Category: Money Moves Markets

Following its recent rally, the Dow Industrials index stands only 2% below the “six-bear average” path discussed in previous posts, based on recoveries after previous large US stock market declines – see chart.

A post in May speculated that tighter global liquidity would push the Dow, then trading in line with the average, into the lower half of the six-bear range, thereby presenting a buying opportunity. At the trough in early July, the index was 10% below the six-bear mean and only 1% above the bottom of the historical range.

Liquidity indicators have improved at the margin but have yet to turn positive, suggesting that the Dow will struggle to move above the six-bear average. G7 real M1 expansion is still well below industrial output growth in year-over-year terms but is close to converging on a six-month basis. The G7 monetary base has been moving sideways after falls in the spring and summer, with an increase possible if the Federal Reserve embarks on “QE2” and / or the Japanese authorities conduct further unsterilised currency intervention.

The six-bear average moves gradually higher over the remainder of 2010, finishing the year 6% above the Dow’s closing level on Friday.

Combined industrial output in the G7 and seven large emerging economies (the “E7”) moved above its pre-recession peak in July – see first chart. US and Chinese data suggest a further gain in August. Output fell by 14% between February 2008 and February 2009 and it has taken 17 months to recapture the loss – not quite a V-shaped recovery but close.

The heavy lifting, of course, has been performed by emerging economies, with the E7 contributing 9 percentage points of the 16% recovery in combined output from the February 2009 low – second chart. E7 output is 15% above its pre-recession peak and 1% higher than its log-linear trend since 2000 – a positive “output gap” is reflected in rising domestic inflationary pressures.

G7 plus E7 industrial output continues to track the path of G7 production during the mid 1970s recession and subsequent recovery – see previous post and third chart. (G7 output was a good proxy for global activity in the 1970s, when the E7 were much smaller and / or locked out of world trade.) This comparison suggests a significant near-term slowdown in growth but no “double dip” – a scenario consistent with recent monetary trends.

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COMMENT:
AUTHOR: Curious Reader
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IP: 96.246.69.207
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DATE: 09/19/2010 10:23:22 PM

Please can you explain why you think the 1970s is the appropriate historical comparison?

UK house prices are no longer expensive relative to a measure of “fair value” based on rents. Prices fell significantly below fair value during the major house price busts in the 1970s and 1990s but a big undershoot is unlikely in the current downturn because low interest rates will limit forced selling.

The notion that housing is no longer overvalued is controversial because the house price to income ratio remains far above its average since 1965 – see first chart. This average, however, is unlikely to be a good guide to fair value because the ratio has trended higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

An alternative approach is to use rents rather than income as the basis of comparison. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

An economy-wide rental yield can be calculated from national accounts data by dividing the sum of actual rental payments and imputed rents of owner-occupiers by the value of the housing stock – second chart. The yield averaged 3.6% between 1965 and 2007. This seems low but the measure includes subsidised social housing and takes account of vacant properties.

The housing boom pushed the rental yield down to 2.8% at the end of 2007, suggesting that prices were then overvalued by about 29%, based on the 3.6% long-run average. The Halifax index has fallen by 21% since December 2007, while rents had grown 6% by the fourth quarter of last year. These changes imply a current yield of about 3.8%, consistent with small undervaluation.

The rental yield rose well above the 3.6% long-run average during prior housing busts. If the overshoot in the current downturn were to equal the undershoot during the boom, the yield would rise to 4.4%. This would be consistent with a further fall in prices of about 14%, assuming unchanged rents. A decline of this order is widely expected.

Such a scenario, however, is probably too pessimistic. A key difference from prior busts is the low level of mortgage interest rates, which is allowing many struggling borrowers to continue to service their loans. The Council of Mortgage Lenders last week reported that repossessions and arrears cases rose by less than feared in the first quarter. The CML intends to revise down its earlier forecast of 75,000 repossessions in 2009.

With less distressed selling, downward pressure on prices from rising supply is much smaller than in prior downturns. According to the Royal Institute of Chartered Surveyors, the number of unsold homes on the books of the average estate agent stood at 69 in April – far below peaks of 166 and 196 in the last two major housing downturns. Meanwhile, buyer enquiries have picked up recently.

Translating buyer interest into transactions depends critically on mortgage availability. The last Bank of England credit conditions survey reported tighter mortgage supply in early 2009 but expectations of an improvement in the spring. Signs of a stabilisation of prices could have a self-reinforcing effect by encouraging lenders to reduce current high deposit requirements, designed partly to protect against negative equity.

Of course, if house prices bottom at a smaller discount to fair value than in previous downturns, this also implies less scope for a significant recovery over the medium term. Moreover, an increase in supply may have been postponed rather than cancelled – “zombie” borrowers will have their life support turned off once the MPC starts raising interest rates.

 

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COMMENT:
AUTHOR: Drew
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DATE: 05/27/2009 12:22:52 PM

Interesting,however rental yields are now beginning to fall in response to lower demand. Moreover, forced sales are unlikely when normal severance terms give 6 months salary and interest rates are at 300 year lows. When (not if!) interest rates have to rise, the impact of higher mortgage rates and continuing unemployment will push a lot of home owners into sales they might wish to have made now.It will also trigger sales from the rental sector as the gap between mortgage payment rates and rental yield narrows to zero and then turns negative.Cycles mean just that and there is no reason why the down period should be shorter or shallower than the uptick.

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COMMENT:
AUTHOR: SJG
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DATE: 05/28/2009 03:09:05 PM

I am more inclined to agree with Drew – not least as a) unemployment is still rampant, accelerating, and IMHO not likely to abate for months yet, and it’s traditionally a good proxy for property, b) many deals from 2 years ago are about to come to an end and the borrowers will, in the main, be ADVERSELY affected in the current market and c) I am far from convinced that the banks/lenders have the appetite or, in some cases still, the funds to lend!

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COMMENT:
AUTHOR: Simon Ward
DATE: 05/29/2009 04:24:06 PM

Thanks for the comments. SJG: unemployment will rise further but the rate of increase may have peaked – the monthly change in the claimant count was 137k in February, 66k in March and 57k in April. On your refinancing point, the average quoted two-year fixed rate (75% LTV) was 5.7% in May 2007 according to the Bank of England, above the current average standard variable rate of 4.06% (March data).

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COMMENT:
AUTHOR: Daniel
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IP: 196.215.23.238
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DATE: 09/19/2010 06:05:01 AM

Brilliant analysis. The best I could find online.

I know Jeremy Grantham views the current income/value ratio as unsustainable. You're view is that we're on a continued uptrend. Have you got analysis of other major cities/areas like Tokyo, New York and Hong Kong. I doubt that there is anything that makes London unique compared to these ones. What does history say about their ratios?

I do find it difficult to swallow that the uptrend increases indefinitely.. At 100:1 ratio, no first time buyers would ever be able to buy a home…. ever, and you'd only be able to sell your home to a very small portion of the rich population. Remember that in a global sense UK property and living competes with other cities.

Regards
Daniel

PS
Not entering my email address, as your comments form didn't say whether it would be kept private.

According to the CPI, clothing and footwear prices fell by 1.7% in the year to August. The alternative RPI clothing and footwear index, by contrast, rose by 6.3%. The difference is large enough to affect an assessment of economy-wide inflation – the headline 12-month CPI rise would have been 3.5-3.6% rather than 3.1% in August if the clothing and footwear component had matched the increase in the RPI measure.

The technical explanation for the difference is that the CPI uses geometric averaging to combine price movements of individual items, while the RPI uses arithmetic averaging. A non-technical explanation is that the CPI assumes that consumers are expert at shopping around for best value – so expert that they can obtain the same volume of clothing and footwear as a year ago while reducing their spending by 1.7%, despite a 6.3% rise in label prices.

This stretches credulity. If the same volume could be bought for 1.7% less, it would be reasonable to expect total cash spending on clothing and footwear to be little changed from a year ago. Retail sales figures, however, show a 6.4% rise in turnover in textile, clothing and footwear stores in the year to August. Based on the 1.7% CPI fall, this suggests an increase of 8.2% in the volume of purchases – implausible when overall consumer spending has been growing weakly.

While difficult to prove, the 6.4% rise in cash spending is likely to have been driven by higher unit costs rather than a surge in consumer demand for clothing and footwear. The 6.3% increase in the RPI clothing and footwear index, in other words, is probably a better reflection of consumers’ experience than the 1.7% decline in the CPI measure, in turn implying that the headline CPI understates true cost of living inflation.  

Official intervention to weaken a currency is more likely to succeed when the exchange rate is overvalued relative to “fundamentals” and investor sentiment is at a bullish extreme, implying that opposing buyer power has been exhausted. These conditions do not apply to the yen currently, suggesting that massive, unsterilised intervention will be required to stem the currency’s rise. A consequent large increase in the Japanese monetary base would improve prospects for global equities.

A possible further rise in the yen was flagged in a post in May, which argued that the currency was undervalued, in contrast to prevailing investor opinion. Subsequent appreciation has, apparently, hardened the consensus belief – a net 72% of fund managers now regard the yen as overvalued, a record high and up from 51% in May, according to Merrill Lynch.

Japan’s real effective exchange rate, however, is close to its long-term average – see first chart. Japan’s high real interest rates, moreover, justify the currency trading at a premium to a long-run competitive level – the implied future depreciation back to this level would then offset the interest advantage of holding yen. Japanese 10-year real yields are 2.0% versus 0.6% in the US, 1.2% in Germany and zero in the UK (using nominal government yields minus the current rate of harmonised CPI inflation).

Claims of yen overvaluation are also at odds with balance of payments trends, with Japan’s surplus on the current account and net direct investment flows rising to 2.3% of GDP in the year to June from 0.3% in the previous 12 months – second chart.

With fundamentals supportive, and little evidence of a major overhang of long positions to be “shaken out”, yen suppression is likely to require a prolonged campaign of large-scale, unsterilised intervention. Even this could prove fruitless, as recent Swiss experience shows. The attempt to weaken the yen, moreover, could create conflict with the US authorities, hastening the Federal Reserve’s adoption of “QE2”.

The “battle of the yen”, therefore, could be the trigger for renewed central bank monetary base expansion, adding to the picture of an improving liquidity backdrop for markets and suggesting further strength in equities, commodities and other “risk” assets in late 2010.

The OECD’s G7 leading indicator index fell by a further 0.4% in July, resulting in the six-month rate of change turning negative – see first chart. The index suggests that industrial output will flat-line or weaken into late 2010.

Based on an earlier slowdown in G7 real narrow money, M1, the OECD measure may decline further in August and September – see previous post. Recent M1 reacceleration, however, may presage a trough in the leading index this autumn, in turn implying that the recovery in industrial output will resume by early 2011.

In contrast to the G7 measure, a leading index covering seven large emerging economies (the “E7”) rose by 0.4% in July. The six-month change slowed further but remains consistent with respectable output expansion – second chart.

While the G7 index registered a larger monthly fall in July, E7 monthly momentum seems to be stabilising – third chart. This could be significant since the E7 change led that of the G7 by a month at the trough of the recession and by two months at the 2009 growth peak. Stabilising E7 monthly momentum, in other words, could be a precursor of a slower decline in the G7 index, consistent with the autumn trough suggested by monetary trends.

Recent rises in global food commodity prices may lift annual CPI food inflation to about 7% by late 2010, from 1.7% in June, implying a boost of half a percentage point to headline CPI inflation. If food costs continue to spike, CPI inflation could reach 4%. Such an increase would hit consumer spending and recovery prospects and could destabilise inflationary expectations. This could warrant postponing or cancelling the coming VAT hike.

The Food and Agriculture Organisation (FAO) food index – a monthly measure covering meat, dairy products, cereals, oils and fats, and sugar – rose by an annual 22% in sterling terms in August, the fastest rate of increase since September 2008. Food prices have increased further in September: the Commodity Research Bureau daily spot food index is currently 7% above its August average, again in sterling terms.

Consumer food prices have already started to respond to these cost rises. Annual CPI food inflation increased from 1.7% in June to 3.0% in July (August figures are released on Tuesday). The historical relationship with the FAO index suggests a further rise to about 7% by late 2010 – see chart.

Rising pressures are confirmed by today’s producer price numbers, with annual input cost inflation in food and beverages manufacturing rising from 3.2% in July to 4.6% in August. The British Retail Consortium’s (BRC) shop price survey, meanwhile, showed a rise in food inflation from 2.5% to 3.8% between July and August.

In its August Inflation Report, the Bank of England forecast headline CPI inflation of 3.2% in the fourth quarter (mean projection). The Bank may have assumed that food inflation would remain at about 2% – the June reading of 1.7% was the most up-to-date when the Report was prepared. If so, a rise to 7% would boost the Bank’s fourth-quarter forecast by half a percentage point, to 3.7%, given food’s 9.6% weight in the CPI basket.

If a further food commodity price spike pushed CPI food inflation up to an annual 10%, the headline CPI rate could reach 4%. (10% food inflation would be below the peak of 14.5% reached in August 2008.)

Such an increase would damage recovery prospects by squeezing real income and money supply expansion. It would also risk destabilising inflationary expectations, particularly if the MPC were thought likely to respond to renewed economic weakness by restarting asset purchases.

A preferable policy response would be to postpone or cancel the VAT rise, thereby cutting headline inflation in early 2011 by about one percentage point. This could be justified partly by recent better-than-expected public sector borrowing numbers, suggesting that the 2010-11 total will undershoot the OBR’s £149 billion forecast by at least £10 billion – the VAT increase is estimated to raise £12 billion in 2011-12.

The stock of commercial and industrial (C&I) loans advanced by US commercial banks shrank by 18% in the year to July. The pace of decline, however, has slowed sharply, with August figures due on Friday likely to show a three-month change of close to zero – see first chart. (The chart uses a new Federal Reserve dataset that adjusts for series breaks.)

In the Fed’s July survey of senior bank loan officers, the net percentages reporting stronger demand for C&I loans from larger and small firms rose to +2% and -4% respectively. An average of the two series has been a leading indicator of C&I lending and the current reading is consistent with a return to expansion – second chart.

C&I lending accounts for only 18% of US banks’ total “loans and leases” but they usually move together, with total lending also declining more slowly recently – third chart. The Fed survey also reported notable improvements in loan officers’ assessment of demand for mortgages and consumer credit. The officials, meanwhile, signalled looser lending standards for C&I loans and prime residential mortgages and increased willingness to advance consumer installment credit – fourth chart.

A return to credit expansion, if confirmed, would increase confidence in the sustainability of the recovery, in part because of its likely positive impact on monetary trends.

 

The six-month growth rate of G7 industrial output is falling sharply, as previously signalled by the OECD’s composite leading indicators index and, much earlier, G7 real narrow money, M1 – see chart.

The six-month change in real M1, however, bottomed in January and had recovered to a nine-month high by July, suggesting that economic weakness should abate by the end of 2010.

In terms of six-month rates of change, real M1 led industrial output by 11 months both at the recession trough and the recent momentum peak. If the same lead-time applies from the January real M1 trough, the six-month change in industrial output should bottom in December. (The average lead historically has been shorter, so an earlier turnaround is possible.)

The OECD leading index turned only two months before industrial output at the recession trough and by three months at the recent growth peak. A December bottom in industrial output momentum, therefore, could be presaged by a trough in the leading index in September or October.

The OECD leading index is widely monitored by market participants, with a July reading due on 13 September. The above analysis suggests that this number, and possibly also figures for August and September, will be weak.

The view here remains that a “double dip” will be avoided but markets are likely to have to negotiate more downbeat economic data over coming weeks.

After the Lehman failure in September 2008 the view here was that central banks should embark on “quantitative easing”, in the sense of direct purchases of assets, ideally from the non-bank private sector, in order to boost the broad money supply and reliquefy frozen credit markets. A severe shortage of money was developing, threatening economic freefall, as bank credit creation stalled and investors attempted to rebalance portfolios in favour of cash – put differently, increased money demand was depressing the velocity of circulation. Large-scale Federal Reserve securities purchases from late 2008, emulated belatedly by the Bank of England from March 2009, succeeded in alleviating the monetary imbalance both by expanding the money supply and stabilising markets, thereby slowing the “dash for cash”. Faster growth of G7 broad and, particularly, narrow money, M1, from late 2008 confirmed that monetary conditions were improving, laying the foundations for a solid recovery in global economic activity starting in the spring of 2009.

With global momentum slowing recently, and fears growing about the impact of coming fiscal tightening, there are calls for central banks to engage in a further burst of “QE”. In contrast to late 2008, however, there is little evidence that the global economy is being constrained by a shortage of liquidity. Broad money, admittedly, has been sluggish over the last year, with US M2 and UK M4 (on the Bank of England’s preferred definition) rising by 2.0% and 1.2% respectively in the 12 months to July. The demand to hold money, however, has been reduced by negative real short-term interest rates and a revival of risk appetite. Velocity, in other words, has recovered – by 2.1% and 4.7% in the US and UK in the year to the second quarter (calculating velocity as nominal GDP divided by M2 or M4). Reflecting reinvestment of “safe-haven” cash, inflows to US and UK mutual funds have been strong, amounting to 4.7% and 2.5% of respective broad money stocks in the 12 months to July. (The latest UK figures, released today, show a £2.2 billion retail inflow in July alone, the largest since November – see chart.) Broad money, moreover, has reaccelerated over the latest three months, with US M2 growing by 5.4% annualised and UK M4 by 5.6%. Narrow money has also picked up, suggesting that economic momentum will revive in late 2010 (see second chart in Wednesday’s post).

QE proponents argue that, even if there is no current monetary shortage, further action is warranted as insurance against the “tail risk” of a second recession leading to Japan-style deflation. An additional monetary boost, however, would involve its own risks and costs. One probable side-effect would be a further surge in commodity prices – “QE1” contributed to a 66% rise in industrial raw material costs during 2009. This would raise G7 inflation and lower real income expansion, thereby offsetting the direct boost to demand from monetary stimulus. Higher material prices had limited dampening impact on global growth in 2009 because they allowed commodity-producing countries to increase spending. This is much less likely now, since many of these commodity producers are in danger of “overheating” and will be forced to tighten monetary policies in the event of further stimulus from rising export prices. Even if central banks could be sure that more QE would provide a net boost to global growth, the wisdom of attempting to “fine tune” normal cyclical fluctuations is questionable: stimulus might arrive in early 2011 just as the economy is naturally regaining momentum, leading to excessive expansion and pressure for an abrupt policy reversal.