When Will The Economic Coughing End?

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 |  Includes: DIA, FXE, UUP
by: Elliott Gue

The boundless creativity of financial journalists has produced at least a dozen rationales for the extraordinary gyrations suffered by US equity markets since the beginning of August. But investors are worried primarily about one thing: The state of the global economy.

As I’ve said before, the odds that the US will slide into recession over the next six months stand at 1-in-3. With the prospects of an economic contraction weighing on investors’ minds, even inconsequential data points can roil the stock market.

The economic recovery is clearly fragile, but the outlook remains murky. Although data points suggest that economic activity has improved markedly in recent weeks, equity markets remain volatile. The Institute of Supply Management’s Purchasing Managers Index and other surveys of business sentiment suggest that fear continues to rule the day.

Three important economic data sets have come out since August 23. The Federal Reserve Bank of Richmond’s Fifth District Survey of Manufacturing Activity usually doesn’t move the markets. However, the most recent installment of this survey attracted more scrutiny than usual, largely because the Federal Reserve Bank of Philadelphia’s August 2011 Business Outlook Survey indicated that expectations for future economic activity had deteriorated substantially. Investors looked to the results of the Richmond Fed’s survey to ascertain whether the Philadelphia Fed’s dismal business outlook was an outlier or a harbinger of further economic weakness.

Check out this graph of the Institute for Supply Management’s Manufacturing PMI, one of our favorite leading indicators of US economic health, and the regional indexes released by the Federal Reserve Banks of Philadelphia and Richmond.

Click to enlarge
Source: Bloomberg

The trends in the two regional Fed surveys tend to track one other and the national PMI data closely over time, albeit with plenty of outliers. The 2001 and 2007-09 downturns stand out on the graph: Regional expectations for business activity tumble well into negative territory (left-hand scale) and Manufacturing PMI drops into the low to mid-40s (right-hand scale).

When the Federal Reserve Bank of Philadelphia’s general economic index plummeted to minus 30.7 from 3.2 in July, this marked one of the largest single-month declines in the indicator’s history and one of the biggest upside or downside surprises. (Analysts’ consensus estimate called for a reading of 2.) The last time the index plumbed these depths was in March 2009, when the Manufacturing PMI had sunk to 36.5 and the economy was in the final months of the Great Recession. In 2001 the Philadelphia Fed’s index of general economic activated also dipped below minus 30 when the Manufacturing PMI was about 43.

If the August Manufacturing PMI reading declines to 43, the US recession debate will be all but over; at that point, the question will be about the severity and duration of the economic contraction. Given the historical precedents, the rapid deterioration in business sentiment reported by the Federal Reserve Bank of Philadelphia spooked anxious investors.

Although the Federal Reserve Bank of Richmond’s index of regional business conditions slipped to minus 10 from minus 1 in July, the S&P 500 still rallied because these numbers didn’t corroborate the big downturn reported by its counterpart in Philadelphia. Most of the index’s underlying components were weak, including expectations for future orders and production.

But a reading of minus 10 is significantly higher than what one would expect in a recessionary environment. Also consider that the Richmond Fed’s index bottomed at minus 7 in August 2010 amid last summer’s temporary soft patch.

Business conditions in the Federal Reserve Bank of Richmond’s district suggest that the most recent reading from its counterpart in Philadelphia was an outlier.

In short, the US economy has softened. The August manufacturing PMI will likely drop to less than 50, but the business environment isn’t as dire as the Philadelphia Fed’s index of general economic conditions would suggest.

The Census Bureau’s advance estimate of durable-goods orders also gave investors a glimmer of hope. Durable goods are defined as products that have a useful life of three or more years -- for example, machinery, motor vehicles and aircraft. These purchases (or lack thereof) indicate how confident companies are in the health of the economy.

Analysts typically scrutinize the headline change in orders and durables excluding transportation, a number that factors out order for jumbo jets and other big-ticket items.

No matter how you slice it, the July numbers were strong. Orders of durable goods were up 4 percent in July, roughly two times the growth rate in June. Economists’ consensus estimate called for a 2 percent increase. Meanwhile, even with transportation-related orders backed out, demand for durable goods increased by 0.7 percent, a marked improvement to the 0.1 percent growth reported in June.

At the same time, the data underlying this report was collected before Standard & Poor’s downgraded the US government’s credit rating and the stock market swooned. Orders of durable goods likely weakened in August. This highlights the biggest risk to the US economy: That negative sentiment will sap any improvement in business activity.

Although I peg the odds that the US economy will slip into recession at 1-in-3, I expect the world’s leading economy to continue to suffer through a prolonged period of lackluster growth. Expect the next few years to bring their fair share of modest upticks in economic growth and additional growth scares. See Jim Fink’s InvestingDaily.com article, Bear Market Rebels: Stocks That Have Gone Up During the Market Decline, for a couple of good names to turn to during this market weakness.

The US isn’t the only developed economy that has weakened; burdened with an ongoing sovereign-debt crisis and fiscal austerity measures, Europe appears to be in worse shape. The IFO Business Climate Index, which has traditionally been a reliable predictor of German economic performance, fell in August to its lowest level since June 2010. With growth stalling in Europe’s largest economy, many worry that the EU could slip into recession.

But the Eurozone PMI Composite indicator held steady at 51.1, defying analysts’ consensus expectations, which had called for the index to decline to 50 in August. Readings above 50 indicate expansion, while readings in the mid-40s are consistent with a recession. As of yet, this indicator hasn’t deteriorated to levels that would suggest an imminent downturn. This index was bolstered by Germany’s stronger-than-expected Manufacturing PMI and France’s Non-Manufacturing PMI.

That’s not to suggest Europe is out of the woods. Rather, recent PMI data from the region suggests that the market’s dire projections about the eurozone have yet to come to fruition.

While bullish opportunities can be found, worries about the global economy slipping into recession continue to outweigh company-specific factors in the energy patch.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.