June 5, 2023
Optimists and stock markets reassured by a buoyant services sector
Pessimists and bond markets are worried about the collapse of industrial activity
Most of the other leading indicators seem to be in favour of the latter...
... paving the way for a new stock market correction

CHART OF THE WEEK: "Is the economic cycle accelerating or slowing?"


Traditionally, the outlook for companies is moving in tandem in the two main sectors of activity, industry and services. In recent months, however, purchasing managers' confidence has diverged: it has rebounded strongly in services, while weakening in industry (see Chart of the Week). Pessimists will point out that the manufacturing sector is a more reliable indicator for forecasting activity because it is more cyclical. Optimists will prefer the tertiary sector, on the grounds that it is more representative of overall economic activity, accounting for 76% of the total in developed countries, compared with just 22% for manufacturing (see Fig. 2). Who is right, the bulls or the bears?

There is no simple answer to this question. However, it is crucial. Regular readers will recall that, to turn positive on the financial markets in 2023, we need good news on at least one of these three parameters: a rebound in leading indicators, a cut in key interest rates, or a capitulation by investors. Do we finally have a 'green light' on the first, given that the last two light up 'red'?

The phenomenon of dispersion between manufacturing and services is not the norm, but it does occur from time to time. There are two reasons for this:

  • Firstly, purchasing manager confidence is structurally higher in services than in industry, by around 4 points for the American ISM indices. To correct this bias, all we need to do is observe these two indices in periodic variation (see Fig. 3). The picture is now very similar: in both cases, the economic situation is still deteriorating (the spread is still negative), but at a much slower pace than before (the spread is narrowing). While mathematics enthusiasts will talk about a positive second derivative, investors will prefer to say that momentum is improving. Whatever you call it, it's a very good signal.
  • Secondly, the industrial sector is more volatile than the services sector. During the different phases of the economic cycle, the message is usually 'overdone' in industry, while that conveyed by the services sector remains 'moderate'. In concrete terms, the worse/better the economic outlook, the more negative/positive the gap between industry and services (see Fig. 4). Given the recent divergence, this is a bad signal.

To tip the balance one way or the other and come to a definitive conclusion, investors need to rely on other leading indicators such as the yield curve (see Fig. 5), financial conditions (see Fig. 6), or the price of computer memory (see Fig. 7). Unfortunately, most of these indices describe a false start scenario.

Supporting this pessimism, the Federal Reserve estimates the probability of a US recession at 68%, a level not seen for 40 years (see Fig. 8). Even the National Bureau of Economic Research (NBER), which is officially responsible for setting recession dates for the US economy but is usually late in giving its verdict because it takes a large number of parameters into account, is in the process of tipping its hand. Two of its members recently published a working paper (see link) in which they indicate that Americans should expect a recession in 2023 and 2024.

Using the channel formed by the purchasing managers' confidence indices for manufacturing and services, the annual upside potential for equities was between -22% and 0% in the United States (see Fig. 9), and between -26% and +8% in Europe (see Fig. 10). With the S&P 500 delivering +2% and the EuroStoxx +6% over the past twelve months, markets have been rational but at the top end of their channels.


Investors will soon have to accept that the good news is priced in. As long as purchasing managers are not more positive about the outlook for their companies, the stock markets will have no room to rise. Conversely, if their confidence erodes even slightly, a new stock market correction will be inevitable. The distribution of potential stock market returns is negatively skewed.


Financial Research