Amid The Melt-Up, Never Mind The ISM’s Flagrant Heresy

Friday’s disappointing ISM manufacturing print in the US was a not-so-subtle reminder that all is not well economically, even in the US, which has been a bastion of stability over a two-year period of slowing growth abroad.

Markets were too preoccupied with geopolitical developments on the second trading day of the new year to worry about ISM, but the fact is, the disconnect between the manufacturing gauge and virtually every other indicator of US economic vitality is glaring.

Some readers may describe that as somehow naive or alarmist, but it is what is – when you plot the damn thing atop other series, it sticks out like a sore thumb. Can you explain it? Well, sure. Everything is in some sense “explainable”, but if you had to describe it and you were confined to only two adjectives, “disconcerting” or “meaningless”, you’d almost surely choose the former.

Even if you’re inclined to dismiss it as anomalous or a false recession prophet, you’d admit it’s annoying, especially considering the recent rebound in the labor market which suggested the world’s largest economy is set to tack at least another several quarters onto what is already the longest expansion in history.

And here’s the thing: Bonds noticed this a long time ago, and while yields justifiably bounced off the August “false optic” recession-scare lows, it’s worth asking whether the disconnect between ISM, stocks, high yield spreads and investment grade credit (which had its best year in a decade in 2019) is sustainable. Here’s a visual (and there are multiple “chart crimes” present, but you’ll forgive them since we admit to guilt):

You could very plausibly look at the top pane and suggest that yields had simply overshot to the downside in August – even if the US was headed for a shallow recession, 10-year yields below 1.50% might have been a bit much, so that small divergence on the right-hand side is forgivable.

However, the bottom pane is less defensible. High grade spreads (not shown) are among the narrowest in two years. Junk spreads, while still above levels that persisted for most of 2017 and 2018, are 200bps lower than they were in the depths of the Q4 2018 selloff and 600bps tighter than during the deflationary doldrums of early 2016. Stocks, meanwhile, are in the midst of a “melt-up”, although geopolitics may short-circuit the euphoria at least temporarily.

The point is simply that there are lingering signs of economic malaise even in the US, where, for the most part, the economy has stabilized after the late-summer swoon. In the rest of the world, “nascent” would be a generous way to describe any inflection for the better.

That isn’t meant to be some kind of ominous assessment. Rather, it’s just reality.

Speaking of reality, SocGen’s Andrew Lapthorne (who isn’t shy about throwing cold water on ebullient sentiment), on Thursday described 2019 as being “awesome…except [for] the economy, profits and valuations”.

“Most indices performed quite well [in 2019] with 70% of stocks in MSCI World posting gains of 10% or more, yet this performance went hand in hand with deteriorating economic sentiment, falling interest rate expectations and declining profits”, he remarked, adding that the “MSCI World delivered a total return of over 28%, with almost all of that coming from P/E expansion, and the decade ended with the index trading at 17x forward EPS, close to its highest forward valuation outside of the tech bubble”.

(SocGen)