to-trough decline may not imply that a recession is significantly worse in terms of cumulative output loss. There may be natural forces tending to equalise this cumulative loss across cycles. This observation, however, may apply only to “normal” recessions. Once the output fall exceeds a certain amount, the dynamics may change, resulting in a recession developing into a depression or slump.

The case for a V-shaped revival later in 2009 is that this tipping point has yet to be reached and unprecedented monetary and fiscal policy stimulus will strongly reinforce natural recovery tendencies. Optimistic indicators include a surge in inflation-adjusted narrow money growth – third chart – and a widening gap between sales and production – fourth chart – suggesting a potential big boost from the stocks cycle.

The cumulative loss approach outlined above can be used to generate a forecast path for G7 industrial output in an optimistic economic scenario. Specifically, assume that:

1. The cumulative output loss in the current recession / recovery cycle is 200% (i.e. slightly greater than over 1974-76).
2. February 2009 proves to be the trough.
3. Output subsequently recovers at a constant rate.

These assumptions define the forecast path shown in the fifth chart, which implies a return of output to its February 2008 peak by June 2010.

A key argument against a V-shaped rebound in output is that credit supply constraints will short-circuit natural recovery tendencies and render policy stimulus ineffective. Surveys of bank loan officers will be important for judging if credit conditions are easing, boosting economic prospects. The latest Bank of England survey, released today, was encouraging – final chart.

Services sector output data released today confirm that the economy continued to contract rapidly in early 2009. A monthly GDP estimate based on services and industrial output fell a further 0.6% in January, to stand 1.4% below its fourth-quarter average – see first chart. Monthly GDP has now declined by 4.2% from its peak last April.

The January result suggests GDP will fall by more in the first quarter than implied by the central projection in the Bank of England’s February Inflation Report – second chart.

The GDP decline should slow as the recent big drag from destocking abates. More promising monetary trends, if sustained, warrant hopes of a recovery in GDP from late 2009, though probably from a significantly lower level than implied by the Bank of England’s central projection.

The current recession could yet prove less severe than the catastrophic 1979-81 downturn. GDP would have to fall a further 2.4% from its estimated January level to match the quarterly peak-to-trough decline in the early 1980s.

UK monetary conditions were starting to improve even before the MPC embarked on “quantitative easing”, according to Bank of England data for February released today. Economic news is likely to remain grim for most of 2009 but the monetary foundations are being laid for a 2010 recovery.

Key features of today’s data include:

• Broad money M4, excluding holdings of financial corporations, grew by an annual 3.0% in February, up from 2.9% in January. This conceals a big rise, of 2.4% or 10.0% annualised, in the latest three months – see first chart.

• M4 holdings of non-financial corporations jumped by 5.3%, or 23.0% annualised, in the three months to February. Corporate money holdings are still down 2.1% from a year before but this compares with a 5.9% decline in November. The recovery is greater in real terms and suggests less pressure for retrenchment – second chart.

• Bank lending to non-financial corporations has also recovered, rising 1.6% in January / February combined. The larger rise in money holdings, however, has pushed the corporate liquidity ratio (money holdings divided by bank borrowing) up to its highest level since May 2008.

• Narrow money is weaker than broad money, with M1 – currency in circulation and overnight / sight deposits – up by just 0.3% in the year to February. The rise over the last three months, however, was 2.2% or 9.1% annualised.

• “Underfunding” has contributed to the recent pick-up in broad money – “sterling net lending to the public sector” accounted for 1.0 percentage points of the increase in M4 in January and February combined. This reflects purchases of gilts and Treasury bills by commercial banks, motivated partly by regulatory pressure to boost liquidity reserves. With QE kicking in, underfunding will rise further.