The Factory Daily Letter

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Recession concern prevails

How much is priced?

How far can the Fed go?

Anecdotally the consensus now seems to have settled around the idea that recession is inevitable, and the question has now shifted to how Fed can avoid a deep one. This is a key question for investors as historically there is a relationship between the extent of the economic slowdown and the accompanying equity market price action.

In the press conference that followed last Wednesday’s FOMC policy meeting, Fed Chair Powell reaffirmed his commitment to do everything possible to fight inflation - even if this could weigh on economic growth (which in his view is strong enough to cope with rate hikes). The Fed appears to be moving decisively more aggressive in terms of how it goes about normalizing its ultra-accommodative monetary policy, while other global central banks are now following suit and raising rates in their efforts to fight inflation.

However, as Powell said on Wednesday in his semi-annual testimony to Congress, it is of course not the Fed's intention to create recession (even if he appears to acknowledge that avoiding one could be a challenge). He remains confident that the US economy can withstand tighter policy – and once again he reiterated that it will be the upcoming economic data that determines the speed and magnitude of policy moves: as he said explicitly, future rate hikes will be decided on a meeting-by-meeting basis.

The market narrative has however shifted from whether or not a recession will occur, to discussion around how deep it could be.

As we discussed in our recent letter “The anatomy of a bear market”, historically the magnitude of a bear market appears to have been affected by whether the same has been accompanied by economic recession or not. The historical data also suggests that bear markets have tended to have been stronger when the accompanying recession has been structural, whereas during cyclical recessions, bear market declines have been more contained.

So far, economic momentum (as measured by the Citigroup surprise index) has been falling since the beginning of the year. The question now is to what extent the expected deterioration in the economy has now been priced into equity markets.


Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

Eurozone PMIs: as bad as they look

Yesterday the preliminary PMI figures for the Eurozone were released by S&P Global. The main takeaways from the ‘flash’ June data were that both the manufacturing and services gauges missed expectations (across the Eurozone as a whole, but also in France and Germany) and suffered sharp falls compared to recent months.

The flash manufacturing PMI came in at 52.0 (a 22-month low, much lower than the 54.0 expected and down from prior’s 54.6) while the services sector gauge fell 3.3 points to 52.8 (vs 55.5 expected). Perhaps of greater significance is that the manufacturing output index fell to a 24-month low of 49.3 (from 51.3 in May). This is based on the following survey question: “Is the level of production/output at your company higher, the same or lower than one month ago?”. Such deterioration sends a warning signal that the Eurozone economy has been losing traction over the past month and that further deterioration could be on the cards. The composite came in at 51.9, falling from prior’s 54.8.

A similar trend is evident in the data for Germany and France with both suffering sharp drops across their manufacturing and services PMI gauges. The services data - that had been looking more resilient over recent months, suffered the largest monthly declines in June (this was particularly the case in France - where the PMI survey dropped from 57.0 to 52.8).

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

So what’s behind this deterioration in the PMIs?

In its press report, S&P Global highlighted several key factors behind the recent PMI data:

  • Companies’ output expectations for the next 12-month hit its lowest level since October 2020;
  • Stagnating demand, tighter financial conditions, higher energy and global prices, the war in Ukraine and supply chain issues exacerbated concerns;
  • New orders for goods and services stagnated for the first time since March 2021 and are down for two consecutive months;
  • Delivery times lengthened (yet at the slowest pace since December 2020);
  • Jobs growth slowed to a 13-month low in both manufacturing and services;
  • Business expectations for manufacturing and services fell their lowest levels since mid 2020;
  • Average prices charged for goods and services rose significantly again in June;
  • Input costs eased slightly, especially in the manufacturing sectors (yet prices remain elevated from a historical perspective);

Overall, weaker outlook expectations, lower demand, tighter financial conditions, higher overall prices and slowing jobs growth are the main reasons behind the disappointing PMI survey data in Europe.

US PMIs also disappointed

Later in the day S&P Global also released its flash June PMI data for the US, and the trends are similar to those seen in Europe: the PMI surveys deteriorated sharply in June, missing consensus estimates. The manufacturing gauge fell to 52.4 (vs 56.0 expected, down from prior’s 57 and making a 23-month low) while the manufacturing output index came in at 49.6, thereby falling into contraction territory and reaching a 24-month low.

The services gauge also fell (and disappointed) but to a lesser extent (51.6 vs 53.3 expected, down from prior’s 53.4). The composite, at 51.2, was also below expectations but still in expansion territory. 

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

What was behind the US PMI report?

In the press report that accompanied the data release, S&P Global highlighted the following:

  • Factory production fell to a degree only that has only been exceeded twice over the past 15 years (2008 and 2020);
  • The new orders component fell for the first time since July 2020. Weaker demand amid rising costs and falling confidence cited as the main reasons behind this;
  • The new export orders gauge also suffered, from pause in foreign demand, higher inflation and supply chain issues;
  • Input and output charges rose substantially in June, particularly in food, fuel, transportation and materials;
  • Firms reported wage pressures adding to operating expenses;
  • A tight job market in the US as well as uncertainty encouraged some companies to not replace leaving workers;
  • Backlogs of work reduced for the first time since 2020;
  • Business confidence fell by the greatest degree since 2012. Tighter financial conditions, inflation concerns and lower demand the key concerns;

Common concerns across the US and Europe

So it is that the issues of concern across the US and Europe are similar, with weaker economic expectations, the prospect of lower demand, the threat of tighter financial conditions, higher input costs, and changing job market conditions the factors having an impact on the PMI surveys across both sides of the Atlantic.

Have equity markets yet priced what is being reflected in the PMIs?

Economic activity has continued to deteriorate, and markets have fallen sharply, but one of the main questions for investors is what the current price action has already discounted in terms of economic impact and how far economic activity might decelerate further.

The charts below compare the year-on-year price change in the S&P500 and the Stoxx Europe 600 indices with the US ISM new orders gauge and the EU PMI, respectively. In both cases, its seems that the regional equity market has already priced the slowdown in manufacturing activity (insinuating that the signs of deterioration reflected in yesterday’s S&P 500 PMI shouldn't have really come as a surprise):

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

How low can the PMIs go?

We have developed two different proxies for the ISM PMI manufacturing index. The first is based on three leading equity indices (semis, homebuilders and transport) that tend to underperform when the economic cycle peaks.  As illustrated below the proxy found its top in March 2020 (along with the ISM manufacturing index). But it has since rapidly reversed reflecting a rapid deterioration in economic momentum (and it is so far showing little sign of inflection):

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

The second proxy is based on a standardized reading across oil prices, yields and the dollar. The advantage of this one over the first is that this one has a stronger correlation when a nine-month lead is applied. Such implies that the strong resilience of the dollar, the surge we have seen in oil prices and rising bond yields are likely to continue to weigh on economic activity data for the months to come: it is calling for a further deterioration of economic activity:

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

So where are we now in the PMI cycle?

Equity markets are leading indicators of the economy and as such show a pretty strong correlation with PMIs. We use the PMI manufacturing gauge as a tool to help us to determine current EPS momentum; risk reward and sector positioning, and also to identify phases of internal market rotation.

In the current cycle, the ISM manufacturing gauge topped in March 2021 when it reached 63.7. Since then the economy has remained resilient, as it has continued to be supported by looser financial conditions and the strong recovery in activity that has followed the Covid recession.  Looking ahead, record inflation, high commodity prices and restrictive monetary policy is however now likely to pile increasing pressure on economic activity and we consider it unlikely that we will see a significant rebound in the current cycle over the coming months. The result is that while activity growth remains positive to date, indicators are suggesting that the ISM could soon fall into contraction territory (below 50).

Below we present a crude illustration of the ISM Manufacturing cycle and identify four distinct phases:

  1. Inflection from a depressed levels whereby PMIs start to improve;
  2. PMIs are already high and accelerate until they reach a top;
  3. PMIs remain elevated but start to decelerate; and
  4. the end of cycle which is characterized by low and decelerating PMI levels.
Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.
Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

Further slowdown in the ISM Manufacturing index suggests lower market returns

Unsurprisingly, the equity market tends to perform best when economic conditions are improving. Since the market is a leading indicator of the broader economy, it has historically posted its best performance (2.01%) when the ISM has been in its “low and rising” phase (anticipating the rebound) and when activity accelerates (1.23%). Average returns fall significantly once the peak in economic activity has been reached (0.47%) - but they are still positive – and this is where we stand now.

But as we have discussed, it seems markets may have already anticipated further deterioration in economic activity with the current price action arguably already reflecting “phase 4” (during which historical average monthly returns are on average negative (-0.32%).

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

In the current context, energy stocks appear particularly vulnerable

A change in the business activity regime has also historically had a significant impact on market leadership, with periods of fading business growth seeing the more defensive sectors such as health services, utilities, media, biotech or food historically take the lead. The biggest rotations are apparent in sectors such as seedlings, capital goods, energy, banking, materials and automotive, all of which tend to switch from being market leaders to laggards. Against the current backdrop, we see some risk to the energy sectors, which have been benefiting from rising energy costs due to idiosyncratic factors such as reopening demand and the war in Ukraine: they are facing downside risk now that investors appear more concerned about the severity of a coming economic downturn.

More globally, the trend looks likely to continue to favour the defensive (for so long as our proxy model does not start to show signs of inflection).

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022.

Uncertainty prevails, but there are some early indicators that we can watch closely in our efforts to identify a change in the trend as early as possible.

While economic forecasting in such an uncertain environment may be difficult, getting a handle on what the market may or may not have already ‘priced’ is even trickier. However, taking a view on what the maximum market drawdown might be is a key component to gauge risk reward ratios.

The current figures do not currently signal imminent recession, but our leading indicators continue to decline. While most seem to point to a moderate economic downturn, some are already approaching levels consistent with the levels of decelerating manufacturing activity akin to those experienced in 2008 and deep recessions.

As we discussed earlier this week, for now the market seems to be toying with the idea of a relief rally as we approach the end of the first half of the year – a half that has seen some of the worst equity market performance in US equity market history. And we are seeing some of the same rhetoric emerge as drove that in May, namely around the possibility that the Fed may be obliged to ‘pause’ in order that the central bank avoids doing too much economic damage. The combination of extreme bearish sentiment and oversold market indicators suggests that the ground is fertile for a relief rally, but while necessary it is also of itself insufficient to support a more sustained one: we will need to see evidence of more fundamental shifts in the leading indicators before the longer-term investors are persuaded to reenter the market, and there is little evidence of this at the moment. Moreover, this nascent relief rally will arguably become increasingly fragile in nature as we approach the next CPI data release on 15 July.

Among the most sensitive proxies for economic activity is the combination of oil, the US dollar and the US 10-year bond yields. Such may be showing early signs of a pause and accordingly possible indications of a shift in sentiment (particularly if they move below short-term technical supports). It is our view that close monitoring of these three will be critical when it comes to spotting when sentiment might shift and getting an early indication of the emergence of new bull trend.

A peak in yields may be a first positive signal for risky assets

After breaking its former high, the positive momentum accelerated and pushed U.S. 10-year rates to a new important psychological level at 3.5%. However, after approaching this level, the positive momentum seems to be running out of steam as evidenced by the bearish divergence of the RSI that has materialized.

Given the various moving averages that serve as support, the trend is clearly upwards as long as rates remain above 2.80%.

Our preferred scenario remains a consolidation in the second half of the year. A daily close below the 50-day SMA, currently holding at 2.95% would confirm this scenario:

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

Lower yields may help US tech stabilise

The Nasdaq 100 has formed a bullish “island gap reversal” pattern, a technical signal that an important local bottom has been forming and that a new bullish phase may have started.

Moreover, Technology stocks usually outperform when the ISM enters a contraction phase (since their revenues are less correlated to the economic cycle and their growthier profiles start to attract investors in a growth-scarce environment). The next technical hurdle is the 50-day SMA which is currently holdings at 12 563:

Source: FactSet; Pictet Trading Strategy; as of 23/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

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Please see criteria explanation in the endnotes

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