Patience is not passive; on the contrary, it is concentrated strength.
— Bruce Lee
Over the past year, we have identified the weaker global manufacturing environment as a source of earnings risk and, therefore, equity market risk. Along the way we have been presented with the counter-argument of “yes, but we are starting to see signs of a bottoming.” Or, the other argument from a year ago, “the China recovery is a Q1 (2019) story,” which became a “Q2 story,” followed quickly by a “Q3 story”. All the while, the predicted recovery never quite materialized as advertised. And then just as we were starting to see nascent signs of a modest rebound of manufacturing activity in December, news of the coronavirus broke. Efforts to contain the spread of the virus will effectively stunt GDP growth for the first half of 2020 in China, with some secondary effects felt around the world. While global manufacturing seemed to have truly bottomed in the fourth quarter and started to improve according to the most recent surveys conducted by IHS Markit, a more meaningful recovery will no doubt be delayed for at least a quarter.
The January JP Morgan Global Purchasing Managers Index (PMI) came in at 50.4, the third straight month of expansion (a reading greater than 50 indicates expansion) and its strongest reading since March 2019. The number of countries with monthly PMI increases versus declines in January is the strongest since November 2017. Despite reaching a ten-month high, the latest reading is still modest by historical standards. The rise, nevertheless, hints that the global slowdown potentially bottomed out late last year.
While the data looks positive, the story is not the same in all regions. In Asia, five out of seven countries saw declines in January from the month prior. The slowdown may be likely due to the shutdown for the Lunar New Year; however, we can reliably say that the February data will show an additional deceleration of manufacturing activity as a result of the coronavirus.
Similarly, the Eurozone activity seemed to have bottomed in September of last year, and though it has improved, the manufacturing index remains below the breakeven level of 50, at 47.9, and given its strong trade dependency with China, it is unlikely to escape the after-effects of China’s efforts to contain the virus. Meanwhile, the US showed some signs of moderating growth following a rebound late last year. Here too, we do not expect the US will be completely isolated from a slowdown in China.
While our team follows the IHS Markit surveys to get a better picture of the relative global landscape, we look to another organization, the Institute for Supply Management (ISM), to get a read on the US specifically and expected earnings growth. While the ISM survey is slightly different than Markit, the idea remains the same as an indication on the direction of the overall manufacturing economy and, subsequently, earnings growth.
The ISM Manufacturing PMI saw a sharp rebound in January, returning to expansion territory for the first time since July 2019. Nine of the ten components of the manufacturing index saw an improvement over the prior month. At current levels, the PMI would imply low to negative earnings growth on a year-over-year basis for the S&P 500 Index into the first half of 2020 followed by a modest rebound in the second half. However, we would expect that the coronavirus will have some negative impact on first quarter earnings for the S&P 500. At the end of 2018, according to S&P Global, Asia accounted for 8.24% of sales for the S&P 500 Index constituents, the highest of any region.
The impact of the coronavirus on manufacturing and services and the knock-on effect to earnings will be something we will be following closely over the next few months. Our main examination will be the degree and length of the disruption that this epidemic has caused and to what level corporate fundamentals have been affected. Given the recent strength it would appear that the equity markets are brushing off the coronavirus and its potential impact on corporate activity as a non-factor. While we are not as confident as equity investors would appear, we would also caution against an overreaction in either direction, be it overly bullish or bearish. When it comes to exogenous shocks such as this, we need some level of patience as we refocus and let the fundamentals dictate our actions. To that end, while we anticipate the effects of the coronavirus containment will wane through the second quarter and rebound in the back half of the year, given current equity market valuation and the headwinds facing earnings growth, we continue to emphasize a modest underweight to equities in favour of the downside protection fixed income traditionally provides.
Kevin Headland, CIM
Senior Investment Strategist, Manulife Investment Management
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