It’s been an interesting month or so in global equity markets. However, if all you did was look at the price movements across key global equity markets in our daily morning report (see Fig 1), you would probably struggle to understand the “interesting” reference. All seems calm with prices up across the board. But these movements are masking a fast & furious price correction experienced in mid-July, especially in the U.S. In fact, the technology heavy Nasdaq 100 Index declined -12.4% from recent peak to trough, which meets the definition of a genuine market correction (i.e., 10-20% price decline). Similarly, the S&P 500 Index fell -6.5% (a mini correction) over the same period. However, so far in August, most of the losses (if not all) have been recovered, including in Australia, Europe and the UK. The correction was largely driven by some of the unwinding of the Yen Carry trade – which in simple terms means borrowing in low-interest rate currencies like the Japanese Yen to invest in higher-yielding / growth assets in other currencies. Surprise, surprise the fast & furious move in global markets was (again) driven by leverage.
Market correction didn’t stop funds rolling into equities. Despite the sudden market drop and uncertainty that comes with it, recent funds flow data shows investors didn’t stop pouring money into U.S. equity and technology funds. U.S. equity funds reported their seventh consecutive week of inflows. Investors bought the dip!
Figure 2: Recent trends in funds flow across equity fund categories.
Source: Deutsche Bank Asset Allocation
Economic data helped allay any immediate recession fears in the U.S. What has also likely helped the recent market correction to quickly find a floor and recover is the fact subsequent economic data reports have been broadly supportive of “the resilient economy” narrative in the U.S. It was the July U.S. ISM Services data release which came in ahead of market expectations that helped turnaround equity prices. The index registered a reading of 51.4, which was ahead of market estimates at 51.0 and above prior month’s 48.8 level. A reading above 50.0 indicates the sector is expanding. Underneath the headline numbers, the subsector readings were also positive for the U.S. economy including the important employment reading which came in at 51.1 versus market expectation of contraction at 46.1.
Reminder – the services sector matters more. As a side note to our discussion on PMIs, we do want to remind investors that for most developed economies (like the U.S. and Australia) the manufacturing sector is no longer the biggest driver of economic output. It’s the services sector which makes up 70% of the output for most developed economies. Why is this important to understand? There are several reasons:
(1) Manufacturing and services PMIs are used by investors as leading indicators for economic growth and therefore direction of equity prices – hence understanding which one matters more is important;
(2) Investors often take a contraction in manufacturing sector as imminent sign of a broader recession (even though manufacturing’s contribution is much lower now – see Fig 3 which shows how the importance of the services in the U.S. has picked up since 1950 whilst manufacturing has declined); and
(3) We have seen economic models which try to forecast future recessions which overweight the readings of manufacturing PMIs in developed economies despite it being a much lower contributor to output.
Source: Bank of America, Banyantree
Australian activity expands. Fresh off the press, the latest business activity data in Australia showed activity returned to expansion levels in August driven by rising new orders and accelerating employment growth. The Judo Bank Flash Australia Composite PMI – which tracks sentiment among purchasing managers at manufacturing, construction and/or services firms – increased to 51.4 in August. This is after activity marginally declined in July (reporting a reading of 49.9).
More headaches for the RBA. The latest PMI data shows the Australian economy is growing but is relatively weak. The solid headline numbers were driven by acceleration in services activity in Australia, whereas manufacturing activity is contracting. This creates a headache for the Reserve Bank of Australia (RBA) with respect to their monetary policy path. The RBA has already signalled that the cash rate will remain on hold for the rest of this year. However, the RBA has not ruled out raising rates if inflation risks accelerate. We remind investors of the fiscal stimulus which was injected into the economy as tax cuts commenced in July. Strong labour markets and additional fiscal juice could easily raise upside risks to inflation. This increases the probability the RBA may have to raise rates again, which would further put pressure on parts of the economy already feeling the impacts of high interest rates and could potentially slowdown (or even reverse) the strength in the services sector.
