The ISM Manufacturing Index is not only an important indicator of future growth, but is also highly correlated with market returns. What many investors overlook: it’s not just correlated with equity returns, but also bonds.
By using indicators that say something about the direction of the ISM Manufacturing Index to define different ISM scenarios, you can derive implied returns for each asset class.
Examples of indicators that reliably give signals about where the ISM Manufacturing Index is heading are OECD leading indicators, confidence among small US entrepreneurs, and the difference between the ISM sub-indices for New Orders and Inventories.
Not negative on equities
The table below shows the implied returns for US stocks and bonds, based on three different stocks of the ISM Manufacturing Index at the end of February next year. My base case is that ISM Manufacturing drops to 45 in the coming months. The other two scenarios are an ISM falling through to 42.5 and an ISM holding steady at 47.5.
The table shows that while there are plenty of reasons to remain cautious about equities, the ISM Manufacturing Index is not one of them. Only in the scenario where the ISM Manufacturing Index falls to 42.5 is there still 2 per cent downside. But if the ISM reaches my expected 45, that implies a positive return of 6 per cent from current levels.
20 per cent return?
But, that is nothing compared to the implied return on US government bonds. In each of the three scenarios, that is above 20 per cent.
What runs through this, of course, is the extremely low interest rates of the past decade. But even when you correct for this, the implied return is well above that of equities in two of the three ISM scenarios (42.5 and 45). On top of this, bonds tend to have lower volatility, although there is little evidence of this at the moment.
Connecting the dots
Investing is often a matter of tying the right dots together. By defining ISM Manufacturing Index scenarios and linking them to the returns of not only equities but also other asset classes, you get an idea of the (relative) performance possible. And by building a broad framework of different factors within different disciplines, macro, sentiment, valuation, you get a consistent set of signals that should ultimately take you to a better risk-return ratio.
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.