Earlier this year, we suggested that the policy response to the covid-19 crisis would lead to a strong rise in global money growth, in turn suggesting strong economic growth in late 2020 / 2021.
The subsequent monetary pick-up has exceeded expectations, raising the prospect of a full-scale boom in 2021 with an accompanying inflation pick-up. Emerging Market (EM) equities would be expected to outperform in such a scenario.
The key monetary indicator used for economic forecasting here is the six-month change in real (i.e. inflation-adjusted) narrow money in the G7 economies and seven large emerging economies (the “E7”). Narrow money measures money in physical forms that can be used as a medium of exchange, generally notes, coins, and certain balances held by banks. As narrow money is the most liquid form of financial asset and generally used for transactions and commerce, when narrow money expands it is seen as a leading indicator of increased economic activity. Narrow money was at a modest level entering 2020 but surged over February-May, reaching the highest level on record in data extending back to the 1990s as shown in Chart 1 below. Allowing for an average nine-month lead, the suggestion is that global economic momentum will rise into early 2021, at least:
The global surge owes much to a 22% explosion in US narrow money since end-2019 but the reality is that strong accelerations have occurred in almost all economies.
Narrow money is more useful for anticipating economic momentum turning points, but broad money is a better guide to medium-term inflation prospects. Broad money includes all money in the economy that households and businesses have in cash or assets that can easily be converted to cash. Central banks monitor this metric closely when developing inflation forecasts, as it provides a leading indicator of the amount of money that can enter the financial system and potentially chase-up the prices of goods and services. Annual growth of G7 plus E7 country nominal broad money, like that of narrow money, is the highest since the 1990s (at least) as shown in Chart 2 below. The dual surge contrasts with late GFC developments, when a narrow money pick-up signaled an economic recovery but broad money weakness argued against an accompanying rise in inflation.
G7-only money data are available much further back. Annual broad money growth is the fastest since 1973 and not much below a post-WW2 peak in 1972, ahead of an inflation surge – see Chart 3:
The 1970s inflation upswing was magnified by a quadrupling of the oil price following the Arab oil embargo of October 1973. Absent a similar shock, a reasonable expectation is that G7 inflation will reach 6-7% in 2021-22. This assumes that current broad money growth of about 17% is partly reflected in strong real GDP growth of 3-4%, while velocity falls by 7% pa – two standard deviations more than the average rate of decline over the past 50+ years.
The global cycle analysis conducted here is consistent with the monetary signal of strong economic growth and rising inflation. Recent business surveys confirm that the stock-building (inventory) and business investment cycles bottomed during H1, while an upswing in the longer-term housing cycle is regaining momentum in response to record low mortgage rates. Overlaying these activity cycles is the “long wave” price / inflation cycle, which averages 54 years and suggests a secular rise in inflation to a peak in the late 2020s.
The suggested scenario of strong growth and rising inflation would probably be associated with outperformance of EM equities relative to developed markets, given their historical positive correlation with global economic momentum and commodity prices.
A consistent message is given by our seven-factor checklist for assessing the relative attraction of EM equities, which is the most bullish since 2016. Five factors are positive: global industrial momentum (reviving), global “excess” money (strong), earnings revisions (stronger recently in EM than DM), commodity prices (recovering) and valuations (low in absolute terms and relative to DM). A sixth factor – the US dollar – is close to turning positive: the US effective exchange rate peaked in March and could be starting a trend decline.
The sole negative checklist factor is the G7 / E7 real narrow money growth gap as displayed in Chart 4. G7 strength, however, is focused on the US – real money growth in the rest of the group is on a par with the E7 – and the gap may be less relevant when both series are rising sharply. The US relative money surge is a key reason for thinking that the US dollar trend may be turning.
Strikingly, the Chinese economy has staged the strongest recovery globally despite more measured policy easing than in the US and Europe. Growth rates of narrow and broad money have picked up but remain within historical ranges, see Chart 5 below. The risk of a medium-term inflation upswing, accordingly, may be smaller in China than elsewhere, a consideration that may attract inflows to a government bond market offering a globally attractive yield, in turn suggesting support for the currency.
While Chinese money trends signal favourable economic prospects, the Chinese component of the MSCI EM index has outperformed significantly year-to-date and other markets may offer greater potential.
The baseline scenario outlined above argues for overweighting “cyclical” markets that have exhibited a positive correlation of relative returns with global economic momentum historically. Such markets include Brazil, Indonesia, Korea, Malaysia, Poland, Russia and Taiwan.
The scenario, conversely, suggests a winding back of central bank stimulus moving into 2021 with accompanying upward pressure on bond yields, which might act as a drag on “liquidity-sensitive” markets. This group includes Mexico, the Philippines, South Africa and Thailand.
Narrow money growth has picked up across countries but is particularly strong in Brazil, Colombia, Korea, Poland and Thailand, suggesting greater potential for money flow into equities and / or positive economic surprises. Monetary laggards include India, Indonesia and Taiwan, as well as China.