Weekly Perspective: Dire Straits – PMI Contrarianism in the Age of Pandemic

Sultans of Cyclical Swings

The March Manufacturing Purchasing Managers Index (PMI) hit 64.7 last week, the highest in four decades. This makes the cyclical investor in me shiver (in the dark).

I had the great fortune to spend many of my formative years as an investor covering Industrial equities and learning from some truly gifted cyclical analysts and traders.

The first lesson you learn investing in cyclicals, whether by heeding the advice of veteran traders or by making painful mistakes yourself, is: BUY when the PMI nears 45 and SELL when the PMI nears 60.

Of course, this offers no advice in exact timing and a lot of money can be lost by being too early or too late at these turns, but the general message of simple contrarianism is extraordinarily helpful for long term investors.

When the PMI nears 45 the world seems to be in dire straits. Manufacturing is rapidly contracting, causing companies and market prognosticators to warn about the end of the world. Fear is abundant. Every headline encourages you to “hunker down” and seek defensive stability. At this time, earnings expectations are getting slashed at the same time as valuation multiples may also be contracting. Further, positioning in cyclicals has likely become very light as investors have had every reason to rotate out of cyclicals and into defensives. But in reality, it can’t get much worse, and that’s the opportunity.

Forward returns for cyclicals and the market overall are actually the highest when readings of the PMI are in the bottom decile (meaning in that sub-50, nearing-45 territory). That combination of low expectations, low valuations, and low positioning is the ideal contrarian opportunity. It highlights another important rule for cyclical investing: for the market, less bad is good enough.

But that is not at all where we stand today.

Today’s PMI at 64.7 is the top decile of readings. The mood and messaging is ebullient, the appetite for cyclicals is ravenous (see fund flows YTD into cyclical sectors), estimates are being revised higher, valuations are expanding, and investors seem to have every reason to be positioned cyclically (Reopening! Inventory shortage! Pricing! Infrastructure! Supercycle!).

The catch is that this PMI environment is typically associated with the lowest forward returns for the market. Chart 1, created with data from Strategas, illustrates this contrast. Returns are still positive, but significantly lower than when the PMI was depressed..

Chart 1: 6-Month Returns for the S&P 500 Based on PMI Decile

“But Worst of All Young Man, You’ve Got Industrial Disease”

So does this mean the cyclical, and even broader market, rally is over?

Not necessarily, but returns are likely harder to come by from here. The easy money in cyclicals has likely been made. The rising tide has lifted all boats as expectations and valuations have now been recalibrated higher off of last spring’s deep-fear lows. From here, winners and losers will likely emerge, favoring those who can both growth and defend margins in an environment of rapidly rising input costs.

The distortion of the amplified pandemic data swings and equally amplified policy response may cause some unique market behavior in the near-term, though. But don’t get too excited, we don’t think this time is permanently different, with contrarian rules eventually winning out.

In the near-term, tight supply chains, with their resulting higher prices, low inventories, and extended delivery times, can persist. Easy year-over-year comparisons will be passed, while transportation and manufacturing bottlenecks will eventually clear, but over the next couple of months stimulus-boosted reopening can keep conditions tight. This could provide further support for cyclical expectations in the near-term, but nowhere near the degree of revisions higher coming out of the 2020 low.

One of the reasons a high PMI is bad news for forward returns is because the rapid economic expansion usually spurs the Fed to tighten policy to prevent overheating. Expectations for tighter Fed policy would usually show up in the short end of the yield curve, with 2-Year yields moving higher in anticipation of higher rates. But the Fed is committed (in both words and actions) to keeping policy ultra-accommodative. Chart 2 shows how the 2-Year has barely budged despite the soaring PMI.

Chart 2: U.S. 2-Year Treasury Yield and US Manufacturing PMI

2-Year yields moving higher would likely put downward pressure on cyclical valuations, even if earnings expectations continue to move higher. This is what happened in 2018, when earnings soared on tax reform and “global synchronous growth,” but valuations contracted as the Fed embarked on a tightening cycle. The lack of movement in the 2-Year could allow high valuations to persist for now, but the historical bet would be that eventually Fed policy catches up with economic reality. The question, of course, is when.

So what can we look to in order to answer this “when” question?

One metric we will watch closely will be cyclical vs. defensive appetite within sectors. This tends to be a purer way to capture positioning and can often lead broader market positioning. A favorite is Machinery (cyclical) vs. Commercial & Professional Services (defensive) within Industrials. You can see in Chart 3 how the peak in this ratio anticipated the “it can’t get any better” peak in the PMI (and broader market for that matter). If this ratio rolls over, we will be inclined to expect a broader pause in cyclically sensitive assets, as well as a loss of momentum in the PMI expansion.

The conclusion is that the timing may not be precisely now to turn ultra-bearish on cyclicals, but it is certainly time to be more discerning adding to positions here, despite all of the narratives that will appear to be highly supportive of further outperformance.

Chart 3: Machinery vs. Commercial & Professional Service and U.S. Manufacturing PMI

A Thought on Infrastructure

The prospect of further stimulus in the form of infrastructure will be an outstanding question for cyclical areas. We are inclined to be skeptical here, not only because of a history of failed attempts to pass big infrastructure spending (despite the obvious need), but how signs of support for the proposed bill are already starting to wane from both parties (see WSJ article here). We also hold that China remains vitally important from a commodity consumption perspective (China used more concrete between 2011 and 2013 than the U.S. did in the entire 20th century, see here). The industrialization and rapid growth of China in the 2000’s created the conditions for the commodity supercycle and a multi-year string of cyclical outperformance. A world of tighter old-economy policy out of China could prove highly important for the future path of cyclical end markets (see FT article here on China policy tightening).

Last Week in Markets: Choppy Equities Still End At Records; Long Yields Higher While ECB Promises to Step Up Buying

Equities

U.S. large cap equity markets were broadly higher last week (S&P 500 +2.82%, NASDAQ +3.87%, Dow Jones Industrial Average +1.64%). The S&P 500 crossed over 4,000 for the first time, bringing the first quarter advance to +7%. Smaller cap sizes also outperformed (Russell 2000 Small Cap +3.24%, S&P 400 Mid Cap +3.14%), with the Mid Cap index reaching a new all-time high. Growth (+3.95%) staged a sharp comeback vs. Value (+1.89%), with the largest weekly outperformance since January. We have discussed how the rotation out of Growth into Value had gotten ahead of itself in March, as seen in Chart 4, where the Growth vs. Value ratio broke down below its short-term trend.

Chart 4: Growth vs. Value

From a sector perspective (see Table 1), it was Growth areas like Tech that dominated, while defensive areas like Staples, Utilities, and Health Care that lagged. The Tech rally was broad based, but the most cyclical portions of the sector outperformed. The Philadelphia Semiconductor Index rallied +9.47% on the week, but the rallies in other Tech and related areas like Software (+5.19%), FANG+ (+5.06%), IPO’s (+5.08%), and Innovation (+5.62%) were also powerful. The weakness in cyclicals vs. defensives or risk-on vs. risk-off that we highlighted in Discretionary vs. Staples in the prior week (see article here) paused last week with this outperformance of cyclicals over defensives.

Table 1: S&P 500 Sector Performance
Index Name 1 Week YTD
Consumer Discretionary 3.0% 4.0%
Consumer Staples 0.9% 0.2%
Communication Services 3.0% 10.0%
Energy 2.2% 32.7%
Financials 1.9% 16.8%
Health Care 1.4% 2.5%
Industrials 2.2% 11.4%
Materials 2.2% 9.6%
Tech 4.7% 3.9%
Utilities 1.2% 1.9%
Real Estate 2.9% 10.1%
S&P 500 2.8% 7.0%

Source: Bloomberg, Fieldpoint Private, as of 4/2/21

Fixed Income

In the U.S. Treasury market, longer term rates were flat to down. The 10-Year finished the week nearly unchanged at 1.71% (still the highest in 14 months), while the 30-year edged lower by 5 bps to 2.35%. Interestingly, there was some signs of life in the shorter part of the curve. The 2-Year rose 4 bps to 0.18%, a fairly meaningful percentage move given the low starting base, however zooming out to a three-year view, 2-Year yields remain very subdued (see Chart 5). This is thanks to the Fed commitment and communication that it intends to keep policy highly accommodative for the next couple of years.

Despite Fed communication indicating that it intends to keep policy rates near-zero until at least 2023, the market is now pricing in one rate hike by the end of 2022 and is ascribing a more than 50% probability of two rate hikes by the end of 2022. Now of course, the market has a terrible track record of being too early and aggressive expecting Fed rate hikes (see Bloomberg article here), except, of course, when it was way behind the curve in 2018.

Chart 5: U.S. 2-year Treasury Yield

Currencies and Commodities

The US Dollar was slightly higher on the week (+0.2% to $92.95). Higher yields in the U.S. have spoiled USD short bets that were extraordinarily one sided to start the year (see our 1/11/21 article and our 1/18/21 update). The stronger dollar in the near term is starting to cause an unwind in short positions (see Chart 6 from this Bloomberg article, and this Bloomberg article).

Chart 6: Traders Paring Back Short Dollar Positions in the Face of Dollar Strength


Source: Bloomberg

Precious metals prices stabilized last week with gold +0.92% and silver +1.39%. Gold prices are down nearly 9% YTD. This is mainly due to the rise in longer dated real yields, with the inverse relationship of gold prices and real yields seen in Chart 7. As real yields rise, gold, as a non-yielding long duration asset, looks less attractive. This has sparked over $7B of outflows YTD, the largest since 2013, which was the last time we saw a sharp move higher in real rates during the taper tantrum. Further, dollar strength and the risk-on/pro-cyclical tone of the market has made gold has a safe-haven asset less attractive to investors. For further reading on these dynamics, see this Bloomberg article and this Bloomberg opinion article.

 

Chart 7: Gold Prices (red line) and 10-Year Real Treasury Yield (black line, inverted)
Higher 10-Year real yields (black line moving lower) weighs on gold prices

 

 

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Johnny Gibson
CFA®, Chief Investment Officer

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Cameron Dawson
CFA®, Chief Market Strategist

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