Key takeaways

• We see early but promising signs of supply chain pains easing.

• This underscores our belief that inflation should moderate over the next year even as demand remains strong.

• For investors, the easing of supply chain pressures and the moderating inflation rhetoric will help to drive the healthy margin outlook for lower margin sectors.

While there were certainly pockets of variation as we received our final scorecard of Purchasing Managers’ Index (PMI) numbers across the world, global growth remained sufficiently robust for us to officially put a bow on 2021. The global manufacturing sector has adapted its processes through successive COVID-19 waves and ended the year on a positive note at 54.2, firmly in expansionary territory.

As headline PMI numbers can be subject to distortion due to the input variables, we think it is necessary to perform a complete autopsy in order to get answers to some of the pressing questions on forward-looking demand, supply chain issues and the knock-on effects on inflation.

As a start, it is helpful to understand what constitutes headline PMI: 

EXHIBIT 1: PMI SUB-COMPONENTS

In a normal environment, strong demand in a growing economy results in longer delivery times as suppliers struggle to meet the increased demand for inputs. The inverted series is an input to the headline PMI as longer delivery times are typically coincident with sanguine economic conditions. However, shutdowns and disruptions stemming from pandemic control measures also resulted in supply chain delays that contributed to the lengthening of delivery times. Hence, the headline number can be perceived to be artificially inflated as long as bottlenecks on the supply side remain an issue. Taking a closer look at the sub-components can reveal important clues about where growth and inflation are headed.

While global suppliers’ delivery times have continued to stay elevated, the series seems to have peaked in October 2021, falling for the subsequent two months. The manufacturing output sub-index has also improved over the same timeframe in response to that dynamic. The biggest question that remains on our minds is the following: Will the easing of supply chain pains last and reduce price pressure?

Our analysis of the sub-components leads us to believe so. 

EXHIBIT 2: (LHS) RELATIONSHIP BETWEEN ECONOMIC BALANCE AND INPUT PRICE CHANGES, (RHS) THE IMPACT ON HEADLINE INFLATION

Source: J.P. Morgan Markit Global PMI, J.P. Morgan Asset Management. *Economic balance is the difference between New Orders PMI and Output PMI.  A positive economic balance indicates a surplus in demand over supply, while a negative economic balance indicates surplus in supply over demand.
Data reflects most recently available as of 11/01/2022. 

Computing the difference between the New Orders sub-index (proxy for demand) and the Output sub-index (proxy for supply) can give us an idea of the demand-supply balance in the global economy. We shall refer to this difference as economic balance.

While New Orders has continued its upward march, the Output sub-index improved even more. As a result, the difference between the two has continued to trend lower towards achieving balance. Achieving balance is important because of the relationship between our computed measure of economic balance and input prices sub-index changes, where the latter is a leading indicator of headline inflation.

The chart in Exhibit 2 above shows that economic balance and input price changes are highly correlated. The larger the imbalance, the higher the input price changes are. The table also shows the relationship between the input price gauge and headline inflation, where the input price gauge leads headline inflation by about six to ten months, with the strongest positive correlations at the 10^th month lead. This underscores our belief that inflation should moderate over the course of the year even as the growth environment continues to remain supportive. 

Investment implications

Supply chain tightness resulted from a sudden surge in demand for goods, a sharp shift from goods to services consumption, lockdowns delaying productions, and the pulling forward of orders and pre-cautionary inventory build-up. The reality is that there are still a number of logistical bottlenecks that will continue to challenge global supply chains in the near term, but our analysis suggests that we are starting to see early signs of a reversal of these forces, which will continue to alleviate supply chain tightness, resulting in lower inflationary pressures. This may allow central banks not to rush into tightening policy too soon and too aggressively. Therefore, as the economic recovery continues and supply chain bottlenecks resolve, a preference for equities over bonds makes sense.

From an earnings perspective, profit margins remain key. Despite supply chain disruptions, margins have stayed incredibly resilient: S&P500 delivered an aggregate net profit margin of 12.7% in 3Q 2021 (vs. 10.4% 5-year average), with 10 out of 11 sectors delivering margins above its 5-year average level. Even sectors traditionally associated with thinner margins such as consumer discretionary and industrials delivered robust profit margins over the past two quarters. Should supply chain pressures ease over the next quarters, a moderating inflation rhetoric would help drive healthier margins for low-margin sectors as companies continue to deliver topline growth. On the flipside, high margin sectors such as technology may encounter near term headwinds from stretched valuations, high earnings estimates and rising bond yields, even as the secular growth story remains intact.

That said, if Omicron were to heighten supply chain disruptions, low-margin sectors with high raw material exposure and a large work force may be adversely affected while sectors with higher margin buffers like Financials, Communication Services and Technology will be more resilient.

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