Category: Money Moves Markets

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in November – figures are released tomorrow – while National Savings attracted a bumper £2.8 billion, mostly into now-withdrawn “guaranteed growth bonds” offering a premium interest rate.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.

With a further rise to 1.9% in November, annual consumer price inflation remains on course to exceed 3% in January, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor. The November increase was ahead of market expectations but in line with the forecast presented in a prior note.

While commentary will focus on the role of higher fuel prices, the real story is a further pick-up in “core” inflation. Excluding energy, food, alcohol and tobacco, consumer prices rose an annual 1.9% in November, up from 1.8% in October. Had VAT not been cut last December, core inflation would probably stand at 2.7-2.8% (based on an estimate by the Office for National Statistics of the impact of the reduction).

Core inflation has exceeded Bank of England and consensus forecasts by a wide margin this year. The forecasts overestimated the disinflationary impact of rising economic slack while underestimating offsetting upward pressure from the collapse in the exchange rate. The November rise may partly reflect some retailers hiking prices ahead of the VAT reversal.

Further fuel price effects and the dropping-out of last December’s VAT cut are projected to lift headline inflation to 2.6-2.7% this month. This would yield a fourth-quarter average of 2.0%, above the 1.85% forecast in the November Inflation Report. The headline rate may reach 3.2-3.3% in January as VAT is raised before moderating later in 2010, while remaining above the 2% target – see the earlier note.

The retail price headline rate jumped from -0.8% in October to 0.3% in November, in line with the prior forecast, and is on course to reach 4% or higher by next spring. The annual rise excluding mortgage interest costs and housing depreciation climbed from 2.4% in October to 3.0% last month; the VAT reversal, energy effects and recovering house prices will push the headline rise well above this level in early 2010.

At the November Inflation Report press conference, Governor King stated that the Monetary Policy Committee intended to “look through the short-term rise in inflation” but there is a risk that sharply higher headline rates will destabilise inflationary expectations in the absence of any policy response. With fiscal plans widely judged to lack credibility, the UK can ill afford any loss of confidence in the Bank’s inflation-fighting determination.

Assuming that Bank of England purchases finish in February, the gilt market faces a six- or seven-fold increase in net supply in 2010-11. A resulting rise in yields is likely to boost pressure on an incoming government to accelerate fiscal tightening.

Revised Debt Management Office (DMO) projections issued with last week’s Pre-Budget Report show net gilt issuance – gross sales minus redemptions – of £208.5 billion in 2009-10. The Bank, however, is on course to buy £183 billion of gilts this year, based on current plans for cumulative asset purchases of £200 billion by February. The £200 billion target implies gilt-buying of £198 billion, of which £15 billion occurred in March 2009, i.e. in 2008-09.

The net supply of gilts to the market, therefore, will be only about £25 billion in 2009-10 (i.e. £208.5 billion minus £183 billion), down from £110 billion in 2008-09 and the lowest annual total since 2002-03 – see chart. This fall has contributed to the recent low level of gilt yields – 10-year yields averaged 3.6% in the first eight months of 2009-10 versus 4.2% in all of 2008-09.

Net supply to the market, however, will surge next year, barring an extension of the Bank’s buying. The Pre-Budget Report projects a fall in the central government net cash requirement (CGNCR) from £223.3 billion in 2009-10 – inflated by financial rescue costs – to £174.0 billion in 2010-11. Assuming Treasury bills and national savings contribute up to £25 billion to funding this gap (£21 billion in 2009-10), this implies net gilt supply of £149-174 billion, i.e. six to seven times this year’s £25 billion.

Combined industrial output in the Group of Seven (G7) major countries and seven large emerging economies (the “E7” – Brazil, China, India, Korea, Mexico, Russia and Taiwan) rose by 8% between February and September but fell back marginally in October – see first chart. Within the G7 there were large declines in Germany and France, partly reflecting lower car production after the end of “cash for clunkers” schemes, while among the E7 output was down in India, Russia, Korea and Taiwan, in all cases following strong gains.

The October setback was not signalled by business surveys and probably represents a pause for breath in an ongoing solid recovery. As the chart shows, a composite of the OECD’s leading indices for the G7 and E7 countries continued to rise strongly in October. G7 narrow money trends also suggest favourable near-term growth prospects – see previous post. Today’s Chinese output numbers for November were upbeat.

The recent recession and current revival in world industrial output bear a close resemblance to the deep 1974-75 contraction and subsequent recovery – see second chart and another prior post for more discussion. This comparison suggests a continuing upswing through 2010 but with growth momentum slowing as the year progresses.

US non-financial corporations’ financial surplus – the difference between their retained earnings and capital spending – rose to 1.3% of GDP in the third quarter, according to flow of funds accounts data released yesterday. Excluding the third and fourth quarters of 2005, which were distorted by a one-off repatriation of foreign profits to take advantage of temporary tax incentives, the surplus was the highest since the fourth quarter of 1960 – see first chart.

The further improvement last quarter reflected a combination of stronger profits and cuts in dividends and fixed investment, partly offset by slower destocking.

On top of this surplus, corporations raised cash from equity transactions for a second quarter, i.e. issuance exceeded share buy-backs and retirements due to cash take-overs – second chart. Bond issuance fell back from its record first-half pace but was again substantial.

Strong internal cash generation combined with capital market issuance allowed firms to increase their holdings of liquid assets and pay down short-term debt. The liquidity ratio – liquid assets divided by short-term liabilities – continued to surge, therefore, reaching its highest level since the fourth quarter of 1959 – third chart. This mirrors improvements in the Euroland and UK and supports hopes of a recovery in hiring and investment.

Some commentators have interpreted the contraction of bank lending to companies as supply-driven and likely to curtail business expansion. The flow of funds accounts suggest that bank debt repayment has been mostly voluntary, reflecting the financial surplus and fund-raising in share and bond markets. Bank loans and commercial paper outstanding fell more slowly last quarter and may stabilise and recover as destocking ends – second chart.

The yield spread of non-investment-grade corporate bonds over Treasuries is inversely related, with a lag, to the sum of the financial surplus and equity sales, expressed as a percentage of GDP. This remained historically high last quarter, suggesting scope for further spread compression – final chart.

The Pre-Budget Report announced surprisingly large medium-term fiscal tightening measures but these were necessary to prevent a further upward revision to borrowing projections. The Report takes a big political risk by raising taxes on the middle classes as well as high earners, and an economic risk by delaying a cut in borrowing until 2011-12.

Key points:

The main surprise was the 0.5 percentage point rise in National Insurance Contribution (NIC) rates from April 2011, which will hit middle earners and raise £3.0 billion by 2012-13. A further attack on pensions tax relief brings in £500 million and a freezing of the higher-rate income tax threshold £400 million in the same year. The one-off bankers’ bonus tax was overtly political rather than fiscally meaningful – it is doubtful that the projected £550 million in 2009-10 will be achieved.

The Chancellor also cut longer-term spending forecasts, with “total managed expenditure” now projected at £752 billion in 2013-14 versus £758 billion in the Budget. Savings include £3.4 billion from a one percentage point cap on pay settlements in 2011-12 and 2012-13 and £1 billion from pension reforms. The Report’s overview refers to growth in real current spending of 0.8% a year between 2011-12 and 2014-15 but this greatly underestimates the coming squeeze because it ignores plans to slash investment and a rising burden of debt interest. Detailed figures within the Report imply that total spending excluding interest will contract by a real 0.6% a year between 2010-11 and 2014-15.

Despite tax increases and reduced spending, the projection for public sector net borrowing in 2013-14 is only £1 billion lower than in the Budget, at £96 billion. With little change to underlying economic assumptions, the implication is that the Budget revenue forecasts either were too optimistic or embodied an assumption of further significant tightening.

The debt interest projections continue to be based on hopeful-looking interest rate assumptions. Net interest is forecast to rise from 1.9% of GDP in 2009-10 to 3.3% by 2014-15 but the latter figure implies an average interest rate on outstanding net debt of 4.3%, well below projected money GDP growth of 6.1% in the same year.

The Chancellor revised his projection of the fall in GDP in 2009 to 4.75% from 3.5% but maintained growth forecasts of 1.25% and 3.5% for 2010 and 2011 respectively. Despite this year’s shortfall, the money GDP projection for 2010-11 is higher than in the Budget because of faster-than-expected inflation.

By delaying deficit-cutting until 2011-12, the Chancellor is relying on the kindness of the gilt market as it takes over responsibility from the Bank of England for funding the current gargantuan shortfall. A big rise in gilt yields could yet derail his economic and fiscal strategy.