China’s economy is slowing. GDP growth was 7.5% in the second quarter, the least since the global economy collapse early 2009. The deceleration is also visible in monetary factors like money growth. M2 money supply growth came in at 14% in June, comfortably below the average in the last decennium. In this ‘quick fact’ I try to explain why this could be of more importance to investors than the GDP growth number itself.
There are competing theories on why this is. Keynesian economists argue that the relationship between money supply and returns should be negative. If there is a positive money supply shock now, investors will anticipate a tightening of the money supply in the future. This anticipation will drive up current interest rates. Using a simple discount model, higher interest rates lead to higher discounts and thus lower equity prices.
Within the real activity framework, which can count Bernanke as one of its followers, the relationship between money growth and returns is expected to be positive. The rationale is pretty straightforward, when the demand for money is increasing, hence money supply growth rises, investors anticipate higher economic activity. This leads to higher expected profitability and so on, causing equities to rise.
There has been extensive work on this relationship, with rather mixed results. As usual most of the research is on US data. For China M2 growth is much stronger linked to overall economic and monetary policy determined by the central government. This makes the second theory, where an increase in money growth leads to higher equity prices and vice versa, the more appropriate one for the Chinese stock market. In fact, looking at the historical relationship between Chinese M2 growth and equity returns seems to point is this reaction. On average higher money growth has been accompanied by higher returns.
Click to enlarge