investment viewpoints
Are markets pricing in manufacturing’s comeback?
A significant number of surveys are pointing to a recovery in manufacturing. This is usually the most cyclical sector of an economy, and many economists choose to dissect it to interpret the economic cycle. In this weekly edition of Simply put, we ask whether this recovery can generate an upturn in corporate earnings.
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On the rebound
After several months of contraction, the global manufacturing industry made a 180-degree turn and showed unexpected strength. Given this upturn, you'd expect the global economy to improve after months of lacklustre real growth. Where industry goes, everything goes, is the general consensus.
If so, are markets reflecting this in valuations? At this stage of the cycle, the confrontation between expectations and the reality of the economic situation should become increasingly important.
The manufacturing sector tends to demonstrate a large proportion of the major variations in the economic cycle. Market economists know this, which is why many of their signals have been flashing red (like ours) since January as conditions in the sector deteriorated, particularly in the US. This downturn was probably the most significant macroeconomic development of the year.
But the recent improvement in these signals should not distract us from an important question: if the decline in manufacturing has not created the long-expected recession, can its recovery single-handedly generate an upturn in corporate earnings? As the third-quarter earnings season gets underway, the answer to this question will quickly become crucial.
Pricing in recovery
For the time being, whatever leading economic indicator we look at (particularly in the US) shows a clear improvement in the outlook (see figure 1). The Atlanta Federal Reserve's famous GDPNow, which monitors US growth on a daily basis, has seriously improved, moving from growth of close to 2%, as seen in the first three quarters of 2023, to more than 5%. We can doubt the figure, but we can hardly doubt the trend.
Our own nowcasting indicator (in this case, the diffusion index) captures the same improvement. But we should beware of jumping to conclusions. Both these indicators are based on historical econometric analyses, and this history teaches us the importance of the manufacturing sector. But is this story still as relevant today as it was then, given the significant role played by the services industry in this cycle? It's hard to say, but it is a key question for navigating the waters of the next few quarters.
The question, in the short term, is whether the market downturn has already factored in this situation. If markets are already pricing in the worst, there is potential for investors to be surprised by any repricing as manufacturing continues to recover.
FIG 1. Growth indicators: the Atlanta Fed’s GDPNow and the diffusion index of LOIM’s Growth nowcaster
Source: Bloomberg, LOIM at October 2023. For illustrative purposes only.
The market scenario vs growth nowcasting
One way of answering this question is to compare two scenarios: one showing the growth implied by the economic data in our nowcasting indicators with the scenario that is currently driving market fluctuations.
While the translation of our indicators into US or European growth comes naturally, the scenario implicit in market prices is more difficult to produce. With the help of a few regressions, we can separate the effect of expected growth from the effect of changes in interest rates. With these interest rate and market changes confirmed, expected growth becomes the unknown in this mathematical problem.
Figure 2 shows the market's estimates of expected growth as a function of the levels reached by the S&P500 and Eurostoxx indices. It shows very clearly the coinciding phases of improvement and deterioration between the two indicators, in both the US and Europe. It also seems to suggest that this summer's market surge was perhaps more a matter of sentiment than fundamentals.
More recently, the market downturn seems to have coincided with a reconciliation between the two sources of information. It should not be forgotten that, with significantly higher interest rates, the neutral point for equity markets is probably already lower.
FIG 2. Implied growth scenario for the SP500 and Eurostoxx indices
Source: LOIM, Bloomberg as at October 2023. For illustrative purposes only. Past performance is not a reliable indicator of future results.
| Simply put, the recent abberation is behind us and the macro situation could stabilise in the coming months as manufacturing recovers. For the moment, growth is improving, while the cost of capital is rising. |
Nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.
This week, the key points are:
- Our growth indicator improved over the week. This improvement masks the clear deterioration signalled by US newsflow. We have seen up to 60% of data improving but this has share has dropped to 45%
- Our inflation signal continues to rise and has been driven by the US print last week
- Our monetary policy indicator rose marginally, partly as a result of the US data
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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