Here Comes The Next Eurozone Recession - Maybe To Probably

by: Tim Worstall

Recessions, once they start, are self-reinforcing, all that Keynes and animal spirits stuff.

The manufacturing sector is always more volatile over the business sector than services.

So, here we are, the beginning of that downward slope into recession in eurozone manufacturing. Is this the start of one in the general economy?

What Is It We're Worrying About?

The eurozone is, by rough rule of thumb, some 20% of the global economy. If that goes into recession then it's going to affect everyone and every market.

How do we tell if the eurozone is going into recession? Ah, well, that's much more of an art than it is a science. Still, we have some aids.

And what do we do if there is a recession? Well, it'll be equities hit hard, bonds might actually gain in value dependent upon monetary policy to try to end it. Effectively, investment strategies get stood on their head in a recession - equities become a place for income, bonds for capital appreciation.

So, What's Our Recession Indicator?

As with the German numbers out earlier today accept that manufacturing is more variable in output than other sectors of the economy. It's thus a leading indicator, a canary in the coal mine if you wish. If we see falling manufacturing output then we aren't sure that a recession will arrive but we think it likely.

It's also true that actual GDP numbers are a trailing statistic. We go out and count them after they've happened. What we'd like is something that tells us before. Thus the purchasing managers' index. To make something someone has to go out and buy whatever it is that it will be made from. So, go ask the purchasing managers whether they're buying more this month than they did last. That's a pretty good sign - and it is a good leading indicator - that they will be making more this month than last. GDP is rising therefore if the PMI is showing expansion.

Such systems are set up so that a reading of more than 50 is expansion, less is contraction. And economic contraction is, if general, a recession.

What's The Indicator Indicating?

The eurozone manufacturing PMI is not giving us a happy answer, putting us in a nice comfortable place:

Eurozone PMI from IHS Markit

(Eurozone PMI from IHS Markit)

Just from that you should be able to see the when of Europe's recessions. But to show that it really is a useful leading indicator here is the PMI as against actual output:

Eurozone output and PMI from IHS Market

(PMI and output out-turn from IHS Markit)

The advantage of the PMI is that it's a forecast, rather than a recorded out turn after the event. It's clearly a pretty good forecast too.

No, We Still Don't Know About A Recession

But the more we see these numbers, the deeper we drill down into them, the more we think that really might be true.

By nation, Germany continued to endure the sharpest deterioration in manufacturing operating conditions, with its respective PMI again signaling a marked rate of contraction. Austria saw the health of its manufacturing economy deteriorate to the greatest degree for over four years. Italy's PMI also remained below 50.0, albeit only slightly. Only marginal growth was seen in France and Spain. Greece remained the best-performing country in terms of manufacturing expansion. Underperformance of the region's manufacturing sector continued to be closely linked to deteriorating order books. Latest data showed an eighth successive monthly fall in new work received. Panelists reported falling demand both at home and abroad - as highlighted by another solid (albeit slower) fall in new export orders during May.

The best we can say is that we're only on the cusp of a manufacturing recession rather than actually being in one. The worst is that it's all already underway.

So, What Do We As Investors Do?

As I've said before, macroeconomic factors can and will over ride even the most carefully thought through investment in a specific stock or situation. These factors tell us about sectors and directions, even as they don't dictate absolutely which specific opportunity is going to work out best.

If we are going to have a eurozone recession - something I'm calling as a greater than 50% probability here - then the correct response is that investment priorities invert. Bonds are the place for capital gains as lower interest rates - or unconventional monetary policy - will be used to try to get out of the recession. Stocks become places to look for income as dividends are - hopefully - maintained.

One indicator does not a recession make. But the best indicators we've got seem to be telling us we might well be in one. Be ready to switch strategies if you're investing in the eurozone.

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.