investment viewpoints
Should markets fear the services slowdown?
Growth in the services sector has taken a downwards turn. Can the improving manufacturing alone sustain US economic growth? In this weekly installment of Simply put, we assess the likely impact of a slowdown in the services industry on markets.
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Slowing services
US manufacturing has been slowing down for nearly a year, although recently there have been signs of an early recovery. That has led some to hope that the worst may be behind us, and the underlying components of the September data continue to suggest this may be the case.
At the same time, the US ISM Services Purchasing Managers Index (PMI eased in the third quarter. Market economists generally concentrate on manufacturing as it is usually the most cyclical sector of the economy. However, this time could be different, and the strength of the service sector could matter more to markets.
Different trajectories
US manufacturing took another step towards recovery in September, with the US ISM Manufacturing PMI posting its highest reading since November 2022 at 49. This was up from 47.6 in August. The sector is considered a leading indicator of economic trends as it shows a marked sensitivity to the economic cycle, and most investors have been focused on these numbers in recent months.
September was the 11th consecutive month in which the manufacturing ISM remained below 50, which should indicate a contraction. Despite the recent improvements, this is the longest sustained contraction since the 2007-2009 Great Recession, and the fact that manufacturing has been contracting for nearly a year without a broad economic downturn is noteworthy. In the meantime, the US services sector is showing signs of weakness. The US ISM Services PMI decreased to 53.6 last month, from 54.5 in August. This indicator tends to be stickier and less responsive to rate hikes than its manufacturing counterpart, with a value of above 50 meaning growth.
One reason why the ISM gauges are among the most closely followed economic indicators is because of their strong correlations with GDP. And they are typically released early each month. Figure 1 charts the manufacturing and services PMI data with corresponding GDP components on a quarterly basis. The correspondence between year-over-year variations in GDP and their ISM looks strong: the services survey decline places the service sector on course to deliver close to zero GDP growth, while manufacturing should generate about 1.5%.
This isn’t brilliant, but it’s not bad. However, we all know the saying: ‘the market is not the economy’. So what happens to markets when the services industry slows down?
FIG 1. Manufacturing and Services PMI correlations with GDP, YoY
Source: Bloomberg/LOIM. For illustrative purposes only.
What happens to markets when services slow?
How have markets previously reacted during a services slowdown? The responses of equity and fixed-income markets to three scenarios – a manufacturing downturn, a services slowdown, and a combined contraction – are depicted in figure 2, covering during the 1990-2023 period.
During manufacturing downturns, the impact on equities and bonds has often been pronounced. Deteriorating corporate profits typically lead to declining stock prices and lower yields. The situation is a bit different if only the services sector contracts: there has typically been a limited impact on bonds, and still a negative one for equities, but one that is less painful. Therefore, in recent decades, a services recession is less harsh on markets than an industrial one.
The most concerning outcome is when both sectors deteriorate in tandem. Equities show an average fall of about 40% and fixed income down almost -3%. This potential outcome likely represents a blind spot for markets at the moment – and a risk to the currently priced-in ’soft landing’ scenario .
FIG 2. Market responses to manufacturing and services downturns, 1990-2023
Source: Bloomberg/LOIM. For illustrative purposes only
| Simply put, US manufacturing data are improving – in contrast to the US services gauge. The economy may well show resilience, but it is important not to underestimate how the slowdown services slowdown could weigh on markets. |
Nowcasting corner
This section gathers the most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises. These indicators keep track of the most recent macro evolutions that make markets tick.
- Growth: our growth indicator has shown expansion over the past week, as a consequence of stronger consumption data in the US and China
- Inflation: our signal rose slightly, reflecting the rebuilding of inflationary pressures in the US
- Monetary policy: our indicator has remained steady, still showing the consensus that monetary-policy surprises are currently a low risk
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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