“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” – Milton Friedman

The rapid pace of money supply growth in Hong Kong may have reached an exhaustion point. This could weigh on the stock market.

Small, open economies, like Hong Kong, can be buffeted by the ebb and flow of international cash flows. Money flows in and out of the economy with ease and so, in these types of economies, there tends to be a relatively strong link between the quantity of money and the prices of goods and assets.

As our chart below shows, in Hong Kong, there is a relationship between money supply growth and the Hang Seng Index.

The annual rate of change in money supply is measured by M3. According to the Hong Kong Monetary Authority website, M3 includes the following: legal tender notes and coins held by the public, customers’ demand deposits placed with banks, customers’ savings and time deposits with banks, negotiable certificates of deposit (NCDs) issued by banks held outside the banking sector, customers’ deposits with restricted license banks and deposit-taking companies, and, finally, NCDs issued by these institutions held outside the banking sector.

The rate of growth in Hong Kong M3 mirrors the Hang Seng Index because, in such a small, open, flexible regime, both measurements are barometers of social mood. Both are gauges of confidence in Hong Kong.

The chart shows that Hong Kong has experienced a few periods of deflation (year-on-year declines in M3) over the last fifteen years. With the exception of the brief one-month dip in 2004, deflation tends to correspond with drops in the stock market. In 2002 and 2003, the deflation came when the stock market was two-thirds of its way through a 55% decline, and in 2008, M3 first registered deflation in June of that year, after the Hang Seng had topped, but still before the severe falls of September and October.

In 2011, the M3 deflation came at the end of the 35% drop in the stock market. When that decline started in 2010 though, the Hang Seng had made a new high whereas the M3 rate-of-change had fallen. A similar divergence was seen at the top in 2015, before the Hang Seng experienced another 35% drop.

At this juncture, that dynamic is occurring again. The Hang Seng has been on a tear over the last year and, up until August this year, M3 was inflating at a faster rate. However, the rate of growth in M3 has slowed whilst the Hang Seng has made new highs. This is a warning that, perhaps, an exhaustion point is being reached. With the Hang Seng Index also up against the old 2015 high, slowing M3 is not the only headwind it faces.

The evidence suggests that, after such, a strong run up, everyone may be out of breath, and a period of disinflation may be starting.

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