On predicting the US and European cyclical economic outlook

As I mentioned in an earlier post on Europe, a slew of manufacturing data was released today. When I wrote the first post, Europe and Asia had been released but the US had not. SInce then, the US numbers came out showing a shock contraction. Here are some thoughts on the numbers overall. I have three threads to discuss: data analysis, second derivatives, and secular patterns.

Read the first post to see the PMI and links to data for Europe and Asia. My general tone there was upbeat. But I do have some caveats.

Here is what has been posted by Markit on twitter on the North American and global data since then:

• Global manufacturing growth and oil prices charted since 2005 #PMI https://twitpic.com/cv3dsn 
• Research note on Global manufacturing #PMI data added to our commentary site: https://bit.ly/13giuxE 
• The JPMorgan Global Manufacturing #PMI posted 50.6 in May, up from 50.4 in April. PR here: https://bit.ly/14bgmIB 
• Mexico Manufacturing #PMI remains at lowest level since data collection began in April 2011(51.7). PR here: https://bit.ly/10LM7Hn 
• Canada’s Manufacturing #PMI rose to an 11-month high in May, posting 53.2 (April: 50.1). PR here: https://bit.ly/11z4QkH 
• HSBC Brazil manufacturing #PMI falls for fourth successive month in May, but remains in positive territory (50.4) https://bit.ly/17RBmIp 
• MARKIT U.S. manufacturing sector final #PMI for May: 52.3 vs flash reading 51.9 and 52.1 in April. Full PR here: https://bit.ly/15v8rVp 

The numbers in North America and Brazil were poor compared to the numbers in Europe despite the fact that they were higher. Markit’s numbers for Canada and the US were relatively good but Mexico and Brazil’s numbers were poor. The US ISM manufacturing PMI, which is what I generally follow, was poor. If you combine this with the Mexican and Brazilian data, you get a different reading on the Americas.

Here is what the ISM wrote (emphasis added):

Economic activity in the manufacturing sector contracted in May for the first time since November 2012, and the overall economy grew for the 48th consecutive month, say the nation’s supply executives in the latest Manufacturing ISM Report On Business®.

[…]

WHAT RESPONDENTS ARE SAYING …

• “Customers are anticipating resin price decreases and holding back orders.” (Plastics & Rubber Products)
• “Slight uptick in overall business but not substantial.” (Textile Mills)
• “Government spending has tightened, which has moved out program awards and caused some reduction in force.” (Computer & Electronic Products)
• “Market outlook is relatively flat, with some promise of raw materials inflation relaxing.” (Electrical Equipment, Appliances & Components)
• “General economy seems sluggish and pensive. Buyers are not buying much beyond lead times.” (Fabricated Metal Products)
• “Downturn in European and Chinese markets is having a negative effect on our business.” (Machinery)
• “We are having a difficult time hiring skilled employees.” (Transportation Equipment)
• “Business continues to increase, but over the past 20 days we have seen the trend flatten.” (Furniture & Related Products)
• “Market was holding strong until mid-month — then softened.” (Wood Products)
• “Decline in sales for FYQ2 over same period a year ago due to softer demand [in] both domestic and exports.” (Chemical Products)

The overall tenor here is of weakening end demand and concern about future demand right across the board. My takeaway here is that the fiscal tightening has yet to have a significant effect. Last month I spoke to someone who works at the Department of Defense in budgeting and he told me that none of the sequester cuts are going to be substantial through September. The real whammy for the sequester will hit in Fiscal Year 2014 after September when the departments will be forced to make real cuts. We should keep this in mind in terms of the fiscal drag. The biggest effect of the fiscal drag in the US has been the payroll tax cut. The sequester has not been a significant headwind…yet. But it will be.

So this gets me to my next point about 2nd derivatives. As I mentioned in the last post, the 2nd derivative is what I care about in terms of gauging cyclical turns. When it changes direction, that is significant. A 2nd derivative shift essentially says the economy has stopped growing as quickly or has stopped shrinking as quickly. If this directional shift lasts for more than 1 or 2 months, you have a pattern – and that pattern tells you that the top or the bottom is in.

In Europe the second derivative is shifting from contraction to expansion. On the other hand, in North America and Emerging Markets like China and Brazil, the numbers are shifting in the wrong direction. In fact, I would say that all of EM is downshifting right now: Russia, Mexico, Brazil, China, India. All of these countries are putting up weaker growth numbers. If  weaker EM numbers combine with weaker North American numbers, you have a real problem. The US weakness is not a pattern yet but it will be important to pay attention to this from a global perspective. Notice the highlighted areas in the chart below.

Now, a reader asked me the following question via email:

I was wondering why in economic analysis the culture /character of a population doesn’t matter? even if austerity is relaxed, Italy is so corrupt that you have millions of people doing the wrong job so productivity is very low. italians do not accept reforms of any kind, especially pro-business reforms. most people think that it is the state who must provide work, and it is written in the constitution that people have a right to work.

Great question. This gets to the difference between cyclical and secular.

Sometimes I make some very serious complaints about economists managing their policy prescriptions to cyclical concerns only. I see the US recovery in this light; the US is being boosted by zero rates boosting asset prices via portfolio preference shifts, discount rate reductions and multiple expansion and it is also being boosted by a decrease in savings rates despite the sluggish jobs picture and weak wage growth. My macro secular view on this is negative. I believe that we will need to see catch up wage and job growth soon or this trend will be found out as unsustainable, precipitating another large deleveraging wave and carnage in asset markets and on bank balance sheets in the next recession.

But so what? From a cyclical perspective, it doesn’t matter. From a cyclical perspective, what does matter is that the second derivative numbers on economic data keep above zero. That’s all that matters cyclically. As an investor this presents you with a problem if the cyclical and secular diverge. It means you get caught up in the musical chairs asset-based economy dance that everyone else is playing – by definition. We have seen a massive run on shares in the US, for example. If you were out of the market, you can’t catch up now. You have missed the boat and will be permanently behind because the move was so large. Missing a bull market is a dismmissible offense.

So you have to rotate asset classes and sectors or investing strategies and move from cyclical to defensive or low to high beta depending on the circumstances. And this is what makes a secular bear market tricky to navigate. On the economic side of that coin, a country like Italy can certainly do better on a cyclical basis but the amplitude of that uptick is limited by the secular macro policy. So the answer to my reader’s question I believe is that secular policy does matter because it limits growth. But from a cyclical perspective what matters is second derivatives. And these can be pushed and pulled a considerable amount by cyciical policy. Just look at Europe versus North America.

Bottom line: Europe is moving back into recovery in my view. Though the recovery is still a way’s away, the second derivative uptick is most pronounced in Greece. The perma-bears will tell you otherwise. But the second derivatives are mostly moving up. The problem now is not Europe where the fiscal drag will weaken and numbers are already getting better; the problem is in the emerging markets and increasingly it will be in the US because of the fiscal drag and the likely removal of monetary stimulus. None of this has anything to do with secular ‘sustainability’ but it is important in terms of gauging when the next global downturn is coming.

From a secular perspective, PIMCO’s April post on the euro zone captures the more nuanced analysis:

Without individual member states implementing needed structural reforms and without political agents specifying and committing to a feasible destination for the eurozone’s governance structure, we believe the region will remain mired in stagnation reminiscent of Latin America’s lost decade in the1980s.

Looking ahead, we expect regional growth to be in a range of -0.75% to -1.25% over the next year, with the risk of high unemployment and bail-out fatigue disenfranchising its citizens from the benefits that a monetary union was supposed to achieve. The ECB can buy time, engineer lower interest rates and fix the fragmented market for credit. But without its political partners committing to a common destination for the euro that completes its fiscal architecture, we believe the ECB’s actions alone will not suffice.