Cause For Optimism

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

The case for a widely anticipated rally in risk assets, carried by improving economic data in the second half of the year, received support on Friday from June manufacturing PMI releases across the globe. While most PMI surveys surprised to the downside, continuing a trend in place since May this year, the US survey put in an unexpected bounce, suggesting growth acceleration at the end of the June quarter.

The more bearishly inclined commentators point out most of the surprise is related to a build-up in inventories, which is true. But there were enough positives underneath inventories and the headline PMI number to encourage most economists across the globe that the slowdown in global economic momentum is approaching its bottom for the year. Is it still possible the China PMI will dip into negative territory this month (below 50)? Yes, that definitely remains possible. In addition, underlying momentum seems to be deteriorating rapidly in India. Brazil's PMI dipped below 50 in June. And Russia needs a quick pick-up in energy and materials prices to avoid following Brazil into negative territory.

All in all, however, general consensus seems to be that between Friday's releases and early September (at the latest), we should see a turnaround in most monthly PMI releases (manufacturing and services) alongside other economic data such as employment in the US. This will provide risk assets once again with a platform to do what they do best once risk appetite returns: rally towards higher price levels.

Before we all get too excited about potential gains that may be ahead of us, let's have a closer look into where this lift in market optimism stems from. June started off with two extremely weak regional PMI surveys in the US, fueling expectations the sharp deceleration witnessed in April and May was continuing for at least another month. Only two weeks ago some economists were suggesting the June manufacturing PMI for the US could well print an outcome below 50, which would likely have marked an historically unprecedented sharp decline from an extremely positive reading of 61.2 in March to a negative reading below 50 reading only three months later.

No doubt, this would have sent shivers along the spines of even the more bullishly inclined equity specialists, along with repeated predictions of an imminent recession ("double dip") and calls for more quantitative easing from the Federal Reserve (QE3).

One surprise later, however, and some experts dare to again come out of the closet with predictions of double digit gains for equities by year end. This, once again, just goes to show how powerful these monthly PMI surveys are. I have lined up some of my past analyses and commentary on monthly PMI surveys at the bottom of this story. Feel free to re-read for a better understanding and insight as to why.

Regardless of the unexpectedly large impact from rising inventories, the US June manufacturing PMI has provided a boost to market confidence that growth is ready to re-accelerate. This is because several components of the national PMI index that are directly linked to economic growth showed strength in June, including the employment index, the new orders index and the production index.

As indicated previously, while the US survey suggests a turnaround in the underlying trend is materialising after a few months of rapid losses in economic momentum, it was mostly still "weaker than expected" for the rest of the world. Economists at JP Morgan, who compile and analyse a global PMI every month, spelled it out late on Friday:

– Only five of twenty-two regional indices showed improvement (including the US and Australia)

– The Euro area manufacturing PMI fell 2.6pts to 52.0, the lowest level since 2009

– The German index slid more than 3pts to 54.6, a multi-year low. German new orders sank 4.4pts to 51.5, marking a nearly 10-pt drop since April (there were more surprisingly weak readings elsewhere in Europe)

– China’s reading of 50.1 (HSBC) marks the lowest level since last July

– Taiwan’s reading showed a loss of 5pts to 49.9 (below 50, albeit only just)

– Russia's index now sits at 50.6

– Brazil's index fell to 49 (in negative territory and the lowest level for nearly two years)

JP Morgan's Global PMI has now declined from a peak at 57.4 in February to 52.3 in June and "new orders" and "export orders" are barely positive on a global scale. Yet, JP Morgan economists (as well as others) see three good reasons to remain positive on the underlying trend overall, because:

– some indices turned positive, like in the US and in Australia (with positive key components)

– the pace of deterioration in key countries such as China seems to be slowing, fueling hope we are "bottoming"

– the global slowdown is having the expected downward impact on input prices and inflation

It is this bottoming process that will have to be confirmed in the weeks ahead before investors can start dreaming about another sustainable rally ahead. Historically, these monthly manufacturing PMI surveys have a strong correlation with global trends in industrial production, hence why so many pay attention when looking for guidance on demand for energy and natural resources.

Other factors that seem poised to assist in the anticipated turnaround in growth momentum are a V-shaped recovery in post-Fukushima Japan, a pick-up in momentum for global car manufacturers (assisted by the Japanese recovery), a bounce in regions that earlier in the year suffered from natural disasters (Australia, New Zealand, et al) and an anticipated improvement in consumer spending worldwide as the price of oil is no longer at US$126/bbl.

With regards to the price of oil, it has been widely noted the coordinated release of 60m barrels from IEA reserves has not stopped Brent oil returning to US$112/bbl. Nevertheless, this should still leave global companies and consumers with welcome relief from pressures that emerged in the early months of the year. How sustainable this relief will prove to be will be answered by oil price movements during times of increased risk appetite.

For Australia, the rise in the AIG/PWC PMI by 5.2 points to 52.9 in June, marking the first gain since February, suggests a bottoming and recovery is in process. Note, for example, the "new orders" component rose by 6.0 points to 54.6, driven by construction materials and basic metals. At the same time, alas, other data remain sluggish at best. On Monday, ANZ Bank economists confirmed recent research conducted by UBS in that Australia's labour market seems poised for negative surprises in the months ahead. The underlying trend in monthly job advertisements turned negative in April, note the economists, and it has remained negative since.

This falls in line with anecdotal evidence from ANZ’s business customers indicating more limited hiring intentions due to mixed economic conditions. Comment the economists: Declining trends in job advertising historically have not been consistent with rising interest rates (and in fact usually foreshadow lower interest rates). ANZ has now officially delayed its timing for the next RBA rate hike to 2012.

At the same time, colleagues at Goldman Sachs warned clients industry feedback indicates discretionary retailers remain cum-downgrades as sales momentum has further deteriorated towards the end of the June quarter. In response, the stockbroker has downgraded its only two Buy ratings in the sector, David Jones ((DJS)) and JB Hi-Fi ((JBH)), to Hold. Over at BA-Merrill Lynch, media analysts have now taken the view weakness in ad spending might well last a good deal longer than widely assumed. The broker is predicting sluggish growth (low digits) for the next 18 months and has lowered forecasts and price targets across the industry.

Don't be surprised if the recovery takes a bit more time than hoped for, in particular for domestic oriented companies in Australia.

More on a possible weaker outlook for the labour market in Australia:

– Weak Labour Market Data, A New Trend? (June 29)

More on the correlation between ISM surveys and equities:

– Why It's A Tough Time For Equities (June 15)

– Why A Global Peak Could Be Near (March 10, 2010)

– Market Relativities (May 17, 2010)

– US ISM Manufacturing Index: The Charts (May 19, 2010)

(This story was originally written and published in the form of an email to paying subscribers on Monday, 4th July 2011).

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