The ISM Manufacturing Index, also known as the purchasing managers› index, fell more than expected in June. The index dropped to 53 where a reading of 54.5 was expected. This was not really a surprise, as the regional sentiment indicators had already fallen significantly.
In fact, they pointed to an ISM Manufacturing of only just above 50.
Yet stock markets did not immediately tumble on the decline in perhaps the most important macro figure published each month. The ISM Manufacturing is not only a good predictor of GDP growth but also of changes in the stock market in both equities and bonds.
The ISM Manufacturing is highly correlated with the year-on-year change in the S&P 500 Index. You can “estimate” the state of the index using a simple regression model with the ISM Manufacturing as the explanatory variable. Below we have done that with an ISM Manufacturing Index in November of 42.5. That is the level to which the ISM can fall based on a whole series of forward-looking factors, and so it almost certainly means a new US recession.
What is priced in?
With an ISM Manufacturing of 42.5, the model estimates an S&P 500 Index reading of just over 3750 points. That is a difference of just over one percentage point from the current reading of just over 3800 points. Only if the ISM Manufacturing were to fall much further, to below 40, which rarely happens, would the downside risk be significant. Conversely, if the ISM does not fall further than, say, 45, the historical relationship with equities tells us that the worst is behind us.
Of course, this is not the only factor that says something about future returns and no model is perfect. The fact that investors are already massively discounting interest rate cuts, for example, seems a tad opportunistic to me.
The point here is that simply assuming that equity markets will fall further because we are heading for recession is not a good reason to be negative on equities. What matters is the misery that has already been priced in and, judging by the ISM Manufacturing, that is quite a lot.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His «chart of the week» appears every Monday on Investment Officer Luxembourg.
This article first appeared in Dutch on InvestmentOfficer.nl
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