The Biggest Risk - An Upside US Growth Shock

The biggest unacknowledged risk to world markets right now is neither in the Eurozone nor in China. It is in the US, where cyclical indicators remains highly constructive, where credit growth is finally creeping back into the system, where M2 growth is nudging double digits, but where in 3Q monetary velocity collapsed to the lowest point it has ever recorded. Unless it keeps collapsing – and there's no historic precedent for that – then the numbers compel us to expect nominal GDP growth to at least double in the coming year. More likely, nominal growth will easily break into double digits.

Neither bond markets, nor currency markets, are remotely prepared.

Much of my week has been spent preparing my quarterly Flow Essentials booklet. I think of this exercise as a fencing-in of the economic imagination. Whereas economic forecasts attempt to describe the world as the forecaster believes it may become, the great ambition of my Flow Essentials is merely to outline the limits of the likely. For example, if return on capital is rising sharply, capital spending can be relied upon to respond. If real labour productivity is rising fast, it would be perverse to expect employment to contract. Coming down to a slightly finer grain, you are most unlikely to see bond yields rise if surplus private sector savings are pouring cash into the banking system.

But having now assembled these ratios and cashflows for the US, Eurozone, China and Japan, I realise that in each economy we now have anomalies sufficiently large and strange to be worth commenting on individually. With luck we might, after all, be able to start fencing in some of the wilder margins of our economic horizons.

Let's start with the US. The ratios tell us there's little to worry about in the US cycle – the main indicators all remain sharply constructive. My return on capital directional indicator continues to rise sharply, and is now at its highest since mid-2000, and in response my estimation of capital stock growth has finally broken into positive territory for the first time since mid-2009. (I estimate capital stock by depreciating all capital investment over a 10 year period.) Growth in real labour productivity (adjusted for capital stock per worker) is running at a little over 3%, down from a bounce-back peak of early 6% in 2010, but no longer declining. In response, employment growth is up around 1.3% and accelerating. Banks have cut their loan/deposit ratio to around 82%, but no longer seem hell-bent on driving it down further: at the margin banks have just started to wean themselves off bonds, and, very cautiously, are expanding their loan-books again. Cashflows remain immensely positive, with the private sector savings surplus stabilizing during 3Q at 4.3% of GDP.

So the cycle is secured? I believe so. Yet there is a risk which needs to be acknowledged – the risk of a sharp upside growth surprise in the coming six to nine months which may scramble the current structure of money markets (bonds selling off) and currencies (dollar strengthening unexpectedly). The problem is simply that in the third quarter we have seen the biggest disconnect between monetary aggregates and economic activity since. . . . . well, since records began. When we measure monetary velocity (GDP/M2), we find that it absolutely collapsed during 3Q to the lowest level on record – a level absolutely off the map in terms of numbers of standard deviations from long-term trends. Now, monetary velocity was already at near-record lows, but the decline seen during 3Q is basically unprecedented.  

Why did it happen? Normally, one would attempt to link such a fall in monetary velocity to a sharp decline in return on capital, which in turn you would expect to see echoed in cashflows and investment spending. But the rest of the readings from the economy absolutely close out any such interpretation. So perhaps something strange was happening in the M2 numbers – some response to shifts in the Fed's balance sheet perhaps? But again, when one searches in detail, there's no rogue explanation there either: during 3Q, the fed was a marginal seller of bonds. So one is left with what seems a rather feeble explanation: a collapse in economic confidence and financial risk appetite which accelerated a substitution of real assets for financial assets, driving up deposit growth far faster than the underlying growth of the economy.

Precisely why it happened is probably less important than understanding the utter extremity of the situation it has left the US economy in. Quite clearly, the risk is monetary velocity stops, or even reverses its unprecedented collapse in the near future. And if it does so, consider this: in the US M2 is currently growing at just under 10% YoY, whilst nominal GDP is growing at 4.1%. Unless we see a collapse in M2 growth (unlikely given that bank credit is finally beginning to expand), here are the alternatives:

• Mere stabilization of monetary velocity at 3Q levels would involve a doubling of the GDP growth rate over the next 12 months on average.
• If even half the collapse in the 3Q monetary velocity is regained and sustained, it implies a nominal GDP growth rate of just under 12%.
• If we return to the (still historically very-depressed) rate experienced in 2Q11, we'd be looking at nominal GDP growth of 13.7%.

The message is unambiguous: the biggest risk to US financial markets in the coming year is a growth shock for which bond and currency markets are utterly unprepared.