In the last few weeks, we have mentioned the concept of the totality of monetary policy. Everyone focuses on interest rates, but monetary policy is more than that. We need to look also at money supply, the yield curve as well as rates, the Fed’s balance sheet and the direction of the US Dollar to get an overall sense of monetary conditions. A number of commentators will make the point that with US rates at only 2%, how can there possibly be bad times ahead; surely rates would have to reach 5% or more for something nasty to happen? Perhaps they are right, but if we accept the argument that we need to look at the totality of monetary policy, along with current conditions, then the situation has to be more nuanced that “ah, rates are too low for a recession to occur”.
Chart 1 below is from the excellent Lacy Hunt of Hoisington Investment Management. His thesis (and we are massively simplifying this) is that M2 money supply growth has decelerated into 17 of the last 21 recessions (since 1900) and that the totality of monetary policy can explain the four occasions when money supply did not decelerate into recessions.
Chart 1 – M2 Money Stock Annual % change
In chart 2 below, we plot the Fed Funds rate and the US yield curve alongside the year over year per cent change in M2 and stock prices (shaded areas = recessions). What we are trying to show here is a more complete look at monetary policy than purely interest rates, which of course remain at a low nominal reading of 2%. This shows that prior combinations of Fed tightening, as shown by Fed rate rises, decelerating money supply growth and a flattening of the yield curve are a powerful force and apparent prior to recent recessions.
Where are we today? Well, the Fed will continue to raise rates until something changes (most likely something untoward in the financial markets in our opinion) M2 money supply growth is decelerating noticeably and the yield curve continues to flatten. We are of the view that these monetary levers need to tighten further prior to a recession, and that we will likely see the yield curve flatten well before such an event.
Chart 2 – The Totality of Monetary Policy
Because of its global reserve status, changes in US policy are felt at home and abroad. Global markets are also influenced by changes in the US current account (a mechanism by which the US supplies Dollars to the rest of the World thereby helping growth) and the level of the Dollar. So, with the current account about half the level it was pre 2008 crisis, and the Dollar up 7% from the recent low, headwinds for the global economy and more especially emerging markets are becoming apparent.
We think that the Dollar could be an important factor for global markets in the weeks ahead. Any further Dollar gains could easily tip markets over towards bear market territory, or a decline in the Dollar will help markets bounce from here. It is important, because as we show in chart 3 below, the MSCI World ex. US is testing a level of support that has been created over the last eight months, and it is trading below its own 40 week moving average. A break of this support could easily lead to further losses.
Chart 3 – MSCI World Index ex. US with 40 week moving average (green)
For months, we have been talking of a multi-month topping process, and this is what it looks like on a chart of a broad based index. Our preference at the current time is that this support will hold and that the Dollar could soften in the weeks ahead. We are therefore looking for the topping process to continue a little longer, and for central banks to tighten policy further (obviously led by the Fed) and for economic growth to remain reasonable. But the risks do seem to be growing and investors need to remain alert.
In the weeks ahead, we will continue to look at the current conditions of the economy, and how policy could affect growth in future quarters. As we tried to point out last week, the economy will only start to deteriorate after the turn in leading indicators and financial markets. We should certainly not confuse economic analysis with market analysis as waiting for an obvious deterioration in the economy will most likely mean that investors have overstayed their welcome. That said, we think the combination of both a financial and economic downturn will be comparable to 2008, and so understanding both is extremely important.
