An Increasingly Deteriorating Outlook

|
Includes: ACWX, ASHR, EPP, EWJ, EWU, EZU, IWM, SPY
by: Eric Parnell, CFA

Summary

Manufacturing activity around the globe has been fading for some time.

Pockets of manufacturing deterioration are increasingly developing in various economies around the world.

Unfortunately for the market, recent data trends suggest that manufacturing conditions and thus corporate profits may end up getting worse before they get better.

Manufacturing activity around the globe has been fading for some time. Past signs of manufacturing improvement during the post crisis period have largely disappeared, and pockets of deterioration are increasingly developing in various economies around the world. This weakening in worldwide manufacturing activity is highly problematic for stocks, as manufacturing is a primary driver of the corporate profits that are so critical to rising stock prices. Unfortunately for the market, recent data trends suggest that manufacturing conditions and thus corporate profits may end up getting worse before they get better.

Why Manufacturing Activity Is So Important To The Stock Market

The Purchasing Managers' Indexes (PMIs) are monthly surveys used to determine private sector business activity. In the United States, two separate surveys are compiled by the Institute for Supply Management (ISM) and Markit. These surveys are sent to hundreds of purchasing managers across various sectors to determine whether conditions are improving, staying the same, or deteriorating versus the prior month. For the manufacturing sector, the survey includes several different items including employment, production levels, new orders, supplier delivery speed, inventories and order backlogs. A reading over 50 indicates improvement in manufacturing activity, a reading of 50 indicates no change, and a reading below 50 indicates a decline. And the higher or lower the reading, the more pronounced the improvement or decline (i.e., a reading of 58 signals more improvement than a reading of 51).

The reading for ISM Manufacturing has been deteriorating for some time now. After peaking in August 2014 at 58.1, it steadily trended lower over the next year and a half, crossing below 50.0 in October 2015 and bottoming at 48.0 in December 2015 before bouncing back modestly over the first few months of 2016. Overall, manufacturing activity has been on the fade in the United States for some time now and has shown some recent signs of deterioration.

Why the focus is particularly on manufacturing activity when it comes to corporate profits? After all, doesn't manufacturing activity make up a fairly small percentage of the overall U.S. GDP at around one-seventh of the entire total? It is true that manufacturing is a relatively small part of the U.S. GDP, but it makes up a much more meaningful percentage of corporate profits at nearly two-thirds of the overall total. And given that these same earnings are the primary driver of stock prices over time, this puts manufacturing activity under the spot light for how it is performing at any given point in time. The last 20 years of history shows the strong relationship that exists between manufacturing activity as measured by the purchasing managers' index and corporate profits.

The Problem Facing Stocks In The Months Ahead

Here is the problem for stocks in the months ahead. While earnings have been declining for some time, many analysts are calling for a profit improvement "in the second half of the year" ("in the second half of the year" and "early next year" have become notorious phrases from market optimists, as the real improvement has been just right around the corner for more than seven years now - unfortunately for the market's underlying fundamentals, the improvement almost never actually arrives), it remains highly uncertain from where the driver of this improvement is going to come. For it does not appear that it is going to come from manufacturing activity, as conditions are steadily trending toward getting worse, not better. As a result, the dreams of +20% profit growth by the end of the year and into 2017 may prove highly elusive at the end of the day.

Let us take a quick journey to see the developing state of manufacturing around the world. We will begin with the United States. A measure of optimism could be taken from the fact that the U.S. ISM Manufacturing Index has edged back higher over 50.0 in the last few months. But a look at its U.S. Markit Manufacturing PMI tells a different story. Although still showing improvement at over 50.0, the Markit survey is moving in a decidedly fading trend instead of showing any signs of acceleration. So when viewing the ISM and Markit surveys together, it confirms an ongoing drift toward deterioration, not improvement, which bodes ill for corporate profits going forward.

But perhaps improving manufacturing activity across the rest of the world might help pick up the slack and offset signs of continued fading here in the U.S. Unfortunately, this is not the case.

Beginning in Europe (BATS:EZU), the Euro Area Markit Manufacturing PMI has been skimming just above the 50.0 line for more than two years. Incrementally improving manufacturing activity at best for some time, but hardly the basis to suggest that robust improvement is ahead. And this is in a market where interest rates have already been negative for some time, so any expectations for a boost in manufacturing activity here, thanks to fresh round of monetary stimulus, should be muted at best.

Conditions appear a bit more bleak in the United Kingdom (NYSEARCA:EWU), where the UK Market/CIPS Manufacturing PMI has dipped back below 50.0 and into declining manufacturing activity territory for the first time in nearly three years. And with the looming overhang of a Brexit vote coming up in the next few months, it's a stretch to think that companies are going to be rushing out to place new orders any time in the immediate future.

Manufacturing activity looks even worse as we head east to Asia (NYSEARCA:EPP). The China Caixin Manufacturing PMI has spent more time over the past several years in decline territory below 50.0 than above it. And despite some improvement in the measure of decline in recent months, sufficient uncertainty remains around the outlook for the China (NYSEARCA:ASHR) economy that a robust improvement in manufacturing activity in the months ahead should not be considered even remotely close to the base-case outlook.

In Japan (NYSEARCA:EWJ), the manufacturing outlook appears arguably the direst. Japanese policy makers unleashed an extraordinarily aggressive stimulus program in recent years designed to finally lift the economy out of a more than two-decade malaise. This included more than doubling the yen money supply over the course of roughly two years, which in a word is absolutely astonishing. And while all of these policy acrobatics managed to generate some positive PMI readings over the past two years, it seems the sugar high is already wearing off as Japan Markit/Nikkei Final Manufacturing PMI has fallen sharply back into decline territory in recent months.

Together, these economies make up 70% of the global GDP. If manufacturing is fading or deteriorating across all of these various regions that make up the vast majority of the global economy, the source of improving corporate profit growth will quickly become difficult to come by.

The Bottom Line

Annual corporate profit growth has been falling for six consecutive quarters and counting. And while the calls for a reacceleration in earnings growth sound great, exactly from where is this fuel going to come? For with global manufacturing activity trending decidedly in the wrong direction, it suggests that we may see corporate profits get worse before they start to get better. And the more that earnings shrink, the more precarious the already lofty valuation perch becomes on which the U.S. stock market sits.

Perhaps manufacturing activity suddenly reverses and improves in the second half of the year as so many optimists want to promise. This would be great news. But then again, maybe U.S. large-cap stock prices as measured by the S&P 500 Index (NYSEARCA:SPY) finally fall back to the reality that so many markets both in the United States such as small caps (NYSEARCA:IWM) and around the world have already been reflecting for some time (NASDAQ:ACWX). Until the manufacturing trend changes, the likely outcome remains biased to the latter.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.