Philip Lawlor, managing director and head of global markets research
The rapid deterioration in leading indicators this year has cast a pall over equity markets and kept their performance relative to bonds in check. However, with financial conditions easing globally, are markets now underestimating the potential for the economic data to improve?
Deterioration in US data on a par with 2001
Consensus forecasts look for the world’s largest economies to continue losing momentum next year and for only a modest pickup in growth in 2021, while still not pointing to recession.
In the US, an economically weighted ISM1 composite index (skewed more heavily to US services than to the smaller manufacturing sector) has tumbled to levels that have been historically consistent with zero US GDP growth. While recession is not in the forecast, signs that weakening global manufacturing may be spilling over into services suggest that further cuts to GDP estimates may be in the cards. However, given how rapidly economic data has deteriorated, the question now becomes how much lower can leading indicators go? The chart below plots the Z-scores (or standard deviations from the long-term average) of six-month changes in the US Manufacturing Index and the Eurozone Economic Sentiment Indicators. On this basis, the US composite has reached a two-standard-deviation correction, on a par with the downturn seen in 2001.
Financial conditions provide a tailwind
As we’ve written in a prior blog post, there is one major difference between today’s economic backdrop and that of the period preceding the 2007-2008 recession. Reinforced by synchronous central-bank stimulus, financial conditions are accommodative globally, with futures markets forecasting even further loosening. A decade ago, the Fed was hiking rates and government bond yields were rising.
At around 3 (the neutral level) and lower, FTSE Russell Financial Conditions Indicator (FCI) scores2 have fallen significantly across the major economies since peaking nearly a year ago. As the chart below shows, scores have eased most significantly for the US and UK, and only modestly in Japan and China.
As noted above, big declines in market rate expectations and bond yields have been the main drivers over this period. Overnight indexed swap rates have resumed falling, offsetting an earlier uptick in response to a brief spike in oil prices.
The modest pickup in real M2 money supply and the Fed and ECB’s decisions to reverse their balance-sheet drawdown programs have also played a role in bringing FCIs lower. Though not a resumption of quantitative easing (as in the case of the ECB), the Fed’s recent announcement that it would begin buying short-dated debt at least through January could lead to modest balance-sheet growth.
Time for a new calculus?
Lingering and difficult-to-model uncertainties surrounding US-China trade talks and geopolitics remain risks to the global economic outlook, even if forthcoming data proves less bleak than some now fear. Moreover, current forecasts for a robust global EPS growth recovery bear scrutiny given continued headwinds from slowing GDP growth and inflation, and with forward PE multiples above 10-year averages across most major markets.
1 Institute of Supply Management
2 To gauge the extent of changes in financial conditions across the regions, we use a Z-scoring methodology that compares the current reading of each variable against its longer-term average, measuring these divergences in terms of standard deviations, which are clustered into bands 1 (loose) through 5 (tight).
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