Recently, US money supply dynamics have caught investors’ attention, explicitly because we are witnessing the first monetary contraction in the US since the 1930s. The latest reading is -4.6%, which would imply a significant disinflationary impulse. What this figure hides is that there is a huge base effect at play: the US M2 money supply exploded in the aftermath of Covid-19, aided by the swiftly enacted USD 6 trillion in pandemic relief payments.
As shown in our chart of the week, US money supply is still above its pre-pandemic trend level but is in the process of reverting. Accordingly, the explosion in US monetary aggregates has translated into nominal US gross domestic product (GDP) growth, while US real GDP growth notably remains close to its pre-pandemic trend.
The boom in US money supply also explains cross-asset performance since the beginning of this decade. Corporate earnings, measured in nominal terms, have been inflated, resulting in equities significantly outperforming bonds. Assuming a scenario where the nominal GDP growth rate converges to its pre-pandemic average but starting from a higher absolute level of nominal GDP, the forward-looking relative return outlook between equities and bonds is much more balanced.
Asset prices to be boosted by likely end to quantitative tightening
Recent market action and the outperformance of the growth equity style suggest that concerns have shifted back from inflation to deflation, and perhaps rightly so, as slowing money growth combined with higher interest rates can arguably act as a powerful drag on inflationary pressures.
There was no hike at last week’s June Federal Open Market Committee meeting, but one could be possible in July. Investors should remember that the current objective of quantitative tightening (QT) is to return bank reserves, the money that commercial banks keep at the Fed, to a more sustainable level. The appropriate level that the Fed is aiming for is estimated to be 8%–10% of nominal GDP, equivalent to USD 2.1 trillion–USD 2.6 trillion. Current net reserves stand at USD 3 trillion. This means we are only about half a trillion dollars away from reaching the target range, indicating that the end of QT is closer than most might think, which is supportive for asset prices.
How does all this affect the probability of a US recession?
With regard to the risk of a credit crunch, we note that areas such as commercial real estate and private credit are increasingly being challenged in the context of tight monetary policy, but not to the extent of raising concerns about widespread systemic risks. Concerns raised earlier this year about the potential emergence of global contagion, particularly in the banking sector, were quickly resolved or did not materialise to the extent initially expected.
In summary, with a June rate hike off the table, the end of QT on the horizon, solidly financed private sector balance sheets, resilient corporate profitability, and excess savings still supporting private consumption for at least most of this year, it is hard to remain convincingly bearish. We believe the case for a continuation of the secular bull market in equities remains intact, as market confidence in the economic outlook is growing.
Biotechnology drought continues in 2023
In our most recent Julius Baer Secular Outlook brochure, we reiterated our expectation of significant value creation in the life sciences this decade, driven by the proliferation of data sciences in healthcare and the convergence of technology and biology.
However, the current environment remains challenging for biotechnology names. After a strong 2020 for the Nasdaq Biotech Index, the sector posted only modestly positive performance in 2021, followed by a dismal 2022. Currently, the index is trading close to flat on a year-to-date basis, as the sector has not been caught up in the excitement surrounding artificial intelligence (AI) in recent weeks, despite its role in advancing biomedical science.
The depressed sentiment towards the segment bodes well for prospective returns, reinforcing the case for a compelling entry point into the segment from a valuation perspective.
Revival of the transitory inflation narrative
In 2021, when inflation started to rise above the Fed’s target level of 2%, we claimed that this surge would be a transitory phenomenon. Two years later, in June 2023, the US consumer price index readings are still close to 5% year-on-year, obviously calling our initial stance into question.
Back then, we argued that the inflation spike was caused primarily by two factors: pandemic-related disruptions to supply and the cost of the energy transition. The proponents of a structural rise in inflation, on the other hand, argued that the pandemic had left US households in a much better financial position, which then led to a permanent increase in aggregate demand. With inflation persisting, this demand-driven inflation narrative seemed to prevail.
However, in recent days, new evidence indicates that the transitory, supply-side driven inflation narrative might not have been so wrong after all. Olivier Blanchard and Ben Bernanke, two renowned experts in the field, conclude that the demand-siders were right for the wrong reasons. Inflation did indeed prove to be stickier than expected, but not for the reasons they warned about. In fact, almost the entire inflation dynamic of this unusual cycle can be attributed to energy and commodity shocks and, in the early pandemic recovery, to supply chain disruptions. The problem was largely (temporarily) reduced supply, not excess demand.
Given the ongoing reversal of negative supply shocks, with supply chain bottlenecks now fully dissipated, we are confident that the current disinflation process will continue mechanically. There is even a risk that the Fed’s inflation target will be undershot this year, helped by favourable base effects.
In the longer term, however, we expect geopolitical turmoil to exert enough pressure to keep supply volatility high, so that Western policymakers ultimately will have to settle for a new normal of 3% plus inflation, instead of the old normal of 2% and below.