Was that this year's biggest buy signal for equities?
Chief analyst Bo Bejstrup Christensen estimates the equity market may have reached its final turning point.
Markets are worried. About China. About the emerging markets generally. About the impact of low commodity prices. About losses at US and European banks that may weaken their ability to supply credit to the rest of the economy. About low inflation. The list of worries is long. Can one economic key figure banish these concerns? Our answer is ... almost!
The figure we are referring to is the US ISM index for manufacturing. Every month the Institute for Supply Management in the US asks companies in the manufacturing sector a series of simple questions. Is your order book growing? Is your production rising? Are you hiring more employees? The results are collated in a single figure – and if the figure is above 50, the manufacturing sector is generally growing. If it is below 50, the sector is contracting. If the figure rises, growth rises. If the figure falls, growth falls.
The ISM has conducted its survey every month since 1948, and this one key figure has spawned a wealth of similar surveys around the world. In the US the figure is released on the first business day of the month. Hence, we have just received the observation for February – and equity markets received it very well, which may seem a little strange, given that the index still lies below 50, as it has done since October. But the index rose in February – by more than expected, and for the right reasons. Order books are growing, as is production. Inventories, meanwhile, appear to be heading for lower, and thus better, levels. Yields rose. Equities rose. The dollar rose.
One key figure above them all
But why is the ISM so important just now? Many – including myself – will point out that the service sector is clearly the more important sector in the US economy. Less than 10% of Americans are employed in manufacturing, and the sector accounts for less than 15% of total annual value creation in the US. And remember economic data do not really say anything about the future – only something about how things were yesterday.
Nevertheless, the ISM plays a key role for two main reasons:
First, the US is still the world’s largest economy by quite some way and its manufacturing sector is very global. That means ISM is the earliest and most reliable data point for the health of both the US and the global economy. Or put another way – since 1948, the average monthly price return (excl. dividends and buybacks) on US equities has been 0.7%, equivalent to the famous 8%+ on average per year. However, in months when the ISM falls, the average return is close to zero, while it is 1.3% on average when the ISM is rising. There are many ways to divide these phases of the economy, and we readily admit the ISM is not a perfect indicator. Rather, we use the historical outcomes to underline the following point: rising growth (rising ISM irrespective of from which level) is positive for risk assets and vice versa.
Naturally, the challenge is to predict which direction the ISM will move in, which is precisely what we work on every day. And right now this is more relevant than it has been for a long time, because global manufacturing is struggling – struggling so much that many in recent months have pointed to this data and said we are already in a recession. The financial markets have to some extent already anticipated the misery and priced in some probability of low growth or recession. In other words, equity prices have fallen. Now, however, this fear suddenly looks less warranted, as a turning point is now indicated instead. Growth is undeniably low, but at least it is beginning to bottom out – and perhaps even rise. Hence, some of the probability of recession has to be removed, and so prices have to change.
Negative shocks will not last forever
Second, the manufacturing sector plays a much bigger role for the companies we invest in. Looking at, for example, the US equity market, manufacturing companies account for more than 50% of earnings and are therefore very different to the overall economy.
The manufacturing sector has been hit by the stronger dollar, knock-on effects from low oil prices – which have for example depressed investment – and weak demand from China and other emerging markets. We have already pointed out that none of these factors can last forever. At some point companies will adjust to the stronger currency, etc. – and when that happens they will begin to be more optimistic about the future and find new business opportunities elsewhere. Hence, an improved ISM signals a potential return to earnings growth, so suddenly the future looks somewhat brighter.
However, we are not out of the woods yet. Geopolitical risk is high on the agenda given the upcoming EU-membership referendum in the UK, the refugee crisis in Europe and the situation in the Middle East. We are not claiming the ISM will rise in a straight line from here – and nor will equities. But – and we are saying this without belittling any of these major political events – these types of challenges will always exist. Think Cold War. Think North Korea. Think how long the Middle East has been in turmoil. In the end, the world gets used to these challenges, and then it is the economic numbers that matter – and one of the most important of these is the ISM.
We are holding onto our equities
Our story is simple – the financial markets have overreacted in the opening months of the year. That is why prices are off. Moreover, the bank system and the housing market will support growth in the US. And as we get more clarity on the losses in the energy sector, companies get used to the stronger dollar and the worst shocks from China dissipate, earnings growth will return.
Put the two together – more attractive prices and the prospect of moderate earnings growth – and we have a positive scenario for global equities.
So far, 2016 has been a difficult investment year for many reasons, but if we are right, the worst is now finally behind us. That is the story we are telling. And that is also the story the ISM is beginning to confirm. We are therefore holding onto the equities we bought when we increased our equity weighting at the start of the year. Our expectation of further improvements in the US manufacturing sector may make upping the weighting of US cyclicals worth considering.