Are the latest improvement in manufacturing PMIs a sign of recovery?

The Purchasing Managers’ Index (PMI) season is upon us and it is time for the usual monthly health check of the global economy. Unlike the past few months of peeking through our fingers in trepidation, most of us have welcomed the release of the November PMI data with a slight positivity and it did not disappoint. Manufacturing PMI numbers showed an uptick across most economies and the global gauge returned to expansion territory (50.3) after 6 months of being in contraction. Such signs of a possible recovery in global manufacturing activity supported sentiment and expectations of stronger economic growth in 2020.

At a country level, major economies within the eurozone, Japan and various emerging markets have all recorded better manufacturing PMI numbers in November, reaching multi-month highs. Markit PMI data for the U.S. increased as well, but the Institute for Supply Management version contracted further, creating a diverging story. For China, both the Markit and official indexes improved. In particular, the official index returned to expansion territory at 50.2, having stayed below 50 since April 2019. Examining sub-components, support came from stronger outputs, new orders and employment. Sentiment and new export orders, however, remained weak, though the pace of contraction has slowed.

While the upcoming holiday season likely played a part, the recent de-escalation in U.S.-China trade tensions is possibly a key reason to the rise in manufacturing activity. Ever since the U.S. and China headed into discussions over the Phase I trade deal, subsequent news flow on its progress had been positive, providing a boost to both business and market sentiment. In particular, the negative impact of the U.S.-China trade dispute seems to have eased. Contraction in Asian trade activity, a useful barometer of the global economy, has slowed. In particular, exports from Emerging Asia to China showed a marked improvement, falling -6.3% year-over-year (y/y) in September compared to -8.4% in August and -10.2% in July. Business investments, which had been indirectly affected by weaker sentiment, have also recovered slightly. It was reflected in the 1.2% month-over-month growth in U.S. core capital goods orders (vs. consensus 0.2% and -0.5% in September), and the better-than-expected capital expenditure (7.1% y/y in 3Q vs. 5.0% expected and 1.9% in 2Q) in Japan highlighted by the 3Q Ministry of Finance corporate survey. This upturn in economic data has provided support for the increasing optimism of a growth recovery in 2020, which has been gaining momentum based on beliefs of fading tail risks from geopolitical issues and expectations that the effects of accommodative monetary and fiscal policies will start to come through.

While it is tempting to be hopeful, investors should proceed with caution. Much of the recent improvement in sentiment is predicated on a successful trade deal, which still has a risk of breaking down. We can also expect an increase in rhetoric against China heading into the 2020 U.S. elections which could risk straining relations, rolling back on any progress made. Such a scenario will place renewed pressure on business sentiment and consequently, business investments. Furthermore, while PMI numbers have improved, note that manufacturing activity in many countries is still contracting and forward looking components still show a weaker outlook, albeit at a softer pace. The employment outlook is also a source of concern as rising unit labor costs have been squeezing on margins, threatening the consumption outlook if there isn’t a sustained improvement in the economy and companies begin to retrench workers.

EXHIBIT 1: Global Purchasing managers’ index

Source: CEIC, J.P. Morgan Asset Management.
Guide to the Markets – Asia. Data reflect most recently available as of 3/12/19.

Investment implications

While still very uncertain, a sustained de-escalation of the U.S.-China trade dispute will serve as a strong catalyst for a recovery in business sentiment. That, coupled with the lagged effects of accommodative monetary and fiscal policies as well as consumer resilience amid a tight labor market, will possibly support a recovery in economic and earnings growth for 2020. In particular, a global recovery in trade and investment activity is expected to favor trade reliant economies within emerging markets and parts of Europe. As such, earnings expectations for emerging markets and Asia Pacific ex-Japan have emerged higher than the U.S. at 14% y/y and 13% y/y respectively (vs. U.S. at 10%). Under such an outlook, international equities are expected to perform better than their U.S. counterparts next year. Cyclical sectors are also expected to outperform amid such a recovery environment.

However, as mentioned above, there are several risks to such a rosy outlook. Investors should monitor a few more months of data to affirm that an economic recovery is indeed in play and track closely the narrative surrounding the U.S.-China trade negotiations. Already, the recent signing of the Hong Kong democracy bill by U.S. President Donald Trump has put a dampener on weeks of progress towards a Phase I deal. Newly threatened tariffs by the U.S. on Argentina, the European Union and Brazil have also re-introduced ripples on the otherwise calm global trade environment over the past month. Hence, geopolitical uncertainties still exist and while there is scope for positive returns in 2020, investors should recognize that unless we see a meaningful correction in the coming weeks, we will be heading into the new year with equity valuations near or above historical averages.