Global recession or inventory cycle?

Is there any difference? Via the excellent Damien Boey at Credit Suisse:

What a wild ride it was for bonds overnight! In the Asia-Pacific time zone, bonds sold off aggressively outside Australia, as investors became worried about a potential slowdown in BoJ asset purchases in a fairly illiquid environment. But in the US time zone, the ISM manufacturing index came in below expectations, remaining at 47.8 in September, consistent with ongoing contraction in world industrial production. Bonds rallied strongly on the back of this, more than clawing back earlier losses.

Equities sold off on the weak ISM data. Within equities, defensive momentum plays outperformed, while value and small caps underperformed. Macro remained front and centre, even for stock pickers.

We think that the weak ISM data is actually symptomatic of a global de-stocking cycle. History tells us that re-stocking usually follows de-stocking, especially if final demand holds up in the face of high uncertainty. And if the global economy follows this pattern, we should expect to see a rather strong bounce back in activity growth in 2020.

Why are we so convinced that the world economy is simply experiencing a de-stocking cycle, as opposed to a deeper-seated, demand slowdown? Firstly, examine the components of the ISM survey. New orders fell in September (as in, the sub-index printed well below 50) – but inventories fell by even more. The new orders-inventories net balance, a noisy, but longer-leading indicator of growth momentum, actually improved to a slightly positive level from negative territory. Somehow, this was missed in the overnight madness.

Secondly, we note that US retail sales growth remains quite solid. Notwithstanding market volatility and high uncertainty, year-ended growth in real retail sales has accelerated to 4.4% from only 3.2% a few months ago. This matters, because historically, the US consumer has been the buyer of last resort of goods and services produced globally. Therefore, US retail sales has tended to lead world industrial production by several quarters. We already know from recently weak ISM readings that world industrial production growth will slow towards zero. But if US retail sales growth continues to hold up, we will very soon be in a situation where supply has materially undershot demand. Firms will be inclined to re-build inventory levels, and re-invest once they feel confident that uncertainty has peaked. These sort of recoveries are like an elastic band snapping back – they can be very sharp and powerful. They are certainly not recoveries that we would want to stand in the way of by being overly bearish in our investment views.

Thirdly, we echo RBA Governor Lowe’s sentiments, that when uncertainty is high, firms tend to sit on their hands and do nothing. They tend to hold off longer-term investment plans until they get enough certainty about the policy regime they are in. And the data tells us that in response to trade war uncertainty and market volatility, firms have indeed been holding off on their capex spending. US non-defence capital goods shipments have been weakening of late.

Finally, as we have noted recently in our article “Tail risk or apocalypse” dated 5 September 2009, the likelihood is that US retail sales growth will hold up, because mortgage demand has strengthened dramatically in response to lower bond yields and mortgage rates. To be sure, US employment growth has been in the process of slowing. But history tells us that spending growth can easily outstrip income growth when households are inclined to borrow, with positive wealth and credit effects leading the way.

If you believe that we are merely seeing a de-stocking cycle today, you also need to consider the flipside of a sharp re-stocking cycle.

Destocking is also a classic recessionary signal. There has been a supply side shock in world trade. That this has not hit consumers does not mean that it won’t. If earnings break and take down the stock market then the US consumer will be next.

Destocking may be the canary in the coal mine not an excuse for better.

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