Monitoring Demand for Discrepancies

We have highlighted our concerns about end-user demand weakness before. As Yellen and others have touted rosy forecasts of a surging economy, we have questioned their evidence for such optimism. The key area we monitor for confirmation is demand from real people for goods and services. If the economy is going to improve, someone has to have the resources (cash or credit) and the desire to buy stuff.

The Fed can disrupt or delay prudent financial decision-making through their actions. When they did QE, it created a temporary environment for public companies to issue cheap debt and use the funds to buy back stock. This is penny-wise and pound-foolish and we have pointed out why in previous posts (here and here). The Fed played this hand to great effect from 2009 to 2014 and then left the stock market to flat-line as it searches for the next growth fix. 

Investors run into problems when they try to find accurate, actionable data on economic demand. To eliminate noise and bias we look at the New Orders Index from the Institute for Supply Management (ISM) Report on Business® each month. While the Purchasing Managers survey is the most popular part of the monthly release, we focus in on the New Orders data and to a lesser degree, the Production Index. While far from perfect, these data points are timely and robust enough to be useful.

ISM surveys 17 industries and reports the results. In June, the New Orders Index increased 1.3% to 57% which was the 6th consecutive month of growth in the index. This coupled with a 2.1% increase in the Production Index in June leads us to expect an improvement in the manufacturing component of the jobs report this Friday. 

Sounds all good, right? Near term it certainly is good news and as we mentioned, we expect it to have a positive effect on June’s jobs report. Unfortunately, this survey was conducted before the Brexit disruption which, among other side-effects, caused the Fed to halt any action on interest rates. By placing these near term results on a multi-year time horizon, we see a more complete picture. The longer term rate of growth in new orders has slowed to the point that any disruption (real or perceived) could leave the economy with an empty order book:

Here is Non-defense New Orders excluding Aircraft (which reduces government deficit spending effects):

Again we ask, “where is new growth going to come from?” Post-Brexit, US interest rates have declined to new lows and corporate earnings (which starts next Monday) look to be hitting a wall this quarter.

None of this has prevented stock analysts from projecting big increases in earnings and Ned Davis Research pointed out that household equity exposure is hitting the ceiling as well:

Demand (in the form of new orders) needs to pick up to sustain this optimistic setup. We are not so sure this will happen.

If the jobs report comes in stronger than expected on Friday, we think it would be wise to trim the risk sails back to something more prudently aligned with the level of new orders. When new orders accelerate, (or valuations become more attractive) we will get more bullish on domestic equities. In fact, Keeping a tight leash on risk assets until the election seems very prudent to us.