Emerging from the soft patch
Three weeks ago we asked whether the uniform weakness in US data—across manufacturing, services and home construction—signalled the start of a recession or merely a summer soft patch. At the time we concluded that what we were seeing was yet another soft patch. Thankfully, the latest round of data releases appears to confirm that conclusion, with the US economy now emerging from its summer doldrums.
The most dramatic rebound has occurred in the ISM service sector PMI, which jumped from 51.4 in August to 57.1 in September, according to last week’s release. This is a welcome development. The service sector has supported growth over the last two years while manufacturing has sucked wind. So when the service sector PMI also dropped to near 50 in August, we got a little worried. The latest rebound brings the measure back up to the strong levels of 20142015.
The improvement in manufacturing and home construction data has been much more marginal, suggesting stabilisation rather than a rebound, but even that is a relief. ISM’s manufacturing PMI was barely in growth territory at 51.5 in September, but that still beat the 49.4 reading in August. We do not expect a vigorous pick-up here anytime soon. The US dollar remains elevated, which makes US exports relatively unattractive and foreign imports relatively attractive. Moreover, the sector still has a sizable inventory overhang to sell down.
Construction tells a similar story. US construction activity leveled off in the early part of this year after years of recovery. The dip in building permits in July raised the prospect that the sector was actually starting to roll over. Happily, the latest data points suggest the sector has stabilised, and that it may even be growing modestly.
Building permits picked up again in August, restoring the flat trend year to date. And after a prolonged dip, the NAHB homebuilders’ survey rebounded to its highest level in a year. Meanwhile, last Wednesday’s ADP employment report revealed that construction firms have increased hiring by the most since March— nothing spectacular, admittedly, but still a marginal improvement. Here too, we do not expect a return to strong growth anytime soon. Much of the catch-up growth in the construction sector has already taken place, and tighter lending standards on new real estate projects are weighing on future prospects.
In short, the US economy appears to be back to where it was before the summer’s soft patch, with strong growth in services, and little or no growth in manufacturing and home construction. This leaves overall growth modest, but still in positive territory.
As a result, our overall portfolio recommendations are little changed. The odds of a recession have fallen with September’s data releases. But as long as interest rates remained low, the balance of probability always favored a temporary soft patch over recession in any case. However, our Wicksellian framework, which focuses on the spread between returns on invested capital and cost of capital suggests investors should remain cautious. The latest improvement in the data has boosted growth and inflation expectations, which in turn have helped to push bond yields higher. So although the data suggest no further severe deterioration in ROIC over the near term, the COC may be on the rise. As a consequence, our approach continues to suggest a roughly balanced portfolio, with equity/risk exposure at around 50%, balanced by cash or short-tomedium duration treasuries and maybe a handful of quality corporate bonds.