Apparently trade wars aren’t “easy to win”, with both the US and China seemingly digging their heals in for a prolonged fight.
While global equity markets are moving up and down on a daily basis in line with whatever “Trump tweet bingo” says, the fact of the matter is the bond market has voted aggressively in terms of record lows yields and we’re now seeing economic data confirmation of the global damage being done by tariffs.
The clear fact that tariffs are now effecting US economic data is interesting. The US had previously been relatively immune to tariff escalation in terms of near-term economic data but that’s all started to change.
This week we saw very clear evidence that the uncertainty caused by the escalation of tariffs has slowed the US manufacturing sector. This US ISM Manufacturing PMI data suggests the bond market is absolutely right in anticipating a sharp economic growth rate slowdown in the USA. And similarly, that equity investors have been correct to avoid cyclical stocks and buy defensives.
I want to run through this US ISM Manufacturing PMI data in some detail as it’s important for all of us to understand what’s occurring in the biggest economy in the world.
- ISM’s U.S. manufacturing PMI declined for a fifth successive month in August, the longest since September 15 to January 16.
- The headline measure fell 2.1 points to 49.1 from 51.2 in July (Chart 1).
- Notably, and of greater concern, the New Orders Index (Chart 2) sank 3.6% to 47.2 – the lowest point since April 2009.
“Comments from the panel reflect a notable decrease in business confidence. August saw the end of the PMI expansion that spanned 35 months, with steady expansion softening over the last four months. Demand contracted, with the New Orders Index contracting, the Customers’ Inventories Index, recovering slightly from prior months and the Backlog of Orders Index contracting for the fourth straight month. The New Export Orders Index contracted strongly and experienced the biggest loss among the subindexes. Consumption (measured by the Production and Employment Indexes) contracted at higher levels, contributing the strongest negative numbers (a combined 5.6% decrease) to the PMI, driven by a lack of demand. Inputs — expressed as supplier deliveries, inventories and imports — were again lower in August, due to inventory tightening for the third straight month and continued slower supplier deliveries. This resulted in a combined 1.5% decline in the Supplier Deliveries and Inventories indexes. Imports and new export orders contracted to new lows. Overall, inputs indicate that supply chains are responding better and also that companies are continuing to closely match inventories to new orders, which is a positive sign for future expansion. Prices contracted for the third consecutive month, indicating lower overall systemic demand.
“Respondents expressed slightly more concern about US-China trade turbulence but trade remains the most significant issue, indicated by the strong contraction in new export orders. Respondents continued to note supply chain adjustments as a result of moving manufacturing from China. Overall, sentiment this month declined and reached its lowest level in 2019.”
What respondents are saying:
- “Seeing some relief in the availability of electronic components in the marketplace but there are still pockets of short supply, allocation, long lead times and the like. Tariffs continue to be a strain on the supply chain and the economy overall.” (Computer & Electronic Products)
- “While business is strong, there is an undercurrent of fear and alarm regarding the trade wars and a potential recession.” (Chemical Products)
- “Slowest month (July) this year so far in sales.” (Transportation Equipment)
- “Late planting of the corn and soybean crops has increased uncertainty over the final acres and yields. This is leading to volatile markets.” (Food, Beverage & Tobacco Products)
- “Slightly lower rate of incoming orders may be seasonal or a sign of a general slowdown. Monitoring closely.” (Fabricated Metal Products)
- “Incoming sales seem to be slowing down, and this is usually our busiest season. Concerns about the economy and tariffs.” (Furniture & Related Products)
- “Business is starting to show signs of a broad slowdown.” (Machinery)
- “Generally, business remains steady. However, we continue to plan for a hard Brexit and a long trade war between the U.S. and China.” (Miscellaneous Manufacturing)
- “The market for large building structures is slowing.” (Nonmetallic Mineral Products)
- “Current business is OK, nothing to brag about. Under projections and slightly below last year, [but] margins are hanging in there.” (Plastics & Rubber Products)
Chart 1 – The ISM manufacturing PMI vs. U.S. GDP
Chart 2 – ISM manufacturing New Orders v. U.S. GDP
The US ISM Manufacturing PMI showing contraction drove bond yields to new lows and clearly worried cyclical elements of the US equity market. This is confirmation that economic data is weakening and the risks to US and global growth are to the downside. There should be no doubt you will see GDP growth rate forecast cut for the USA and expectations of further Federal Reserve rate cuts.
Before we give up all hope, however, we must remember what the true cause of this US economic slowdown is Trump’s trade war. It’s not the Federal Reserve, it’s the uncertainty created for business and consumers by an unpredictable and futile trade war. It’s now becoming an “öwn goal” for the USA and the question becomes how much economic and market pain can Trump take before he blinks?
No doubt the Fed will blink first and respond to the weak data by cutting rates by another -25bp this month. However, that’s expected. To break this cycle we need Trump to blink. How much US economic and market pain can he take? How much more “recession” talk can he take?
I am sure Beijing are wondering just that too. This is a regime with a 100-year view being bullied by a President with an 18 month re-election cycle target. Beijing may well have just decided to “take the punt ”to see him off. The weak US data would actually hearten Beijing, as that weakness in US manufacturing spells trouble for Trump’s voting “base”. It could just be that Beijing now has the upper hand in all this after Trump overplayed his.
I don’t know the answer but I don’t see either side “blinking” in the near term. Unfortunately, we probably need a genuine Wall St correction to get the US side to “blink” and see the folly of their ways. Sure, there may well be the odd positive tweet that generates a rally but until this issue is truly solved I think all of us need to be prepared for an extended period of equity market volatility. In volatility there is opportunity, but volatility generally scares most equity investors particularly those who bought equities for yield as an alternative to fixed interest.
Central Banks and zero interest rate policy (ZIRP) do provide a floor under equity markets at a point but we are very close to the point where central banks are effectively “pushing on a string” with monetary policy. Similarly, unconventional Central Bank policy is also arguably ineffective, with bond markets behaving already like QE is already happening. That leaves fiscal stimulus yet we aren’t seeing many signs of that yet from Government’s globally.
The main point I am making today is the trade war has arrived in US economic data. It’s not “fake news” — it’s a fact. This will lead to negative consensus earnings revisions for US cyclical and global cyclical companies. We need to be patient and selective in periods like this, with a higher than usual cash weighting in portfolios most likely a prudent decision.
Having a little extra cash gives you the ability to take advantage of volatility and potentially cheaper equity prices when they occur. Also, owning mostly non-cyclical companies that are growing organically is prudent. This doesn’t mean we only own defensives, we can own great businesses that don’t rely on trade as such for growth.
Do not panic and sell everything — that’s clearly not the answer. Equities are long duration assets but have daily pricing. You want to be buying the best long duration equities during periods of market duress. Think of it like going to a twice a year clearance sale where the best brands are discounted for a week. It’s by having some cash to deploy during those clearance sale weeks in equities that you will be rewarded through time, with the compounding effect of owning great businesses.
My advice today is I believe it’s prudent to have some cash ready to deploy, with that cash raised by selling low quality companies that are price takers, not price makers. Put the trash out. You do want to make sure your equity portfolio is ultra-high quality with the ability to even further increase that quality via deploying cash, if we do see periods of index duress over the next few months.
Over the next few weeks, I will attempt to identify a number of high quality global and domestic businesses that I would add to, if the indices were under duress. We need to identify great businesses and an entry point with a “margin of safety”. But first, let’s make sure we have some cash to deploy when that time comes…
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.