Monday, 1 October 2012

GLOBAL ECONOMY (October 1st 2012): Resurgent Global PMIs - Old Trend is Ending, But How Much is Already Priced In?

The global PMI reports released each month from Markit, ISM, HSBC and JP Morgan, all serve as key indicators in our view of global macroeconomics trends.


It has been global PMI data which has kept us most concerned this year. On February 22nd, coinciding with a breakdown in market breadth indicators, PMI reports from Europe started to reverse their 2011 recovery - something which had been key in triggering a market rally up to that point.

Next came Japan and China, who had endured a fragile 2011 - they both began to signal further deterioration in their economic activity as 2012 progressed. Finally, most recently, the US economy completed the set by slowing down dramatically this summer.

In spite of the market's optimism (fuelled by forward-looking solutions to this economic slowdown by central banks), we continued to cite the poor economic data - and expressed doubts over the Fed's willingness to launch QE3 before the US Presidential election. Once QE3 was announced, we acknowledged that the market could now "ignore" present conditions, feeling that the data would start to improve by the winter - while at the same time expressing the risk of market disruption if QE3 did not work by then.


So, with the market now "guessing" that QE3 will produce a positive outcome by the end of 2012, we're left waiting to see what the data does in the meantime. While we might be too early to see the effects of the Fed in today's ISM Report, the ECB's actions in the summer were greeted with satisfaction from the market -  are those actions being reflected in better economic data?

And what about the effect of the Euro dramatically strengthening against the dollar in recent weeks? Would it be negated by an improvement in economic activity? We take a look at data from some of the most important economies in the world:

Let's start with China - posted 47.9 in September, up slightly from 47.6 in August. It's still below 50 (deteriorating), and New Export Orders fell disastrously to multi-year lows. This is still quite a bit worse than earlier this year, and as manufacturing exports are a huge part of the Chinese economy, we have good reason to take notice. However, on a positive note, the trend hasn't gotten worse this month. We're not told anything new about the Chinese economy - it continues to slow, but neither more or less dramatically than last month. The more "official" version of PMI, released this morning, reflecting the same scenario.

Japan - improved to a three-month high of 48.0 in September (August: 47.7), although still below the 50 mark. The report cites the over-valuation of the Yen as a significant factor. Japanese PMI remains weak, without too much improvement. We can be encouraged that like China, it failed to make a lower low in that trend, but in both cases we will want to see another improvement next month.

Russia - improved to a four-month high of 52.4 in September, up from 51.0 in August. In shocking contrast to the rest of the world, this report argues the potential for monetary tightening in Russia. The report cites the impressive growing domestic demand within the Russian economy - and of course, the softening of any international trade slowdowns, courtesy of a robust energy export market. While we cannot really draw global conclusions from Russia's PMI reports, it is interesting to see a strongly-performing economy without as much correlation to the rest of the world.

Spain - improved from 44.0 to 44.5. The epicentre of ongoing European concerns, economic conditions in Spain are extremely relevant in 2012. August, September, and now October have seen very clear signs of improvement in the Spanish economy, from a very low base. Between mid-2010 and mid-2011, the Spanish economy stagnated. From mid-2011 onwards, along with the rest of the world, the Spanish economy worsened - at a very worrying rate of decline between March and July 2012. The improvements in the last three months show a justification for a rally that began with Mario Draghi and the ECB. The recovery in Spanish 10yr yields reflects this quite clearly - we will hope to see this recovery continue into 2013.

Italy - climbed to a six month high of 45.7 in September, from August’s mark of 43.6. The Italian economy has shown less convincing signs of recovery than Spain this summer, stagnating around the lows for 2012. While there isn't a "recovery trend" to speak of, this month's jump up to six month highs is reflective of the good news coming from peripheral Europe. While we don't wish to comment on whether ECB policy is "working", the data is certainly better in September than a few months ago.

France - recorded 42.7, down from 46.0 in August, the worst reading since April 2009. This is a frankly disastrous report. Worryingly for France, a lot of this was down to domestic woes, a loss of confidence in the French economy, and the postponing of new orders in France. This led to the backlog of work being severely depleted, a bad sign for the French economy going forward. Low demand in France can be attributed to many things, but low business confidence perhaps relates to French fiscal policy under President Hollande.

Germany - 47.4, up from 44.7 in August. In contrast to France, a massive improvement in operating conditions and business confidence, despite the strengthening Euro. A very strong report, including a commentary suggesting that perhaps the German economy has troughed in its negative 2012 trend. The improvement in confidence came mostly domestically, although with the rest of Europe still slowly recovering, this might not be much of a surprise. Almost all headline indicators saw an improvement - a very important sign for the German, European, and Global economy.

UK - edged lower to 48.4 in September, from 49.6 in August. A messy indicator, not helped by an independent currency, which has strengthened considerably against the dollar this month. The UK saw its sixth month of decline in new export orders, with Europe and China showing the weakest demand. The commentary cites Europe representing 50% of UK exports, particularly unfortunate in 2012, as their biggest customer struggles with confidence and demand. As with the trend in most of Europe however, domestic demand is shown to have moderately picked up.

Eurozone Composite - 46.1 in September (six-month high, up from 45.1). This broad indicator tends to give us a smooth representation of the European economy as a whole. It peaked in March 2011, troughed in December 2011, peaked again in March 2012 and has now seemingly bottomed again, troughing in August. Two months in a row of improvement signal that PMI for Europe has, on a whole, picked up significantly - even though it remains in contraction.

While in the long run we'd much rather see these PMI stats above 50, improvement is good enough while European equity prices remain relatively depressed. 2009 would be a good example of that on a larger scale after the financial crisis. Most importantly, we have green shoots of recovery, and signs that a deteriorating trend (which began all the way back in February) has concluded.

Finally, we earlier saw the release of the US Markit PMI, and the widely followed ISM Manufacturing PMI.

US PMI - 51.5 up from 49.6, a marked improvement from the rest of the summer, and a move back to expansionary levels. US Markit PMI meanwhile showed a deterioration from 51.5 to 51.1 - with both versions explicitly indicating a US economy only barely growing. The important story from our perspective though, is the improvement in one of our most respected indicators for global growth, the ISM. As we stated earlier, it will take some time for QE to truly filter into the real economy - so ISM moving confidently away from multi-year lows is a positive sign.


With another month of PMI data, we can draw some useful conclusions as to the MEDIUM TERM trend in the global economy.

Our preliminary view is that the MEDIUM TERM bearish trend, beginning on February 22nd, is most likely over.

The wheels were set in motion for this conclusion in June, when the market began strongly rejecting oversold conditions. Our preferred market breadth indicator, the BPNYA, troughed along with the market in June. By early August it had climbed above its 20 week moving average. And now, apart from France, almost every measure of global economic relevance has moved away from previous lows - fairly confidently in the case of Germany. There seems to be a broad sense of recovery in most developed economies, especially in Europe, the epicentre of 2012's slowdown.

Unfortunately, this isn't much of a bold prediction, given the market has moved substantially away from June lows. Unlike in late February, the market has moved several months before the data improved - courtesy of central bank easing.

As we alluded to in previous articles, this makes it difficult to use fundamental or market breadth analysis to gain an advantage - in fact, traditional fundamentalists will most likely continue to be baffled by the market in this current phase. In that type of scenario, which we also saw after QE2 in 2010, "don't fight the Fed" tends to be the easiest option. It remains to be seen how the market would react if that trend of recovery falters, or if the Fed's QE3 is deemed to be failing.

As for how to best recover from being "late to the party", if we're even at the party at all? We remain cautious. However, we acknowledge that many hedge funds in 2012 have found themselves in the same position - and there will be some degree of "performance chasing" as 2012 comes to an end. While we're more convinced than last month of the "green shoots of recovery" emanating from Europe, the market has gone up considerably, increasing the risk in buying at these levels. Also, the market breadth indicator BPNYA, has spent two weeks failing to make a higher high.

So - while we're saying that the February-August bearish MEDIUM TERM period is most likely over, if a new bullish trend has begun, an awful lot of the gains have surely been priced into the market already - and we're not sure if the potential reward is high enough to be too exposed to the market. It would take either "more attractive" entry points, or a truly impressive trend of recovery (including regions China and Japan, which have been tepid at best) to be willing to add much more risk at this stage.

That said, this month's data was fairly conclusive, and in another market this might have presented a very attractive buying opportunity. Fed intervention is the kind of anomalous event that cannot be mitigated for in terms of data analysis - and "better safe than sorry" is our preferred approach to the market.

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