by Gene D. Balas
What Worried Investors about China?
News on China’s economic slowdown – not to mention its plunging stock market – has rattled investors’ nerves worldwide. In data released January 4, China’s Caixin Manufacturing Purchasing Managers’ Index fell to 48.2 in December, from 48.6 in November, contracting for a tenth month in a row and coming in below a Reuters poll forecast for 49.0.
Levels below 50 indicate contraction. Details in the report showed both domestic and export demand for Chinese manufacturing goods was weak. Partly as a result of this latest news, Chinese shares plunged, touching off a sell-off in markets around the globe.
Signs of Manufacturing Contraction in the U.S.
Rather than dissect the Chinese economy or the market’s reaction, we’ll instead direct our concern to why manufacturers are seeing fewer orders – and what it says about demand from economic health in the rest of the world, including the U.S. Indeed, the issue of falling manufacturing activity is not confined to China; we can see it here in the U.S. in the form of the Institute for Supply Management’s Manufacturing Purchasing Managers’ Index. The measure fell to 48.2 last month from 48.6 in November. A reading below 50 indicates the sector is contracting, and the ISM PMI is now at the lowest levels since 2009, when the country was in recession.
The Role of Inventories in Manufacturing Activity
Is that reason to be alarmed? Well, perhaps not. There might be a likely explanation, and that relates to inventories. (Of course, the strong dollar denting exports while making imports more attractive plays a leading role as well.) Wholesalers in particular have increased their stockpiles of unsold goods. We can compare their inventories against their sales to see whether this inventory build could spell falling sales for their suppliers (i.e., manufacturers) at some point. And indeed, the inventory to sales ratio of wholesalers has risen quite a bit in the past year, as seen in the nearby graph, observing that wholesalers hold much more in inventories relative to sales than at any point since the Great Recession, and far more than at any other time besides the Great Recession, in the period since the Tech Wreck recession of the early 2000s.
The logical question is, why have inventories risen so much, to the point where businesses are placing fewer orders with manufacturers? Is demand really that weak? We can look to two different sets of data: one for consumers and one for capital investment by businesses.
Consumer Spending Growth Has Decelerated Notably
Annual increases in consumer spending have been on a steady downtrend since 2010, as we can observe in the Retail Sales data from the Census Bureau at the Department of Commerce. In fact, as one can see in the nearby graph, the year-over-year percent increase in retail sales excluding food service has decelerated notably to hover at the lowest levels since 2010, when the economy was first recovering from recession. (Of course, some of the more recent decrease is partly due to falling gasoline sales, as these data are not adjusted for price changes.) Certainly, as a result, retailers have likely placed fewer orders with wholesalers, explaining some of the increase in wholesalers’ inventories.
Lower Prices May Have Led to Inventory Build
There is another possible explanation as well, and that relates to the stronger dollar, through the connection of lower import prices, whether for finished goods or those used as inputs in U.S. manufacturing output. The Bureau of Labor Statistics publishes several sets of price data, and these include two separate measures, one for import prices (which is more directly affected by the strong dollar) and one for producer prices of finished goods (which can be indirectly affected by lower import prices of crude or intermediate goods). Consider the nearby graphs which show how both measures of prices – often paid by wholesalers – have plunged in the past couple years.
So,the sharp drop in prices of both imported and domestically-manufactured goods may have incentivized some businesses to stock up on inventories while prices are low. With stockpiles now larger relative to sales increases that have likely been weaker than what had been budgeted, the logical response is to order fewer goods from manufacturers.
And that spells trouble for Chinese exporters – and for U.S. manufacturers as well. Thus, we can connect quite a few dots in a complicated web of interrelated variables to explain what seems like a simple equation: manufacturing is soft, so investors sell shares – both here and in China.
However, even though we can explain the aspect of inventories, we still need to puzzle over the deceleration in consumer spending at retail stores. Part of this relates to falling gasoline prices, as these data are not adjusted for inflation, but part of this is due to factors bearing close watching in the future.
Soft Business Investment in Capital Goods
Falling energy prices leads us to the separate issue of business investment in capital goods. Here, we see a similar pattern of recent softness. Business investment can be measured in data from the Census Department at the Bureau of Economic Analysis. Found in the Durable Goods report, the data we seek is the item of “Non-Defense Capital Goods Excluding Aircraft.” This measure, too, has been recently hovering close to zero, measuring the year-over-year percent change in new orders in the nearby graph.
Energy companies’ cutting back on new orders for drilling equipment is reflected in these data. What we might surmise, however, is we know that the world is awash in an excess supply of oil at current production levels. One might even expect that production, at some point, may be curtailed. That means that, going forward, new orders for drilling equipment might be hardly likely to improve, and that these currently soft levels of capital investment could be the norm for the near term. In other words, this cutback in business investment might not be merely passing weakness. In fact, earlier strength in these data could have been (temporarily) boosted by energy investment that may not return for quite some time.
Conclusion
Both decelerating consumer spending and diminished business investment are hardly ringing endorsements of the economy. And both bear continued monitoring. In the meantime, economic growth estimates for the fourth quarter have been ratcheted downwards. To wit, the Federal Reserve Bank of Atlanta said January 4 it now believes fourth-quarter U.S. GDP grew at just a 0.7% pace, down from a prior estimate of 1.3% growth. J.P. Morgan Chase cut its estimate in half to 1% growth from 2%. And forecasting firm Macroeconomic Advisers lowered its estimate by three-tenths of a percentage point to 1.1%.
With these modest rates of economic growth may come more modest investment returns on economically-sensitive assets than what we’ve experienced early in the recovery. For these reasons, having expectations for your portfolio consistent with the global economic environment may indeed be sound advice.
By Gene Balas, CFA
Definitions
The Chinese HSBC Manufacturing PMI is a composite indicator designed to provide an overall view of activity in the manufacturing sector and acts as an leading indicator for the whole economy. When the PMI is below 50.0 this indicates that the manufacturing economy is declining and a value above 50.0 indicates an expansion of the manufacturing economy.
Disclosures
Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.
The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.
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