Janus Henderson: Perspectives on current equity markets

US Treasury borrowing ahead of the reimposition of the federal debt ceiling in December, meanwhile, may have a temporary negative impact on US monetary conditions. A cautious investment stance, therefore, may be warranted, despite favourable economic trends.

Previous commentaries suggested that the global economy would lose momentum over the summer and autumn before reaccelerating in late 2017 / early 2018. This forecast is on track but the growth pull-back to date has been modest. Six-month growth of industrial output in the G7 developed economies and seven large emerging economies (the “E7”) peaked in April 2017 but remained solid through August – see first chart. The equity analysts’ earnings revisions ratio has fallen back but business surveys have stayed strong – second chart.

The basis for the forecast that economic expansion would moderate from spring 2017 was a fall in G7 plus E7 real narrow money growth between August 2016 and February 2017  – monetary trends lead the economy by about nine months on average*. Real money growth, however, recovered solidly between February and June, suggesting a restrengthening of economic momentum around end-2017. June may have marked another peak in real money growth but July / August data remained positive – first chart.

The message from monetary trends is supported by a global (i.e. G7 plus E7) leading indicator derived from the OECD’s country leading indicators, which combine a wide range of economic and financial series (but generally exclude money). The global measure, which typically leads activity by four to five months, slowed in late 2016 / early 2017 but has regained momentum over the summer, consistent with the forecast of near-term economic strength – third chart.

US real narrow money growth has rebounded strongly from weakness in early 2017, suggesting robust GDP expansion in late 2017 / early 2018 – fourth chart. The unemployment rate has stabilised at 4.3-4.4% since the spring but could fall further to 4% or below. Core inflation has declined unexpectedly but this partly reflects temporary influences, such as a large fall in mobile data charges. Fed officials are aware of a possible parallel with the 1960s, when core inflation rose sharply as the jobless rate moved through 4% – fifth chart. Policy rates may rise faster than markets currently discount, boosting the US dollar.

Chinese real narrow money growth fell in late 2016 / early 2017 but has stabilised since the spring at a level consistent with respectable economic expansion – sixth chart. Policymakers have clamped down on housing speculation, shadow financing and polluting activities but plan to support growth via infrastructure spending and targeted easing, such as a recent cut in reserve requirements for small business lending. Current monetary trends suggest that they are on track.

US real narrow money growth is now at the top of the range across major developed economies, along with Canada – seventh chart. UK expansion, meanwhile, has recovered modestly, while growth in Japan and Euroland has moderated. These trends suggest improved relative economic prospects for the US and UK and may warrant adding to equity market exposure, partly on the expectation of better currency performance.

The outperformance of emerging market equities since early 2016 was signalled by E7 real money growth crossing above the G7 level in late 2015 and remaining higher through early 2017 – eighth chart. This positive signal has now reversed, suggesting reducing EM exposure.

Globally, liquidity conditions still appear supportive for markets. Research reported previously found that major equity market declines historically were preceded by one or more of the following conditions: G7 annual real narrow money growth falling below 3%; real money growth falling below industrial output growth; and real money growth falling by 3 percentage points or more within six months. The performance relative to US dollar cash of two switching rules based on these conditions is shown in the ninth chart. The rules would have captured a significant portion of relative equity gains while limiting losses during bear markets.

The three conditions are not yet close to being triggered. G7 annual real narrow money growth of 6.3% in August, however, was down from an October 2016 peak of 8.7%, while the real money / industrial output growth gap has narrowed significantly – tenth chart. Liquidity conditions, therefore, are probably the least favourable since mid-2014 – equity markets made no progress over the subsequent two years.

A near-term concern is that the US Treasury will “overfund” the federal deficit before the debt ceiling is reimposed in December in order to replenish its cash balance at the Fed. An earlier run-down of this balance boosted the monetary base and may have contributed to the pick up in real narrow money growth since early 2017 noted earlier – final chart. A reversal of this effect could have a temporary disruptive impact on markets, particularly if accompanied by strong economic data and an associated upward revision to interest rate expectations.

*Narrow money = currency in circulation plus demand deposits and close substitutes. Broad money = narrow money plus time deposits, notice accounts, repos and bank securities. Precise definitions vary by country. Narrow money has been more reliable than broad money for forecasting purposes historically and is consequently emphasised in the analysis here. Real = inflation-adjusted. The G7 plus E7 narrow money series shown, and an E7-only series in a later chart, incorporate an adjustment to reduce a distortion from India’s demonetisation programme.