Catching a Cold to Start the Year

By Joel Litman, chief investment strategist, Altimetry

If you’re not worried about Europe, you should be…

Here in the U.S., the market has been doing well. The S&P 500 rallied more than 15% in two months from its October 27 low.

It’s a different story on the other side of the Atlantic…

Economists use the HCOB Flash Eurozone Purchasing Managers’ Index (“PMI”) to check the health of the eurozone’s manufacturing and service sectors. Through monthly surveys of companies, the index reveals trends in orders, production, jobs, and supply chains.

And right now, the data isn’t looking too great… The index experienced its seventh consecutive month of contraction in December, dropping to 47 from November’s 47.6. Both the manufacturing and service sectors recorded declines in their respective readings.

Not only that, but economists had predicted a slight rise – although they still expected the index to stay below the 50 threshold, which would signify growth.

The unexpected contraction is a worrying sign for where the European economy is going. At least 27 countries are currently in a recession.

And it’s worrisome for the U.S. economy, too…

You might be familiar with the saying, ‘When France sneezes, the rest of Europe catches a cold’…

These days, it’s more apt to say that when the U.S. catches a cold, the rest of the world catches the flu.

And it goes both ways.

It’s true that while a recession is coming, the U.S. economy likely isn’t in immediate danger. That said, it looks like Europe is coming down with a fever. And the U.S. might want to start stocking up on tissues…

U.S. stocks rallied hard after the Federal Reserve announced it would keep interest rates at 5.25%. Fed Chair Jerome Powell even suggested that the central bank might cut rates as early as March.

All these developments are signaling to investors that a “soft landing” really could be possible. Regular readers know we believe it’s already too late…

The 10-year/three-month yield curve inverted in October 2022. That’s a reliable indicator of a coming recession… typically about 18 months in the future. The clock is starting to run out.

Likewise, the Sahm Rule – which looks at three-month rolling average unemployment – is close to crossing a key threshold.

And the Leading Economic Index (“LEI”) suggests we’re already past the point of no return.

The LEI was designed by a nonprofit called the Conference Board, which researches the global economy. This index tries to be more holistic than simply measuring stock returns or the yield curve. Instead, it aggregates several of these metrics together.

It also looks at factors like consumer expectations, new manufacturing orders, and building permits.

The idea is that by adding all these metrics together, the index is less likely to be skewed by one good or bad number. It also means that when the index falls… it’s bad news.

The LEI goes all the way back to 2000. Right before each of the past three recessions, the index’s six-month average dropped below negative 4.2%.

Considering the LEI has been below negative 4.2% since the middle of 2022… investors should be worried.

In November, the stock market was pretty much the only positive metric…

And as we know, stocks can be more susceptible to emotion than most other measures.

The issue with today’s LEI reading is that every time one metric turns positive, another falls in its place. While the stock market has rallied, the credit index and the interest-rate spread both got more negative.

Likewise, building permits slowed down, manufacturing hours fell, and consumer expectations are getting weaker.

Remember that stock market returns are a tiny piece of the picture. There are a lot more metrics to monitor… including indicators that take into account our trade relations with other nations, Europe included.

Consider new manufacturing orders and average manufacturing orders, which indicate overall demand for U.S. goods. We exported more than $2 trillion worth of goods last year… and total manufacturing orders and hours slowed down yet again in November.

Many of these metrics are out of our control. With our big international trading partners struggling, it’s going to hurt demand for U.S. products, too.

The U.S. is still in trouble. Don’t ignore the warning signs… and don’t think that we can buck the global trend. If more economies start showing signs of weakness, it’s only a matter of time before we join them.

Regards,

Joel Litman
January 2, 2024