Depressed data readings in major industrial economies have made many investors nervous, since they can serve as a warning for a recession. They also follow an inversion in the US yield curve which is the traditional bellwether signal for an upcoming slowdown.
However, there remains an important difference between gloomy manufacturing readings and the more optimistic view from the services sector which tends to be the leading indicator, says Scholten, a portfolio manager in the Robeco Global Macro team.
“Over recent months we have seen continuous signals of a weakening in manufacturing confidence,” he says. “The German Ifo index has reached its lowest level since 2012, the Chinese Purchasing Managers’ Index (PMI) has remained at depressed levels since December, and the US Institute of Supply Management (ISM) manufacturing index even dived two points below the neutral level of 50 in September.”
“It is clear that manufacturing is cooling globally, and this raises doubt about the prospects for the wider economy and equity markets.”
However, the data doesn’t entirely agree with each other. “In the US, for instance, recent ISM data have declined, but continue to show divergence between the manufacturing and the non-manufacturing (or services) data,” Scholten says.
“The manufacturing index tumbled below 48 and landed at its lowest level since June 2009 (at 47.8). The services PMI has slowed as well, but still remains above the neutral level of 50 (at 52.6). The same was visible in 2015-2016, when manufacturing confidence was close to current levels, and the services ISM remained above the neutral level. The gap between the two is now equally large as it was in October 2015.”
“The easiest conclusion from this divergence is that the services sector is apparently still in a better shape than manufacturing. But this divergence obviously raises questions such as ‘which ISM is leading’ and ‘what does that mean for riskier assets going forward’?”
“The ISM manufacturing index tends to get more attention than the services index, probably because it has a longer history, and there is a perception that it has stronger characteristics as a leading indicator. Therefore, the knee-jerk reaction to any plunge in the manufacturing index would be to assume that the services index will also dive below 50. But how valid is this belief?”
To try to find out, a chart was plotted that tried to predict the change in the ISM services index three months out, using the manufacturing minus non-manufacturing index differential. But no clear relationship emerged from the data.
Turning this around, a second chart was plotted to test the predictive power of the differential for the manufacturing index three months out instead. This sought to discover whether a strong signal from higher confidence in services suggested that the less-confident manufacturing ISM index could recover.
“This relationship seems stronger: on several occasions, a positive divergence between the levels of confidence in services and manufacturing was a prelude for a rise in the manufacturing index,” Scholten says.
“We then did a regression analysis on the leading characteristics of each series. This confirmed that when there is a large divergence between the ISM manufacturing and services indices, there is a higher chance that manufacturing will follow services’ lead than the other way around.” The results are shown in the chart below.
So, what does this mean for riskier assets? “We have tried to answer this question by looking at the historical returns of the S&P 500 index and the development of US investment grade credit spreads in previous episodes of a negative divergence of at least five points between ISM manufacturing and services,” Scholten says.
“This occurred in Q2 2015 and Q4 2012: we have identified seven of these episodes since 1995. During these divergence periods, there is some negative impact visible in equity returns. The average year-on-year index return of the S&P 500 tends to cool down from about 9% in the six months prior to the divergence to 1% six months after the divergence started. However, the period of moderation in returns has on average been brief; 12 months after the divergence started, the average S&P 500 return is back at 5%.”
“A similar sort of pattern can be seen in credit spreads. In past episodes, the warning signal from the ISM manufacturing index coincided with a widening of US investment grade credit spreads. But excluding 2008, the average widening remained limited to about 20 basis points after six months.”
The final question is whether investors should therefore ignore the warning signal from the ISM manufacturing index, because the services index is in better shape. “Not entirely,” Scholten warns. “First of all, the manufacturing sector continues to have a sizable influence on the volatility of economic data. The inventory correction currently taking place in the US is a nice example.”
“In addition, we did see from past data that these warning shots from the manufacturing index coincided with a cooling of equity returns, and a widening of credits spreads. The more optimistic conclusion from the historical data is that the decline in manufacturing confidence to current levels was often not followed by similar weakness in services, and that in previous examples, the weakening in asset returns following an ISM divergence was limited in its timespan and magnitude.”
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