Regional Fed Reports Suggest Lower Stock Market Returns Are Coming

Manufacturing Improvement Coming?

The equity market is very confident a cyclical recovery is coming. When poor economic data from Q4 comes out, it is discounted because investors are focused on 2020 which is expected to be the year where earnings growth recovers and the manufacturing sector rights itself. When the manufacturing sector actually does right itself, the stock market should have weak returns. Anticipated improvement will be priced in. That’s why many are predicting multiple contraction.

Question is when the ISM PMI will rise above 50. With the recent increases in the Empire Fed and Philly Fed manufacturing reports in January, that improvement in the ISM PMI can come sooner than some think. PMI being above 50 limiting upside is counterintuitive. But if you knew an indicator was cyclical and would always revert, wouldn’t you get ahead of it? Wouldn't you buy when it’s low and sell when it’s high?

Empire Fed Index

Current Empire Fed index improved modestly, while the Philly Fed index improved greatly. It's good to look at the average of the to date regional Fed surveys since there can be outliers. It’s still possible that the other 3 reports that haven’t come out yet tell the opposite story of the first 2 reports. We're also awaiting the PMI composite flash from Markit which comes out this Friday.

General business conditions index in the Empire Fed report increased 1.5 points to 4.8. That’s its 2nd straight increase and its highest reading since May 2019. June 2019 had a big decline of 20.8 points; the index has been trying to recover ever since. New orders index was up 4.9 points to 6.6 and the shipments index was down 0.9 to 8.6. 

Unfilled orders index was up 11.1 points to 2.7%. There isn’t a surplus of demand that is overwhelming inventories, but fewer firms are seeing a decline in unfilled orders. Delivery time index was up 3.1 points to -2.7 which isn’t problematic. We’re seeing a recovery from an environment with excess slack because demand was weak. 

Inventories index fell 2.9 points to -0.7 as there are no longer more firms reporting increases in inventories than those reporting decreases. There was a big spike in inflation as the priced paid and prices received indexes rose 16.3 and 10.1 points to 31.5 and 14.4. Let’s see if PPI increases in January.

6 month expectations index had a small decline as it went from 26.1 to 23.6. That was still above November’s reading. New orders and shipments indexes were up 0.6 and 4.8 points to 31.4 and 32.7. Capex and tech spending indexes both fell. They were down 0.8 and 4.9 points to 25.3 and 22.6, but they are both still relatively high.

Philly Fed Index Spikes

Philly Fed diffusion index rose from 2.4 to 17. As you can see from the chart below, the regional survey to date average has spiked to being consistent with a PMI of 53. In the past few months, the ISM PMI has been below the Markit PMI and the average of the regional Fed indexes. Even if that stays true, many see the ISM PMI increasing to near 50 if the other regional Fed indexes also improve.

Specifically, the new orders index was up from 11.1 to 18.2. Shipments index was up from 15.7 to 23.4. Just like in the Empire Fed index, inflation picked up as the prices paid and prices received indexes were up 6.2 and 3.7 points to 22.1 and 14.7. Unlike the Empire Fed index, the Philly fed index’s expectations index was also up. It would have been odd for such a large spike in the current index to be combined with pessimism. 

Expectations index was up 3.6 points to 38.4. New orders index rose from 33.6 to 41.9 and the shipments index was up from 38.7 to 42.4. Capex index rose from 26 to 32.9. This overall report is a great sign industrial production growth will rebound. Personally, I think in 1H 2020 we will start to see positive yearly growth in manufacturing and industrial production.  

Trade Deal Is Ambitious In The Wrong Way

Phase 1 of the trade deal isn’t as great as it seems. But maybe markets just like the fact that China and America are working towards something opposed to raising tariffs. As you can see from the chart below, the export U.S. targets to China are incredibly high. 

Problem is they don’t cover all goods, so China can stop buying some goods to purchase the ones in this agreement. Secondly, China will likely stop buying goods from other nations to make up the difference.

It would make more sense to open up free market competition and allow China and America to make the best purchases for them instead of having managed trade where certain goods have arbitrary export targets. Another problem with this plan is that China is being geared to buy an excessive amount of American exports. And China will likely fall short of the targets which could reignite tension. 

Also, China will face penalties for not complying. In previous agreements, China hasn’t bought the amount of agricultural products that America wanted. It would have been better if this plan just lowered tariffs and other barriers to trade. It’s a band aid that could make things worse than they were before the trade war.


Manufacturing sector should rebound in 1H 2020. Right on target, the Empire Fed index increased modestly and the Philly Fed index increased sharply in January. This should actually be bad for stocks because when the ISM PMI is above 50, stocks do worse than when it’s below 50. 

Phase 1 of the trade deal wasn’t great. Maybe global trade growth will rebound because of the cyclical upswing and the decline in uncertainty. But this trade deal with China shouldn’t boost global trade. It is a boondoggle. It doesn’t fix the problems with trade. 

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