With Monday morning's ISM Manufacturing data showing the first decline since July 2009, voices on both the bull and bear sides have gotten significantly louder.
Talk of a potential recession has clearly infiltrated headlines now, and some of these recessionary arguments have some merit. The key driver behind Monday's miss was the plunge in new orders to 47.8 (from 60.1), while prices (an important component of corporate margins) came in at 37 compared to an expected 57.
This figure comes after a series of poor regional manufacturing surveys including the collapsing Philly Fed:
On the flip side, the employment index for the national ISM was little changed at 56.6, hardly indicative of a recessionary environment. Additionally, some are questioning how important the data is in the first place, considering manufacturing is responsible for a mere 10% of our economy.
This kind of thinking seems a bit too dismissive; considering the collapse in global PMI data, it's apparent that at the very least, our economic data has recoupled with the trends of our trading partners. While manufacturing may not have much significance in the context of the entire U.S. economy, it seems unlikely that the services sector will depict an entirely different growth story.
While the non-manufacturing index came in at 53.7 in May, the employment component was down 340 basis points to 50.8, and while respondents remained confident business conditions would remain steady, it was generally expected that actual activity would stay flat for 2H 2012.
Since May, consumer and business confidence has weakened, while EU, Chinese, Brazilian, and Indian data has cemented the global slowdown story. With global conditions having deteriorated significantly since May's non-manufacturing ISM, I expect Thursday's reading to come in well below expectations of 53.0.
Forecasting an imminent recession at this point in time appears to be a bit too pessimistic, as recent U.S. data points are more indicative of slower growth than an outright contraction. Granted, as major overseas economies trend lower, the U.S. will in fact display weaker growth until the Fed attempts to stimulate, or the U.S. economy enters an official recession since July of 2009.
The Implication For Stocks
Monday's market action gave a lot of clues to observant market participants as to the underlying sentiment of equity investors. After Dow futures fell about 75 points in the aftermath of the ISM shock, stocks drifted higher all day (note: on exceptionally low volume).
The market's resilience in the face of a report like this one means the market is likely headed higher in the near-term, though the long-term bear case remains intact. Why the near-term strength? Given the major divergence between Treasuries and stocks (SPY) (10 year yields dropped more than 4% Monday after the ISM report), these two markets appear to have taken the manufacturing weakness as a potential driver behind Fed stimulus. With oil well below $100 and CPI figures indicating low overall inflation, the Fed does indeed have a bit of breathing room.
Traders should now be considering the different potential outcomes of this sentiment. I feel the most likely result at this point in time is that second quarter earnings disappoint slightly, and that eurozone risk is priced back into the market over the next month. The EU summit sparked a lot of short-covering, but the lack of eurobonds and immediate ratification of the ESM left insolvency risks on the table.
For now, the "Bernanke Put" seems to be holding up pretty well. Additionally, strong trailing earnings have provided an intermediate-term floor on stock prices. However, given the trend in recent data points, projected earnings and margins don't appear to be in line with economic reality. We appear to be setting up for a repeat of 2010 and 2011 (not exactly a variant viewpoint), whereby markets drop precipitously on EU worries and weak confidence-induced data point misses, the Fed stimulates, and stocks get an end of year pop.
The issue this year is the short half-lives that coordinated interventions have had on market sentiment. We may be reaching the point where legitimate, painful restructurings actually have to take place. But as usual, that's just in the distant future, right?
Additional disclosure: Short SPY via Put Options