Financial Conditions The Loosest Since 1993

In keeping with the great reports elsewhere, the Markit Flash PMI showed economic strength. Private sector growth reached a 9 month high in October mainly because of the improvement in manufacturing. The composite output index was 55.7 which was an improvement from last month’s report of 54.8. The services index improved from 55.3 to 55.9 which is a 2 month high. The manufacturing PMI was up from 52.4 to 54.5 which is a 9 month high. This report shows the business cycle has started again just like we saw in the Caterpillar and 3M reports. The trade is to buy the firms that are in manufacturing, but haven’t rallied as much as the others. It appears China made sure the transition of leadership went smoothly by making sure the economy is strong. In the long term, the hope is the country focuses on free market reforms.

Speaking of emerging markets, the Brazilian central bank cut rates 75 basis points to 7.5% on Wednesday. It’s expected to cut them by 50 basis points in December to the lowest ever.  Inflation has cratered from the double digits to below 3%. The economy finally stabilized this year as the depression which ravaged the economy in 2015 to 2016 has ended. This economic improvement certainly helps guide the global recovery. The yield curve is signaling additional stress next year from the upcoming elections. The hope is reforms continue no matter who is picked. A healthy Brazilian economy is important because we are now at a point where India, China, and Brazil are all on the right track.

Getting back to the Markit PMI report, the impact from the hurricanes is still being felt as the report showed the greatest pressure on the manufacturing supply chain since 2014. There still are depleted inventories, transportation delays, and increasing raw materials prices affecting the supply chain. Manufacturers needing to catch up to production schedules helped the manufacturing PMI.

Besides the improvement from emerging markets, there has also been improvements in financial conditions which have helped the economy grow this year. As you can see from the chart below, the Chicago Fed national financial conditions index is at the loosest period in this recovery even though the Fed has raised rates twice this year and started to unwind the balance sheet. Financial conditions are the loosest since 1993 which explains why volatility is the lowest since the mid-1990s.

There are two theories on this matter. The first is that the ECB and JCB’s bond buying made up for the Fed. The total purchases in the first half of the year were the highest ever. That theory will be put to the test in the next 8 months as the asset purchases from the ECB slow. The other theory is that the balance sheet and Fed funds rate only have tangential effects on the financial conditions. It appears economic growth in 2014 led to the last period of loose conditions. This is a case of ‘the chicken and the egg.’ Did the financial conditions cause the economy to strengthen or did the economy strengthening cause loose conditions? Either way, we’re in a scenario ripe for speculation in stocks which is why we’re seeing such high equity multiples.

Speaking of the ECB’s bond purchases, one factor which I haven’t mentioned yet is the fact that economists think the ECB is approaching the limit to how much bonds it can purchase under the current rules. As you can see in the chart below, there’s only 200 billion euros in bonds left. That could encourage the program to end sooner than the market expects. Currently the market is expecting 270 billion euros purchased over the next 9 months. This ceiling could make it go the hawkish route which is 120 billion euros over the next 6 months. Either it goes hawkish or it changes the rules. Even with rule changes, there aren’t many bonds left which makes it critical for it to end soon.

Getting back into the economic reports, the Richmond Fed manufacturing index wasn’t as great as the Markit report as the composite index fell from 19 in September to 12 in October. The weakness was probably related to the hurricanes as the shipments index fell from 22 to 9. The highlight of this report was the strength in wages as the wage index increased from 17 to 24 which is the highest reading since May 2000. Most of the subcomponents of the expectations index improved showing that even in one of the weaker reports optimism remains steadfast.

The durable goods report showed orders rose 2.2% in September which beat expectations for 1.0% growth. There was a 5.1% increase in demand for transportation equipment. Non-defense capital goods orders were up 1.3% which is the same as August. Core capital goods were up 0.7%. This beat expectations for a 0.5% increase. They were up 3.8% year over year. Orders for electronic products increased 1.8%.

The GDP Now model was unchanged at 2.7%. This is the second to last estimate before the GDP report is released on Friday. The forecast for the contribution of inventory investment to Q3 GDP increased from 0.94% to 1.01%. The forecast for government spending declined to -1.7% from -1.1%. It’s a good sign for the private sector if government spending is one of the weak links of the GDP report. Considering the impact of the hurricanes, it would be great to see the GDP report show anything above 2% growth. I think stocks will fall if it is below 2%.

Conclusion

There’s nothing not to like about the economic figures. During 2016, one of the aspects which prevented the economy from falling into a recession was the fact that manufacturing is a small part of the economy. Now investors wouldn’t mind if it was bigger as it is the hottest part of the economy. With this in mind, it’s safe to say 2017 will challenge 2015 for the fastest growth of this expansion if Q3’s report comes in better than the expectation for 2.4% growth. 2015 had 2.596% growth.

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