This week’s inversion of the U.S. bond yield curve, a phenomenon with a strong track record of foreshadowing recessions, has forced equity investors to acknowledge that an economic slowdown is upon us.
Investors’ main hope now is that central banks’ moves to reduce borrowing costs will spur a recovery of growth in the short term. Otherwise, a much deeper plunge in stock prices than this week’s volatility is likely.
Equity markets on Thursday reflected anxiety over the dependence on central bankers: North American indexes seesawed between gains and losses, before ending with only minor moves. But the bond market continued to send clear and ominous signals of slow growth, or possible economic contraction. The yield on 30-year U.S. Treasuries fell to less than 2 per cent for the first time ever, while the benchmark 10-year note dropped to a three-year trough.
“Investors must decide if the Fed can deliver the growth needed to justify current or higher [stock] prices," Morgan Stanley U.S. equity strategist Michael Wilson said in a recent note.
In Mr. Wilson’s view, current growth levels for the economy and earnings do not support stock prices as high as they are now. If a recovery doesn’t materialize, market prices will adjust lower for deteriorating fundamentals for companies. He’s predicting a drop of 10 per cent sometime this quarter.
"Given the very broad and steep decline in many leading indicators and corporate earnings growth, I’ve made the case that we are far from mid-cycle [stage of the bull market] and closer to end-of-cycle,” he stated.
U.S. economic data released this week have been mostly positive, including a report released on Thursday on retail sales for July that showed a 0.7 per cent monthly increase, more than double what economists had expected. But elsewhere, the slowdown continues, judging by economic data released this week. In China, industrial production growth fell to the lowest level in 17 years, and Germany’s numbers indicate that Europe’s largest economy actually contracted in the second quarter.
For investors, portfolio risks will continue to rise until a better growth materializes. Here are two charts to help assess the investment backdrop.
The first chart depicts the year-over-year change in the JPMorgan Global Manufacturing Purchasing Managers’ Index (PMI) and the U.S. PMI Manufacturing New Orders.
The JPMorgan index has provided a key indicator of global business activity and the annual change has been closely correlated to industrial metals prices. Year over year, the index has been mired in negative territory since the summer of 2018.
Manufacturing new-orders results are among the most effective leading indicators of the U.S. economy. The year-over-year growth rate for new orders has been declining since 2017.
PMI data are vital during periods of market volatility. Investors should tread cautiously until a clear uptrend is visible on both lines.
In a report released on Tuesday, UBS market strategist Francois Trahan used 20 years of market history to show that “buying the dip” strategies – adding to portfolio equity holdings when indexes decline significantly – are “a losing proposition” when PMI indexes are falling.
The second chart presents the MSCI Cyclicals minus Defensives Index, which measures the relative performance of U.S. economically sensitive stocks against those such as utilities and consumer-staples companies that are largely unaffected by changes in the economy. A rising line indicates that economically sensitive stocks – which includes commodity investments – are outperforming defensives, and implies optimism on future economic growth.
The trend on the chart has been generally positive for all of 2019, although with a steep downdraft in April and May. More recently, a significant decline has occurred as investors shifted money to the defensive stocks that benefit from rapidly declining bond yields.
As with the PMI New Orders index, equity price trends can be a leading indicator of economic growth.
Further declines in the JPMorgan index would cement pessimism on growth prospects for the United States and the limited number of other countries – such as Canada – where the economy remains resilient.
The consensus view, based on the average economist and analyst forecasts for the second half of 2019 and for 2020, is that the global economy, at least for now, is in the midst of a temporary slowdown. There’s optimism that central banks will come to the rescue. More than 30 central banks around the world have already cut interest rates this year, and the U.S. Federal Reserve is widely expected to cut them again next month.
If this is the case, then profit growth will resume and investors have little to worry about. But Morgan Stanley’s forecast suggests the imminent end of the market cycle and post-crisis market rally. This requires investor action to take profits, reduce risk and batten down the hatches for a sustained bear market. These two charts should help investors decide.
Manufacturing indexes
Year-over-year percentage change
JPM Global PMI Manufacturing Index
US PMI Manufacturing New Orders Index
30%
20
10
0
-10
-20
-30
2017
2018
2019
MSCI Cyclicals Minus Defensives Index
1,200
1,150
1,100
1,050
1,000
950
900
850
800
750
2017
2018
2019
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW
Manufacturing indexes
Year-over-year percentage change
JPM Global PMI Manufacturing Index
US PMI Manufacturing New Orders Index
30%
20
10
0
-10
-20
-30
2017
2018
2019
MSCI Cyclicals Minus Defensives Index
1,200
1,150
1,100
1,050
1,000
950
900
850
800
750
2017
2018
2019
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW
Manufacturing indexes
Year-over-year percentage change
JPM Global PMI Manufacturing Index
US PMI Manufacturing New Orders Index
30%
20
10
0
-10
-20
-30
2017
2018
2019
MSCI Cyclicals Minus Defensives Index
1,200
1,150
1,100
1,050
1,000
950
900
850
800
750
2017
2018
2019
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW
Scott Barlow