Category: Money Moves Markets

The story so far:

US and global equities have been following fluctuations in the US monetary base (i.e. currency plus bank reserves) over the last 18 months – see first chart. The most recent low in the base occurred in early May; the Dow Industrials index troughed five weeks later. The subsequent recovery in the base, however, stalled a month ago, suggesting that the rally in equities may be in the process of rolling over.

More positively, the Eurozone monetary base on an expanded definition including one-week term deposits – likely to be regarded by banks as a close substitute for reserves – has continued to rise strongly in recent weeks. The environment is reminiscent of June / July last year: the US monetary base moved sideways but the Dow rallied following a surge in the Eurozone base.

In contrast to then, however, the macroliquidity fundamentals are less favourable, with G7 real M1 growing more slowly than industrial output – see prior post. The stalling of the US monetary base in summer 2009, moreover, was clearly temporary given the Federal Reserve’s quantitative easing plans.

These various cross-currents may mean that equities continue to fluctuate in a trading range that frustrates both bulls and bears, an outcome also suggested by the “six-bear comparison” discussed in previous posts – second chart.

A more positive outlook would be signalled by Fed action to boost US monetary base. The most likely form would be a suspension of the “supplementary financing program” under which the Fed has borrowed $200 billion from the Treasury – repayment of this sum would inject an equivalent amount into bank reserves.

The Chancellor delivered a decisive Budget that should greatly reduce worries about fiscal sustainability. The composition of the measures announced was also welcome, with an emphasis on current spending reductions and indirect tax rises that should be less damaging to economic performance.

However, the new fiscal mandate – to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period – is unconvincing. Estimates of the cyclically-adjusted balance are highly uncertain and it is doubtful that the rule, even if monitored by the new Office for Budget Responsibility (OBR), would have constrained the fiscal policy of the last Government.

Other points:

• The additional £40 billion of savings by 2014-15 announced today builds on £73 billion implied by the previous Government’s plans, bringing the total to £113 billion – equivalent to 6.3% of projected GDP in that year. Spending cuts account for £83 billion, or 74%, of the overall adjustment.

• While the Chancellor focused his axe on current spending, capital investment continues to bear an excessive burden of the overall adjustment, mainly reflecting the previous Government’s plans. Investment is projected to fall by 42% in real terms between 2009-10 and 2014-15, accounting for two-thirds of a 7% fall in total managed expenditure excluding interest payments.

• The cyclically-adjusted current balance is forecast to be in surplus by 0.8% of GDP at the end of the five-year forecast period in 2015-16, implying that the Chancellor has built in about £15 billion of leeway that he will be able to “give away” before the next election. Put differently, he could have avoided raising the standard VAT rate to 20%, raising £13 billion by 2014-15, and still achieved the fiscal mandate.

• The OBR’s assumptions about the longer-term impact of fiscal tightening on growth assist the Chancellor but will displease Keynesian economists. The OBR forecasts that real GDP will be 0.3% lower in 2014-15 than in its pre-Budget forecast despite a 2.0% of GDP reduction in cyclically-adjusted borrowing, suggesting a fiscal multiplier of only 0.15. (The OBR warns that its earlier forecast may have been biased up, in which case the true multiplier would be even lower.)

• The OBR’s forecast of public sector net borrowing of £149 billion in 2010-11 looks overly cautious in light of recent encouraging monthly numbers, suggesting an outturn of below £130 billion – further grounds for questioning whether a VAT rise was necessary at this stage.

The transfer of responsibilities to the Office for Budget Responsibility (OBR) is unlikely to result in an improvement in fiscal forecasting, which is notoriously difficult.

The OBR this week projected a fall in public sector net borrowing excluding the temporary effects of financial interventions (PSNB ex) from £156.1 billion in 2009-10 to £155 billion in 2010-11. Recent trends suggest a significantly smaller deficit. May public finances numbers released today revised down the 2009-10 outturn to £154.7 billion. More importantly, monthly borrowing including intervention effects, after attempting to adjust for seasonal factors, has been running at about £10 billion recently, or £120 billion annualised – see chart. Assuming no further change, this is consistent with the PSNB ex measure falling to £126 billion in 2010-11, based on the Treasury’s March forecast that intervention effects would reduce headline borrowing by £6 billion this year. (PSNB ex figures are currently available only quarterly but will be published on a monthly basis from July.)

The OBR’s caution in extrapolating recent better trends is helpful for the Chancellor as he seeks to justify further significant tightening in next week’s Budget.

“Monetary stability” should be understood to involve a stable price level or very low rate of inflation over the long run coupled with avoidance of credit boom / bust cycles, which inflict major damage on economic performance. The two objectives are intertwined: historically, credit cycles have invariably been associated with significant and sustained price disturbances.

The Chancellor’s plan, therefore, to separate responsibilities for inflation and credit control between two policy-making bodies is questionable. It would have been preferable to assign new “macroprudential” policy tools to the Monetary Policy Commitee (MPC) while expanding its remit to include leaning against major swings in money and credit expansion.

The interest rates faced by borrowers and savers play a key role in the transmission of policy changes to financial market conditions and inflation. One way of thinking about the new arrangements is that the MPC will set the risk-free rate while the Financial Policy Committee (FPC) will influence spreads by varying capital and liquidity requirements. The MPC’s judgement, however, about the level of borrowing / saving rates needed to meet the inflation target may differ from the FPC’s assessment based on its stability goals.

The FPC, presumably, would have leant against credit expansion during the 2005-07 boom, resulting in higher borrowing spreads and slower economic growth. Based on the MPC’s forecasts at the time, however, this would have pushed prospective inflation below target, requiring the Committee to set a lower level of Bank rate, thereby undermining the FPC’s attempt at credit restraint. Would the FPC have responded by requiring a further increase in capital / liquidity buffers?

The preferred alternative of adding credit stability to the MPC’s responsibilities would have allowed such tensions to be resolved within a single policy-making body. The Chancellor, moreover, could have taken the opportunity to change the MPC’s target from 2% inflation “at all times” to a 2% per annum average rise in the price level over the long run. This would allow larger short-term inflation fluctuations to accommodate temporary conflicts with the credit control objective while requiring the MPC to correct under- or overshoots, thereby providing a firmer anchor for long-run expectations than current arrangements (under which the Committee is able to tolerate a persistent deviation while claiming to be adhering to its remit).

Some commentators argue that US stocks are more expensive than suggested by market price/earnings (P/E) measures because corporate margins are unusually high and should revert to average over coming years, depressing earnings.

The first chart shows gross and net corporate margins, calculated from national accounts data. The gross measure expresses the sum of profits, interest and depreciation as a percentage of corporate gross domestic product. Gross margins are at a record high and would have to fall by 19% to return to the historical average.

The current overshoot, however, is exaggerated by a long-run upward trend in depreciation, reflecting a combination of a rising capital/output ratio and a declining average life of capital goods. Margin sustainability is better judged using a net measure, excluding depreciation from both the numerator and denominator of the ratio (i.e. profits plus interest as a percentage of net product). Net margins, while high, are within the historical range and less stretched relative to the average.

The aggregate figures, moreover, obscure a bigger story: the divergence between the financial and non-financial sectors – second chart. Financial net margins are at a record high and would need to fall by 41% to restore the historical average. Non-financial margins, by contrast, are at a normal historical level, having moved temporarily below the average during the recession.

This suggests that non-financial P/E measures should not be significantly distorted by unusually-high margins currently but financial P/Es may be misleadingly low, in turn depressing market-wide valuations. The third chart shows forward P/E ratios, based on 12-month-ahead earnings estimates, for the S&P Industrials and Financial Sector indices.

The Industrials P/E is roughly in the middle of the historical range excluding the late 1990s bubble period. The Financials P/E is lower but the discount is smaller than usual. If earnings were recalculated based on average margins, moreover, the Financials P/E would be far above that of the Industrials and at the top of the historical range.

Possible margin compression, therefore, is a reason for caution on financial stocks but much less so for the rest of the market.

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COMMENT:
AUTHOR: APB
EMAIL:
IP: 86.146.121.66
URL:
DATE: 06/10/2010 08:19:32 AM

A breath of fresh air again, Simon – thank you.
On your US forward PE ratios chart, all the historical data must be ‘actual’, whereas only the most recent data point is ‘forward’ – is that correct?
Thanks
APB

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COMMENT:
AUTHOR: Simon Ward
DATE: 06/15/2010 11:00:00 AM

No, all the data points are based on forward earnings estimates.

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COMMENT:
AUTHOR: APB
EMAIL:
IP: 81.156.163.53
URL:
DATE: 06/16/2010 08:21:09 AM

Ok – which makes late-08 a standout buy!
Thanks Simon

APB

The May Royal Institute of Chartered Surveyors (RICS) survey signals a rebound in housing market turnover following weakness related to the ending of the previous stamp duty holiday (since extended) and the election. The net percentage of agents expecting an increase in sales rose to an eleven-month high, probably presaging a pick-up in mortgage approvals – see first chart.

Despite a recent increase in sales instructions, stock levels are the lowest since November. The new buyer enquiries and prices balances remain positive, the latter at levels historically consistent with solid gains – second chart.

At least until official interest rates rise significantly, real house prices may continue to follow the pattern of the early 1980s recovery, implying increases of 4% and 7% (Nationwide measure) respectively in the years to the fourth quarters of 2010 and 2011 – see third chart and previous post for more discussion. Assuming, conservatively, 3% retail price inflation, this would entail nominal growth of 7% and 10%, resulting in prices regaining their 2007 peak by late 2011.

Such a scenario could be upset by harsher tax treatment of housing but the coalition will be brave to grasp this nettle – the consensus is that any rise in capital gains tax on second homes and buy-to-let investments in next week’s Budget will be vitiated by generous taper relief.

The fall in consumer price inflation to an annual 3.4% in May from 3.7% in April was in line with a projected path presented graphically in a post a month ago and partly reflected favourable base effects, as well as a seasonally-unusual decline in unprocessed food prices.

The projection has been updated to take account of a recent easing of petrol prices and now shows the headline rate moving down to 2.9% by July, implying no further explanatory letter that month. It remains, however, well above the 2% target during the second half and rebounds in 2011, based on a firming of core price trends as the recovery develops and an assumed rise in the standard VAT rate to 20% in January – see first chart.

Tax changes aside, risks to this forecast are weighted to the upside since it assumes a significant near-term slowdown in core inflation that is at odds with rising price expectations in business and consumer surveys – second chart.

Geek’s note: the CPI at constant tax rates (CPI-CT) rose by only 1.6% in the year to May but this should not be used as an estimate of the hypothetical rate of inflation in the absence of this year’s VAT hike because the calculation assumes full pass-through of changes. Based, more realistically, on 50% pass-through, CPI inflation would currently stand at 2.5% if tax rates had been constant over the last 12 months (i.e. the mean of the headline rate of 3.4% and CPI-CT rate of 1.6%).

Global industrial output – as proxied by combined production in the G7 major countries and seven large emerging economies (the “E7”) – rose by a further 0.6% in April to stand just 1.4% below the pre-recession peak reached in February 2008. With business surveys signalling further gains, output is likely to reach a new high by late summer – see first chart.

A composite leading index derived from OECD country indices (except for Taiwan, for which a national series was used) also continued to rise in April but the 0.4% monthly increase was the smallest since February 2009. The index appears to be converging with the long-run trend path of output, with this trend implying growth of 3.4% per annum – first chart.

The loss of momentum of the leading index is clearer in the second chart, showing six-month growth rates. Pessimistic commentators suggest that this slowdown will intensify and is an early warning of renewed output weakness in late 2010 and 2011 – the dreaded “double dip”.

Global narrow money trends, however, have yet to support such a scenario. Real M1 led output and the leading index around the recession trough in early 2009 and again at the recent momentum peak – third chart. Six-month growth has slowed significantly but remains solid and may be stabilising, suggesting that output and the leading index will continue to rise, albeit at a much-reduced pace.

The best guess here remains that the current recovery will follow the pattern of the output revival after the mid 1970s first oil shock recession, implying a mid-cycle “pause to refresh” in late 2010 and 2011 followed by renewed acceleration from late next year – fourth chart. Further weakness in real M1, however, would demand a rethink. A 2011 global slowdown, moreover, could involve stagnant G7 output, allowing for much faster E7 trend growth.

A prior post presented a comparison of the rebound in the Dow Industrials index from its trough in March 2009 with recoveries after the six largest twentieth-century bear markets, excluding the devastating 1929-32 decline. These bears involved index falls of 45-52%, similar to the 54% drop over October 2007-March 2009. (Prices slumped by 89% over September 1929-July 1932.)

At the time of the earlier post, the Dow had moved down to converge with the “six-bear average” of these earlier recoveries. With liquidity conditions for markets having deteriorated, a fall into the lower half of the historical range seemed likely in the short term, although a significant undershoot of the average might present a buying opportunity.

Updating the analysis, yesterday’s Dow close was 8% below the six-bear mean and 1% above the bottom of the historical range – see chart.

Examining the six components, the recovery since March 2009 bears the strongest resemblance to the rebound after the January 1906-November 1907 decline. The Dow was mostly above the six-bear average during the early stages of this revival but a significant correction set in after about a year, echoing recent market weakness.

Like the recent bear, the January 1906-November 1907 decline was associated with a credit bust and financial panic that drained liquidity from markets. Both crises climaxed with the failure of a major bank – the Knickerbocker Trust Company in October 1907, Lehman Brothers in September 2008 – and a subsequent decisive “official” rescue effort (co-ordinated by J P Morgan in 1907, before the institution of the Federal Reserve). The economic consequences were similar, with a severe one-year recession in industrial output followed by a strong rebound.

Relative to the bear-market trough, the Dow is currently very close to its level at the same stage of the post-November-1907 recovery – see chart. On that occasion, prices were reaching a low and rallied by more than 20% over the following six months.

The “six-bear” evidence, therefore, suggests that market weakness will abate. Resumption of an uptrend, however, requires an improvement in liquidity indicators.

Another reason for doubting the significance of the slowdown in US private-sector payrolls in May is that business surveys have yet to signal any weakening of labour demand.

The chart shows a survey-based measure of labour demand comprising three components: the net percentage of Institute for Supply Management (ISM) manufacturing firms expanding employment, the monthly lay-off tally by outsourcing consultancy firm Challenger, Gray & Christmas and the net percentage of National Federation of Independent Business (NFIB) small firms planning to hire. Reflecting increases in the ISM and NFIB components, this composite measure rose further in May to its highest level since January 2007.