Macro Wrap-Up

Taking Exception to Manufacturing

Topics - Macroeconomics

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Taking Exception to Manufacturing

In 1840, Alexis de Tocqueville wrote: “The position of the Americans is therefore quite exceptional, and it may be believed that no other democratic people will ever be placed in a similar one." 1 1 Close Do you think it sounds quaint now? , 2 2 Close Tocqueville, Alexis de (1840). Democracy in America. Vol. 2. Most investors would probably not make as strong a statement about the American economy, but for much of the past few years markets have been trading like America is exceptional. Over the past three years, the S&P 500 Index is up almost 42% relative to 18% for the MSCI EAFE Index. 3 3 Close Total returns from the close on 10/3/16 to the close on 10/2/19. The MSCI EAFE region includes developed market countries in Europe, Australia, Israel and the Far East. Source: Bloomberg. The returns have been underpinned by an implicit and at times explicit belief among investors that regardless of what happens in the rest of the world, the U.S. economy can grow on its own. And this is a good thing because much of the rest of the world has seen an acute slowdown in manufacturing which has put some economies in Europe at or near recessionary levels. Meanwhile, U.S. GDP has managed to stay above 2%, but investors must be wondering if this divergence is sustainable if some of the fiscal stimulus from the tax cuts wears off and geopolitical pressures start to weigh on the economy.

Perhaps the best evidence of recent American economic exceptionalism had come from the ISM Manufacturing Purchasing Managers’ Index. PMI surveys are popular because they provide a variety of timely data on the production sector. They tell us about new orders, backlogs, employment, prices and just about anything else you can think of. And each of the components are compiled into a number that is easy to interpret. If it’s above 50: expansion; below 50: contraction. Some economists consider them to be among the best leading indicators.

Sources: Bloomberg, Markit and Institute for Supply Management.


The Eurozone Manufacturing PMIs peaked in late 2017. At the time, many economists and reporters came up with excuses for the slowdown. You may remember discussion of Chinese auto subsidies and low river levels, but the decline proved to be far more persistent than most economists expected. The U.S. Manufacturing PMI numbers, however, continued to show rapid expansion (as high as 60) through much of 2018. Even after the U.S. PMI started to fall and some of the components such as employment and new orders looked weak, it remained above 50 and still showed expansion in the sector. This would seem to indicate a decoupling between the U.S. and Europe/the rest of the world. That remained true until last month when a disappointing release finally brought the U.S. number into contractionary territory and fell even further to 47.8 on Tuesday. Equity markets sold off sharply. 4 4 Close It was not an end to American stock market exceptionalism. Markets around the world were down.

The stock market reaction may have been strong in part because the PMI was well below the critical fifty line, but the economic case for the manufacturing PMI’s relevance is somewhat muddled at this point. 5 5 Close There are some survey and methodological differences between the U.S. and European PMIs. Markit, which conducts the EU PMI, also does a U.S. one, but it is less used by market participants. A chart of the U.S. Markit number instead of ISM, for comparison, looks much less dramatic and shows much less of a lag, but it is still there. Many years ago, when the U.S. economy was dominated by goods production, it seemed more likely to be relevant. Not only was manufacturing a large chunk of activity, but it was also the most cyclical component because of inventories. Economists could create a simple model of expansion and contraction as companies built inventories and then liquidated them. It’s more difficult to make the case in an economy dominated by services that manufacturing is the driver of the business cycle. Credit and issues in the financial system seem more likely the causes of economic volatility while manufacturing is more reactionary. 6 6 Close It is worthy of note that the market reaction to the Manufacturing PMI was much stronger than the reaction to the weak Services PMI two days later. That may be because services are still above 50, but more likely because markets are more concerned about the global manufacturing slowdown and trade as risks. Sources: Bloomberg and Institute for Supply Management.

It may be that the breadth and simplicity of the numbers may lead investors to overestimate the PMIs’ predictive value. Strategists frequently put out reports saying the PMIs are telling us this or that about the future of the economy or asset prices. Our internal research indicates that PMIs, while they may have some predictive value, tend to lag fixed income prices rather than lead them.

If Manufacturing PMIs are only very good concurrent indicators and not magical leading indicators, it seems odd that equity markets took the weak release so badly. 7 7 Close This is not to say it shouldn’t have market impact as it was a negative surprise. It is just the magnitude of the move seemed out of proportion to the surprise. It may relate to the general fragility of the economy and current politics. There is already concern about the effect of tariffs on the U.S. economy, but so far evidence in the data is only circumstantial. Manufacturing is sensitive to trade both because goods are generally more easily exported than services and because they often have complex international supply chains. The ISM may be an early sign that trade is starting to take its toll on the U.S. economy. On the positive side, if that is the case, then a trade resolution should help reverse the decline.

There has been some talk about increased sensitivity to macro data because of the upcoming election. The basic argument is that a weaker economy will help candidates who promote higher taxes and increased regulation or are just generally market unfriendly. It is difficult to prove or disprove this theory except to point out that markets have a poor track record in pricing voting outcomes. 8 8 Close 2016 was a particularly bad year for that. It would seem unlikely to see such big moves this far in advance of an election.

In evaluating the market reaction, it may help to think about the economy like a simple PMI. If the economy is expanding, it’s good for stocks. If it’s contracting, that’s bad for stocks. The fear has been that the weakness in the global economy could bring the once immune U.S. economy into recession. The ISM PMI reinforces that fear. There was one thing peculiar about the reaction. In recent months, equity markets have at times been able to shrug off bad data and news because investors believe that the Fed can offset the economic weakness, but that was not the case on Tuesday or Wednesday. 9 9 Close The market implied odds of another interest rate cut this year by the Federal Reserve increased after the disappointing ISM Manufacturing PMI data. Equity markets were not solaced by the increased likelihood of further accommodation. The S&P 500 Index fell 3% from the close on 9/30/19 to the close on 10/2/19. Source: Bloomberg. For some reason equity investors don’t seem to think the Fed cares about manufacturing surveys as much as they do or that the Fed will be unable to prevent recession. This behavior may not continue. For this market to lose faith in the Fed’s ability to support asset prices would be something exceptional.

What We Are Watching

Fed Chair Powell Speech (Tuesday) and FOMC Minutes (Wednesday)
Federal Reserve communication will be in focus next week as Chair Powell speaks in Denver on Tuesday and the minutes of the September FOMC meeting are released on Wednesday. Powell will have an early opportunity to set up expectations for the October meeting, with current market pricing implying high odds of a rate cut. It will be interesting to hear the Chair’s take on weaker U.S. data, including this week’s poor PMI readings. Thus far, the Fed has continued to express confidence in the U.S. economy, and has characterized its recent rate cuts as a mid-cycle adjustment tied largely to trade uncertainty. In that context, the September round of economic projections showed a committee divided over the need for further rate cuts. But with high-profile business survey and consumer confidence data now softening in the U.S., the narrative behind the easing cycle may change. If Fed communications this week indicate such a change in narrative, it could weigh on the U.S. dollar and boost fixed income.

U.S.-China Trade Talks (Likely Thursday and Friday)
Since the U.S.-China trade dispute began to escalate early last year, there have been a few periods of optimism that the conflict might be moving towards resolution. In recent weeks, the negative growth impacts of the trade war have become more evident in economic data. At the same time, expectations have risen that resumed negotiations might soon lead to de-escalation. In September, equity markets responded favorably to announcements that the U.S. would delay certain tariff increases and that China would soften some barriers to U.S. agricultural imports. This week, Chinese Vice Premier Liu He is expected to travel to the U.S. for a new round of trade talks. If these negotiations lead to additional signs of progress, such as further tariff delays, risk sentiment in financial markets could receive a boost. Actual reductions in tariffs or removal of existing trade barriers could generate an even more positive response. Conversely, if talks break down once again, investors may fear continued deterioration in global manufacturing activity.

Canada Employment Report (Friday)
The September employment report will be one of the major economic data releases prior to the Bank of Canada’s October 30th meeting. While the market is currently pricing a rate cut as the most likely next move from the Bank of Canada, the odds of a cut at the October meeting are still low. Canadian economic data has generally been positive in contrast with signs of deeper slowdowns elsewhere across the world. Labor market data has been one of the key bright spots, with the latest data for the month of August showing an upside surprise in both jobs gained and the labor force participation rate. Wage data for August surprised to the downside, however, this followed a streak of seven months of upside surprises. 10 10 Close Surprises in economic data are relative to the median estimate of economists surveyed by Bloomberg. A further downside surprise in wage data or a negative surprise to headline job growth could increase the odds of a Bank of Canada interest rate cut in coming months.


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