Via the excellent Damien Boey at Credit Suisse:
Our proprietary measure of the Australian credit impulse has picked up to 5.6% annualized in August, from 4.9% in July, and 4.6% in June. Importantly, the credit impulse is well off the lows we saw at the end of 2018. Indeed, the impulse is running at its fastest pace since 2017. The implication is that financial conditions are genuinely easing, partly because the Federal government has sharply turned around its spending position from surplus at the end of 2018, to deficit in 2H 2019. The government is printing money again. Anyone waiting for the terms of trade boom to filter through to the real economy finally has something to cheer about. And from an investment perspective, the way to play this is via curve steepening in the fixed income space, and value investing within equities.
First, a re-cap of how we measure the credit impulse. Modern monetary theory (MMT) teaches us that bank loans create deposits – not the other way around. Similarly, Federal government deficit spending creates deposits. Governments spend currency into existence before raising it via taxes. From a stock perspective, money supply (deposits) should equal the sum of bank credit, and Federal government debt. There is of course, the issue of shadow money – securities that have money-like properties, but let us exclude consideration of these for the moment.
From a flows perspective, we know from the national accounting identity, that the sum of saving across all sectors (households, corporates, government, foreigners) must equal zero. For every borrower, there must be a lender. Re-arranging the identity, we can show that private sector saving, a proxy for the easiness of financial conditions, must equal the sum of the trade balance and fiscal deficit. Therefore from a flow, rather than stock perspective, the credit impulse cannot just be equal to bank credit growth plus fiscal deficits. We also need to account for foreign currency denominated saving harvested via the trade balance. In other words, the complete measure of the credit impulse is the sum of the change in bank credit, the fiscal deficit and trade balance. We can express all of this as a percentage of overall domestic money supply.
Levels of, and changes in the credit impulse both matter for economic growth. Against this backdrop, we note that the level has turned materially positive, and has picked up over the past year. In contrast, at the end of 2018, the impulse was weakly positive, and had decelerated in the year prior. Therefore, we have just witnessed a remarkable, positive turnaround in the credit impulse and financial conditions. We should expect a similar inflection in real GDP growth in the period ahead, given leads and lags.
Our proprietary financial conditions index (FCI) takes into account the levels of and changes in the credit impulse, as well as other financial variables, such as the slope of the real yield curve (a proxy for the appropriateness of rate settings), the deviation of the exchange rate from equilibrium levels (a proxy for the appropriateness of external sector settings), and real wage growth (a proxy for household cashflow). Historically, the FCI has been a very powerful leading indicator of GDP growth. Updating the FCI, we find that it has picked up noticeably in the past few months, consistent with a strong rebound in activity growth in 2020. The pick-up in the credit impulse is one factor driving this outcome – but it is also worthwhile noting steepening of the real yield curve, and undervaluation of the AUD/USD against fundamentals.
To be sure, activity is badly undershooting the profile traced our by the FCI, as we already know from our proprietary domestic demand tracker, and high frequency data on resources sector exports. But this undershooting is technical payback for the overshooting the economy experienced in 2016-17 on the back of pulled-forward infrastructure spending, and a foreign-driven housing boom.
At some point over the next year, growth will be looking healthy again. Fiscal policy is the appropriate solution to the current malaise, given that monetary policy is visiting the lower bound and is unable to cause a quick turnaround in the residential construction cycle. And fiscal policy is coming to the party. It may take a little while to manifest in the GDP data – it won’t happen overnight, but it will happen. The Federal government loosened the taps in 3Q by stealth. And there may be more to come, given that Prime Minister (PM) Morrison is prepared to revisit budget plans if growth deteriorates further from its 1.4% year-to-2Q pace, and given that Treasurer Frydenberg has just called upon the states to expedite their infrastructure spending.
A tip in the balance of policy easing towards fiscal and away from monetary is net negative for bonds, and supportive of curve steepening. And curve steepening supports value investing within the equity market.
I am still of the view that monetary transmission is inhibited by private saving so do not see growth following the FCI with any great enthusiasm.