What does the slump in manufacturing mean for markets?

The US PMI reports for July were released on Wednesday. The manufacturing PMI slumped to 49.5, a 7-month low, while the service sector survey jumped to 56.0, a 28-month high. The composite index was strong at 55, which is a 27-month high. While this suggests that growth in the US got off to a strong start for Q3, there is a large divergence between the fortunes of the service sector and the manufacturing sector, which can also be seen in the Eurozone.

The main takeaways from this month’s US PMI reports are employment growth is slowing and business confidence has slipped for the second straight month. The decline in confidence could be a sign that the political risks are starting to impact the business community. However, this may not last. Now that the Democrats are set to replace Joe Biden with Kamala Harris, the polls have narrowed considerably. The PreditIt poll has Trump’s victory narrowing sharply so far this week. He is now expected to win 56% of the vote in November, down from nearly 70% last week. Kamala Harris, if she is crowned as the Democratic nominee, is expected to win 46% of the vote. We may have to wait for next month’s survey to see if the change in candidate for the Democrats have reduced some of the political fears for business.

Inflation risks threaten corporate profitability

Prices charged for goods and services edged down this month in the US, however, input prices for goods and services rose at their fastest pace for 4 months. This is an interesting development since commodity prices have fallen sharply this month. For example, the WTI price is down 4.6%, and copper is lower by 4.5%. These price drops may not be felt for a few months, as they take time to filter through the inflation pipeline.

Average prices charged for goods and services rose at their lowest rate since January, and prices charged for services rose by the slowest rate for 4 years. While this is good for consumers, the increase in input costs could pressure corporate profitability down the line, as raw materials, energy and logistics prices all saw price increases this month.

Why the manufacturing slump is a concern for investors

The sharp decline in the US manufacturing sector PMI is worth noting. There was a fall in new orders, production and inventories also contributed to the decline. A reduced rate of employment growth also weighed on the survey this month, suggesting that the US economy will continue to rely on only a few sectors to boost non-farm payrolls, which may cause concern about the health of the US labour market. The drop in business confidence may also hinder hiring in the coming months.

Overall, although the composite PMI suggests that the US economy remains robust, US growth is skewed towards the service sector, while the manufacturing sector is struggling.

German Dax in trouble as export orders are hard to find  

Imbalanced growth is also a feature in Europe. The Eurozone’s manufacturing sector PMI has now been in contractionary territory for 16 months, and the pace of the decline was also marked, since it was the largest decline in the manufacturing index so far this year. The manufacturing sector was dragged lower by new export orders, which suggests that businesses in the currency bloc are struggling to attract orders from international clients. Demand overall was weak, with new orders also decreasing for the second straight month. This does not bode well for the future and suggests that businesses that reply on foreign clients outside of the Eurozone could be in trouble. This is particularly bad for the German Dax, since 60% of companies in this index rely on international revenue streams. Sentiment in the Eurozone dipped to its lowest level for 6 months, with confidence slipping in both the manufacturing and the service sectors.

Like the US, output prices are falling, while input prices have been rising for both the service and manufacturing sectors. This is problematic for the future profitability of firms in the Eurozone.

Can we trust the PMI data?

Overall, these PMI surveys could be a sign of a summer lull, or are they a sign of something more nefarious? In both the US and the Eurozone, actual growth has fared better than the survey data. For example, tomorrow’s Q2 GDP report for the US is expected to show that the US economy expanded at a decent 2% pace YoY. Thus, can we even rely on the survey evidence, and are people saying they are more pessimistic than they are? Or does this survey data suggest that there could be problems ahead? If yes, then the German economy is at risk of dipping into recession, and the US economy could experience a slowdown in hiring later this year.

Survey data complicates path to rate cuts

These surveys should be supportive of rate cuts from the Fed and the ECB, however, the rise in input prices may worry central bankers. While we continue to think that September rate cuts are likely from both the Federal Reserve and the ECB, if this trend continues, then rate cuts later in the year are less likely. The swaps market had nearly fully priced in a rate cut from the ECB in December, however, that has now fallen to less than 80%.

Why are mid-caps outperforming in the US?

The July PMI surveys cloud the outlook for stocks as we move to the peak weeks of summer. Large cap stocks are selling off in Europe and the US, however, in the US the Rusell 2000 mid-cap index continues to outperform the other blue-chip indices, as investors digest the news that Google has yet to see meaningful profit growth from its AI investments and that the cost of its AI endeavors continues to grow. This has led to questions about the long-term benefits of AI, which is rattling stock markets.

In our view the mid cap rally is fueled by the decline in investor sentiment towards tech and towards big growth companies. The blue-chip S&P 500 is weighed down by the unravelling of the momentum trade, particularly big tech. The biggest growth companies are weighing on the S&P 500 right now, and that is allowing the Russell 2000 to play catch up. In our view, the Russell 2000 is not moving on its own fundamentals, since cracks are starting to appear in the US economy, it is hard to know how far the mid cap rally will go.