Affinity Market Commentary August 2020

Technology drives the US market higher

US equities enjoyed another strong month in August, despite weak jobs data. Although there was some evidence of the rally broadening to other parts of the market, technology remained firmly in the driving seat, with Apple’s market capitalization rising above $2tr, and Tesla reaching another new high. The S&P 500 also reached a new all-time high, after rising more than 50% from its March low, in the depths of the coronavirus crisis.

Sterling pushes higher against the dollar

The combination of dollar weakness and Sterling strength continued to provide a headwind for UK-based investors in August, depressing the returns from dollar-based investments when converted into pounds. A fall of 20% in the UK’s Q2 GDP was offset by pleasing PMI data that beat expectations. The strength of the pound was, nevertheless, noteworthy, given the uncertainty over Brexit negotiations, where a deal needs to be concluded in the next few months.

Shinzo Abe resigns as Japanese PM

The Japanese equity market produced one of the best returns in the world in August, despite the largely unexpected resignation of Shizo Abe as Prime Minister. Abe cited ill health as the reason for his departure; the same reason was given for his resignation as PM back in 2007. Overall, the market did not react to this piece of news – Abe was to depart next year anyway, and it seems likely that his successor will be of a similar mindset. Abe is generally regarded as not having particularly helped Japan’s economy to grow, but not damaged it either, despite going early into the negative interest rate policy. More attention is focused on the Bank of Japan governor Haruhiko Kuroda.

Emerging markets up again

A weaker dollar once again helped to boost returns from the emerging markets and this, combined with some strength in the Renminbi, served to provide a good return from both India and China – the two biggest emerging economies. Once again, all three regions – South America, Europe and Asia all provided predominantly positive returns.

The World at a Glance

Source: Bloomberg

 

Source: Bloomberg – National benchmark indices in local currency

Equity investors were in a risk-on mindset again during August, pushing all the major equity markets, and many emerging markets, higher once again. Whilst the coronavirus backdrop remained uncertain, with case numbers rising in some countries and regions, the emphasis was very much on prioritising the economic recovery and getting workers back to work. The sense remained among investors that central banks would still step in to support liquidity if there should be a further shock to the markets.

 

Source: Bloomberg – National benchmark indices in local currency

August was a positive month for both developed and emerging European equity markets, though the UK was, once again, at the bottom of the major market performances. Germany rose strongly, gaining more than 5%, although this followed a 7% fall in July. The rise came even as the Purchasing Managers’ Index showed the July release of pent-up demand slowing, and many regions showed signs of rising virus cases, sparking fears of new lockdowns. The Manufacturing PMI also showed a marginal fall, versus expectations of a rise. By contrast, the UK Services, Manufacturing and Composite PMIs all rose to beat expectations.

 

Source: Bloomberg

Sterling continued to gain ground against the dollar and other currencies during August, presenting a headwind for UK-based investors investing overseas. Whilst there remain a number of unresolved questions about the short-term economic future of the UK, investors seemed sanguine about the outlook for Brexit negotiations, and were further cheered by positive PMI data beating expectations. The dollar, conversely, was weak against other currencies, as attention began to turn towards the election on 3rd November. Whilst there would normally be a presumption that the incumbent president will be returned for a second term, the contest this time remains too close to call, with polls unable to agree on the result.

 

Source: Bloomberg

Bonds yields rose across the globe in August. Investors, who have seen a strong recovery in bonds over the past few months, appeared to take profits in favour of equity investment. The UK 10-year generic bond saw its yield rise from c.0.09% to over 0.3%. Eurozone issues also saw their yields rise, whilst remaining firmly in negative territory. All sections of the global bond markets: sovereigns, corporates and high yield, sold off during the month, as confidence in the global recovery continued to gather currency, supported, at least in some areas, by economic data that was not quite as bad as had been feared. Chinese government bond yields, however, have been climbing and now stand at pre-covid levels. It remains unclear whether this will be the template for other global bonds.

*A Generic bond is a theoretical bond that always has the specified tenor, unlike a Benchmark bond, which is a physical bond, with a decreasing tenor.

The velocity of money

Imagine Global Money supply like a bath full of water. Then the 2008 Financial Crisis and the deleveraging that ensued was akin to the plug being taken out of the bath, and as the water flowed out, sucking money supply out of the system, deflation would follow as it did in the 1930’s.

But that didn’t happen because Fed Chairman Bernanke was a PhD student of the Great Depression, he understood that risk….and so turned the QE taps on….and despite some hairy moments, broadly speaking, managed to keep the bath full of water….but only just. Hence the very low levels of inflation we have seen since.

Given the explosion of the money supply in the wake of the financial crisis, monetarist theory would have expected a surge in inflation. Growth in the money supply was seen not just as an indicator of future inflation, but more recently, as an early indicator of wider economic activity.

So why didn’t we see a huge increase in inflation?

There has been a lot of work around structural long-term deflationary drivers

  • Globalisation–It was slowing anyway as a result of ‘trade wars’ but we will see more ‘on-shoring’ as manufacturers bring supply chains closer to end markets.
  • Migration– again was probably slowing, Brexit, Trump etc but the idea of free movement of ‘cheap’ migrant labour in a post–Covid world seems unlikely.
  • Technology– to some extent this will always be disinflationary but there is also the direct impact of tech on ‘price discovery’.
  • Demographics – aging and in some cases declining populations were seen as sucking the inflationary pressures out of an economy, most obviously in Japan.
  • Ever lower financing costs as yields compress– financing costs are at all-time lows and likely to stay there at least in the short/medium term.

Except for a few quarters we never saw a significant or sustained rise in bond yields or inflation despite evidence that some of those mega trends were reversing.  Therefore, over the last 10 years after the Financial Crisis we are again staring down the barrel of low inflation at best and outright deflation at worst.

If we have had an explosion in the money supply and with the US pre-covid, an economy running at full tilt and full employment, where was the inflation? Clearly something was missing in the inflation equation that was not all explained by long run factors. We are seeing the effects of the current monetary stimulus showing up in the data. The stimulus is showing up in the money supply numbers as can be seen from the St Louis Fed and Schwab chart from earlier this year.

All that monetary stimulus is out there, somewhere, but not getting ‘spent’ or ‘used’, hence why the ’velocity’ of money is still so depressed. Velocity of money is the key missing ingredient.

 

Source: St Louis Fed Reserve

The official definition is “The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.” Or on a more basic level……

Velocity was stable and tended to be slightly above money supply growth in the 60’s and 70s’. But it starts to pick up significantly in the 1990’s and in the years prior to 2008. This reflects deregulation of credit and banking markets and the liberalisation of banking and funding markets. Credit was ever more readily available, balance sheets were geared up, money was circulating ever more rapidly, prop desks were trading, banks were lending and money velocity was increasing. But we didn’t get the inflation because long-term deflationary factors were all in full swing, particularly the Chinese contribution to globalization.

Then in 2008 it all comes to a grinding halt. Just as the Fed stepped in during 2008/09 to bolster the money supply, the collapse in bank and credit lending saw money velocity fall sharply. In the years since then, ever more regulatory burdens on the banks, deleveraging elsewhere and a reluctance to lend has seen money velocity continue to fall. Even before Covid, we had seen several years where money velocity was subdued relative to the previous relationship with money supply growth. This mirrors the way that US 10-year Bonds traded regularly below the nominal GDP rate. With the impact of Covid, we have seen a huge surge in the money supply, which has grabbed all the headlines, but velocity has collapsed. The chart below shows the huge drop in velocity in 2Q20. This deflationary pressure from the collapse in velocity counteracts the theoretical inflationary pressure from the huge growth in the money supply. With the lockdown, it wasn’t just the public that saw a reduction in their activity levels.

The weak link in monetary policy is the connection between money as a stock and money in circulation, ie the velocity of money. The velocity of money can strengthen or weaken the effects of a change of the amount of money. If the money supply increases significantly, but velocity falls, then that reduces any stimulus or inflationary pressures from a simple analysis of money supply growth.

The frequency of the monetary transactions depends on the decisions of the individual users of money in the economy. When people, banks and other lenders decide to use money more rapidly, the velocity rises, and this would accelerate the effect of the expansion of the monetary stock. When, in contrast, the public and financial actors use available money more slowly, then velocity falls. Such actions would offset the effect of the expansion of the stock of money, or, in the case of a reduction of the stock of money, accelerate the contraction.

The velocity of the circulation of money can be subject to strong swings. There are limited tools to control the velocity, unlike the money supply and it’s a much less understood phenomenon. The monetary authorities are not able to foresee how the velocity of money will change. The trends may be long or short, and when they are long and seem to be stable, they may change abruptly. A reliable calculation of the future trend is not possible even if many data points are available.

Central banks can put money into the system, but they do not have effective control about what happens to it after that. Both inflation and GDP have disappointed relative to the size of the monetary and fiscal stimulus of the economy. Given how much water the Govt and the Fed poured into the bath, the significant falls in velocity would seem the most likely explanation for the weak economic and inflation response.

If low and falling velocity of money is seen as a negative in times of weak economic performance, despite the best efforts of the central banks, how do you get the velocity to increase?

In theory, this should be simple. What they need to do is come up with policies to make money go from hand to hand faster or come up with ways to dig out money stuck in the system or blocked in its bowels. For years the politicians have been doing a great job making money go around slower. If 1980s deregulation of credit increased money velocity, the post 2008 obsession with regulation has slowed it down. Getting anything done in financial services is a bureaucratic nightmare. Try opening up a bank account. What once took no time at all, now takes ages. You might find you or your business even gets refused. The treacle of AML (anti money laundering) and KYC (know your customer) legislation has without doubt driven the velocity of money down. Bank reserve requirements and regulatory and risk averse lending practices all add further to the downward pressure on velocity.

Certainly as an economy ages, so the velocity of money falls, but that isn’t the whole picture; money simply isn’t what it used to be because the system has changed and traps money in assets that then don’t move. Banks lend, invest and speculate in more controlled, cautious and timid ways than previously (often with good reason), but it all acts to slow the velocity of money down. What is interesting today is that there is hardly any policy discussion on money velocity either from central banks or politicians.

Conclusion

When contemplating the outlook for inflation, it’s important to remember that it’s all about the velocity!

Velocity of money does seem to be the missing piece in the jigsaw in explaining the huge increase in the money supply set against weak nominal GDP and inflation. But Central Banks, Regulators and Politicians seem to pay little attention to this metric. If you read broker research on money supply and inflation, there’s very little comment on money velocity.

To see the huge increase in the money supply generate a meaningful increase in inflation, we need to also see a sharp pick up in the velocity of money. Policies can be enacted to achieve this, but they seem unlikely to be pursued in the current environment.

Velocity is important, but seems little understood and poorly monitored. Data on velocity seems limited in nature, both in terms of frequency and depth.

It truly is the missing piece in the jigsaw.