Emerg­ing from the soft patch

Financial Mirror (Cyprus) - - FRONT PAGE - Will Denyer and Tan Kai Xian

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.

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