Market wisdom dictates that the Purchasing Managers Index (PMI) is a good lead indicator for economic growth. The theory being that if business leaders feel that the environment is improving then they are likely to invest and expand, which low and behold results in growth. Indeed over the past few decades there was a pretty good correlation between PMI surveys and economic growth 6 months hence. The appeal for the market is that it seems to make intuitive sense.
As the economy quickens, managers can see things are improving and will position their businesses for expansion which of itself should result in further economic growth. As the economy slows and heads towards a recession again managers adjust their business for contraction and the economy shrinks. This relationship has persisted through many cycles, so much so that any recording over 50 which indicates that more managers are seeing an improvement than are seeing a deterioration, is automatically translated into an assumption that the economy must be growing.
So much so that media reports almost always report that the economy grew in a particular month on the back of a PMI survey result, regardless of whether the hard data backs this up or not. Unfortunately, ever since the financial crisis this relationship has broken down. PMI surveys have persistently pointed to economic growth, yet the hard data has failed to back this up. This has become a dangerous situation, where investment decisions can be made assuming an optimistic outlook for economic growth based on positive PMI surveys, yet the reality is that many countries are seeing their economies deteriorate rather than improve.
The recent confirmation that Italy has slipped back into recession is a case in point. PMI data has pointed to expansion in the Italian economy for over a year now, yet the economy has contracted in both quarters this year and shows little sign of any reversal in fortunes. In fact the Italian economy has now fallen in 10 of the past 12 quarters, a truly dismal performance. This is in stark contrast to upbeat market commentary which is invariably based solely on a survey of some business managers rather than hard facts. Germany has also had very positive PMI data for over year, yet even here in the powerhouse of Europe, industrial production in July was actually lower than a year before.
The market has for some time chosen to ignore the facts and focus on the more bullish survey data, but as recent weeks have shown with significant underperformance by European markets, the fundamentals will show through eventually. To paraphrase, ignoring facts doesn’t make them any less real.
So why has this relationship seemingly broken down? It could well be that the depth and severity of the post-financial crisis recession has simply made the answers to the survey less relevant today. When your business prospects were as bad as they probably appeared when the global banking system or many Eurozone governments appeared to be bankrupt then things probably didn’t seem like they could deteriorate any further. So when asked if things are worse, the same or improving, then it’s not hard to see how even in a recession things would appear better than they had been.
This is probably the situation we find ourselves in today. The economy is weak, prospects are not great, but ECB action has prevented the prospects of a complete depression and as such things appear better. However, blindly equating a positive survey with economic growth can lead to mistaken investment decisions when there is no real data backing up this optimism. The facts are that European companies are now well into a third year of unbroken weekly earnings downgrades.
Most economies are deteriorating, not accelerating. Unemployment remains frighteningly high and rock bottom sovereign debt yields are a reflection of the prospect of an ECB liquidity injection, not of a recovering economy as European politicians would like you to believe. This is particularly dangerous for investors as the market has rerated significantly over the past two years on the illusion of improving economic conditions in the Eurozone. The PE of the Euro Stoxx 600 index is now 14.6x having hit around 9x in 2011; a multiple that the market has almost never traded at. This is fine if things were improving, but given any pickup in earnings growth seems unlikely, then the market just looks outright expensive. Beware the bullish hype with few real facts to back it up.
Jake Robbins is manager of the Premier Global Alpha Growth fund