Signs of weaker growth are less worrying than they first appear

A broader swathe of economic indicators — of the recent past, present and future — have fallen to indisputably weaker levels than at any time since the 2008 global financial crisis. That means we have more reasons than at any time over the past decade to be worried about the outlook for the US and global economies over the next 12 months.

For example, US industrial production is contracting quarter-on-quarter (figure 3). The volume of Korean exports is also contracting, as are orders of Japanese machine tools and global sales of microchips. The German manufacturing Purchasing Managers’ Index (PMI) — a much-watched measure of business confidence — is below 50 (commonly seen as the threshold between ‘boom’ and ‘bust’), as are a number of other manufacturing PMIs around the world.

Don’t cash in your chips

However, we shouldn’t infer from these signals that it’s time to cash in the chips. A mild contraction in many of these indicators is not actually unusual. Quarterly US industrial production growth has been negative five times now since the recovery began in 2009, sometimes for prolonged periods. This is the third time Korean export orders have shrunk; the same goes for Japanese machine tools orders and global microchip sales. It’s the fourth occasion that the German manufacturing PMI has crossed below that boom/bust threshold. The fact is, just below 50 isn’t actually consistent with bust.

Since September 2018, we’ve been noting that slowing economic momentum meant that it made sense to be positioned defensively within equity markets, while still preferring them over bonds. The bottom line is that we believe these weak indicators and the poor macroeconomic momentum they point to are reason to maintain this bias. They are not yet indicating that this is likely to be more than a mid-cycle slowdown and that a recession within the next 12 months is more likely than not. And so it’s not yet time to get out of equities and hoard cash and cash-like bonds. For sure, a recession may turn out to be the way we’re heading, but such a conclusion — at least from the business cycle indicators per se — is not currently supported by due analysis and hypothesis testing.

Moreover, in combination, the most anticipatory economic indicators of recession — those that help us assess the risks to growth over the next 12 months — are yet to send a recessionary signal. These indicators include the yield curve, the inflation-adjusted growth rate of money supply (the stock of money readily available to spend), and the difference between real interest rates and the ‘neutral’ rate of interest (all for the US). They regularly signal a recession well in advance of the peak in equity markets — five months on average since the 1960s — giving investors ample time to reposition. In other words, there is rarely any need to jump the gun by trying to anticipate the already highly anticipatory indicators.

Of course, we are vigilant of the risks and remain cautious. Business cycle indicators only take us so far and we need to ask what they are not telling us as much as what they are. The intensifying trade war makes many of us especially nervous, as we have written about many times since before Donald Trump became US President. Yet at the same time, there are also upside risks to equities. The Federal Reserve has pressed pause on its rate tightening cycle, China is likely to add further fiscal and monetary stimulus and, finally, equity market expectations are already quite depressed. In other words, despite the weak data, there is a risk that equities could rise as well as fall.