Defying gravity…manufacturing, equities and beyond.

Even as Uncle Sam’s image is a little tarnished, the US remains the bellwether stock market and is, as a result vitally important to us here in Australia and the outlook for our equities, markets and economies. Not to mention the most important transfer price in an economy, the Aussie dollar.

So the fact that the US equity market has, according to my Bloomberg charts, fallen 4 out of the past 5 weeks is a concern. This is in no small part a result of the fading outlook for the US economy as the stimulatory impact of the Fed’s actions diminishes. Last week was a particularly bad week for US data with employment incredibly poor so far into the so-called recovery. No wonder the USD is under such pressure and US interest rates are rallying.

So we wanted to spend a little time looking at one of our favourite series of indicators for the US economy and see if it can help us tell what the future holds for the US economy and its stock market. The ISM data (Institute of Supply Management) have rolled over significantly in recent weeks along with the regional Fed activity surveys. We’ll outline our argument below but suffice to say the outlook is not great.

Last week saw the ISM manufacturing index fall more than twice analyst estimates, from 60.4 to 53.5. This 6.9 point drop was the biggest monthly drop in over 25 years, that is it was bigger than any one month decline during the slowdown over the second half of 2008, during the depths of the GFC, when it fell 16.3 points over 5 months. Something is clearly amiss in the US economy.


If it were just the ISM telling us this we could be sceptical but as devotees of this data series we know to also closely watch the Regional Federal district manufacturing surveys.

These data had already flagged a large fall in the national index. With 2 of the five Fed regional surveys, Dallas and Richmond, indicating that manufacturing activity actually contracted in May as the chart below shows. In the remaining 3 regions, growth was marginal in two, Kansas City and Philadelphia while in New York the pace of expansion has halved.

Additionally the average of the five regional surveys is only 0.7, meaning the pace of expansion has all but stopped and it is only 2.4 points above the low set back in September last year when fears of a double dip recession where at their peak and rumours of QE2 were running rampant.


Casting our mind back to what occurred then, we see that it became necessary for the Fed to open its wallet and crank over the printing press for the second time, flooding the market with money and manufacturing activity then picked up once again. As noted by Janet Yellen last week and covered in our piece, this liberal dose of liquidity flooded asset markets driving the USD down, equities and commodities higher. But the recent weakness in the ISM, when coupled with the regional Fed surveys suggests that the last few weeks sell off is neither aberrant nor finished yet.

So let’s look at the chart below to try to gauge the implications of the ISM’s reversal. The movements in the ISM index have a clear co-incident relationship with the annual change in equity markets as seen below. The chart shows both the Manufacturing and Non-manufacturing index (which accounts for much more of the economy and fell sharply last month itself) against the annual change in the S&P 500. The correlation between the movements in the manufacturing index and the S&P is 0.73 or (73%) and very similar for the non-manufacturing index at 0.72 (72%).

However if we build a composite of the two indices with the non manufacturing given a 75% weight to reflect its relevance in the overall economy and a 25% weight to the manufacturing index the correlation rises to 0.76.


So a continuation of the weakness in the ISM’s is not a good sign for equity performance over the coming months. Clearly at some point equities can not just float on relatively free money and they must reflect the economic fundamentals in the US and Global economic landscape in which these companies do business.

For Australian’s, as this next chart shows if we are not highly correlated to the top side then the downside should be more protected than that which exists and is potential for US equity markets. But that is only true up to a point. If the US economy falls further and equities swoon and become a severe risk off environment. But hopefully Australian investors might be better insulated from any selling because we haven’t got as far to fall. But the risks are to the downside as we highlighted on Saturday’s Weekly Wrap and the ASX 200 is breaking down through support today. We like to use Tuesday’s as confirmation so we are only watching at present. 


Looking further afield for clues on the outlook there is a massive divergence between the bond and equity markets. Part of this was the aim of quantitative easing. That is, drive down other asset prices so that people make more speculative bets and take more risk so as to get the economy going. But on the evidence of the ISM’s, regional Fed survey’s, initial jobless claims, number of Americans on Food Stamps and Friday night’s weak non-farm payrolls you’d have to say that all QE2 has done is pump up the tyres of speculation and make the market more risky if something goes wrong.

That was the scary point we took from Janet Yellen’s discussion on leverage we mentioned above and again last week. Clearly, having rejected QE2 initially the chart below makes clear that bond traders have been factoring in a slower economy for some time, with treasuries rallying for the best part of the last month pushing yields lower.


Bond guys are worried about the return OF their money while equity guys fret about the return ­­ON their money. In who’s favour will the markets resolve? We think the bond traders. For the broader market whether commodities, equities, currencies or credit all the above suggests a growing instability. 

Our circumspection at present is reinforced and we think opportunities to buy at lower levels beckon over the coming months.


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