A “monetarist” perspective on current equity markets

Global economic sentiment has improved on the back of China’s reopening and a collapse in the European gas price but monetary indicators continue to signal a negative outlook. The “excess” money backdrop remains unfavourable for equity markets, with prospective developments suggesting overweighting non-energy defensive sectors and expecting a further relative recovery in quality / growth. 

Revisions to US seasonal adjustments have slightly altered the recent profile of global (i.e. G7 plus E7) six-month real narrow money momentum – the key leading indicator in the money / cycles forecasting approach used here. On the new numbers, momentum bottomed in June 2022, recovering modestly into December before falling back in January / February – see chart 1. 

Chart 1

The June turning point has been followed – with a lag within the normal range – by a recovery in global manufacturing PMI new orders from a low in December, with the revival driven by a sharp rise in the Chinese component. 

The PMI recovery is expected to fizzle out and reverse into H2, for both monetary and cycle reasons. Six-month real narrow money momentum, as noted, fell back in January / February and remains in negative territory – a sustained economic / PMI recovery has never occurred historically against such a monetary backdrop. 

From a cycles perspective, major PMI lows occur around troughs in the stockbuilding cycle but the current downswing phase was only starting when PMI new orders bottomed in December. With the last cycle trough in Q2 2020, the average historical cycle length of 3 1/3 years suggests another low in H2 2023. 

The marginal recovery in global six-month real narrow money momentum since June 2022 has been driven entirely by China and several other E7 economies. US / European momentum has slid deeper into negative territory as already restrictive monetary policy settings have been tightened further – chart 2. 

Chart 2

The Chinese pick-up suggests economic acceleration through 2023 but a recovery will be held back by – and won’t offset – global weakness. Current Chinese real money strength, moreover, could fade: higher short-term rates / yield curve flattening since late 2022 suggest a slowdown in nominal money growth while unusually low inflation may revive as the economy normalises. 

The assessment of market prospects relies on two indicators of global “excess” money – the gap between six-month real narrow money and industrial output momentum, and the deviation of year-on-year real money momentum from a long-term moving average. The signs of the two indicators define four investment quadrants describing different market environments – see table 1. (This presentation echoes Hedgeye’s investment “quads”, in their case defined by the directions of economic growth and inflation – the approach here offers an alternative “monetarist” perspective.) 

Table 1

The two indicators were negative from January 2022 (allowing for reporting lags) through year-end but the last quarterly commentary suggested that the first measure would turn positive in early 2023 as weakening industrial output momentum crossed below stable or rising real money momentum. Based on historical patterns, the implied shift from the bottom right to top right quadrant might be associated with less negative equity markets and a reversal of some of last year’s sector / style moves, including relative recoveries in quality / growth and tech – table 2. 

Table 2

The suggested sign switch of the first indicator had not occurred by January – chart 3 – but markets appeared to front run the quadrant shift in Q1, with tech / growth outperforming strongly and energy / financials weak. A cross-over of six-month industrial output momentum below real money momentum is still expected here, although timing is uncertain – Chinese reopening has delayed industrial weakness. Some Q1 moves were extreme so it may be advisable to await confirmation before adding to favoured themes. 

Chart 3

A common characteristic of the right hand quadrants of the table is a trend of non-energy defensive sectors outperforming non-tech cyclical sectors. The reverse occurred during Q1, although much of the cyclical relative gain unwound later in the quarter as financials were pummelled by banking crises. With no early move to the left hand of the table in prospect, an overweighting of non-energy defensive sectors – along with quality, which also usually outperforms in both right hand quadrants – is suggested. 

The stark contrast between positive and rising E7 six-month real narrow money momentum and faster contraction in the G7 raises the question of whether investors should overweight EM equities. Over 1990-2022, EM equities outperformed developed markets by 3.2% pa on average when the E7 / G7 real money momentum gap was positive, underperforming by 6.1% when it was negative. 

Further investigation, however, indicates that a positive gap is a necessary but not sufficient condition for EM outperformance – the global “excess” money backdrop, in addition, needs to be taken into account. Table 3 shows that, since 1990, EM equities have outperformed on average only when both the E7 / G7 gap and the first global excess money indicator were positive. Confirmation of a sign change in the latter indicator would strengthen the case for overweighting EM. 

Table 3

Historically, periods of sustained EM outperformance coincided with trend declines in the US dollar. The dollar reached major peaks in 1969, 1985 and 2002. These peaks occurred 6-7 years before housing cycle lows (in 1975, 1991 and 2009). Assuming a normal (i.e. c.18 year) cycle length, another cycle low is scheduled for the late 2020s. A dollar peak in October 2022, therefore, may turn out to be a major top, preceding a trend decline into or beyond the housing cycle trough.