26th November 2010
Simon Ward, chief economist at Henderson Global Investors, argues that the relationship between real money supply and economic output offer a good insight into prospects for recovery from recessions. His forecasting approach is based on the assumption that, in general, real inflation adjusted money supply tends to lead the economy by around six months.
Using this ‘Friedmanite rule' it can be shown, for instance, that slower G7 industrial since spring 2010 was presaged by a fall in real money expansion in late 2009 and early 2010. Ward says that the Friedmanite rule has worked well in recent years, albeit with a slightly longer lead than usual.
Latest analysis by Ward shows that real money growth has actually stabilised at 4% since early 2010. At the same time, however, the analysis suggests that for the time being at least, the liquidity backdrop for markets remains unfavourable but may improve early next year.
Still, the bottom line is that at 4%, the growth in real money is above its long term average and historically consistent with solid output expansion. Ward points out that the five global recessions over the last 50 years were preceded by a contraction in real money.
The liquidity backdrop for markets may be unfavourable at the moment but Ward says it is important to note that it depends less on the level of real money growth than whether it is higher or lower than output expansion. So, a positive differential may imply that there is "surplus" liquidity available to drive up asset prices.
Empirical evidence supports this approach: on average, world equities have outperformed cash by a substantial margin when real money has grown faster than industrial output while underperforming at other times.
Certainly the latest growth forecasts from the Organization for Economic Cooperation and Development (OECD) appears to support the creation of this ‘surplus' liquidity environment. As reported here by Reuters, the OECD has just cut its global growth forecast for next year, predicting a "soft spot" as stimulus spending fades before investment spurs a revival in 2012.
The OECD reckons the global economy will expand 4.2% next year instead of the 4.5% predicted in May, with growth recover to 4.6% in 2012.
Similarly the US Federal Reserve has also lowered economic expectations for 2011, as reported here by the Washington Post.
Ward says real money growth fell beneath output expansion in early 2010 and remains lower currently, warranting a cautious stance on equities, which have trod water since the spring. According to Ward's analysis, however, the annual output rise should slow further over coming months, suggesting that the gap will turn positive by early 2011 if real money expansion is stable (see chart below).
For investors, the implication of Ward's conclusion is that near-term weakness in equity markets could present a buying opportunity.