Economies and equity prices march steadily upward over time as growing populations and human ingenuity combine with commercial motives to increase corporate earnings. Over short periods of five years or less, there are persistent cyclical rhythms around those rising trends.
We are currently in one of those downward rhythms, but a trough is expected this summer. The second half of 2019 is likely to see a recovery in global manufacturing along with rising equity and commodity prices, and a stronger Canadian dollar. Resource stocks have been beaten down globally and expectations are low. The U.S.-China trade conflict hit many non-energy commodities and will hinder their rebounds, while energy remains unscathed. Energy stocks are likely to perform well over the second half of 2019. The expected increase in the Canadian dollar will create some currency headwinds for Canadian energy stocks, but Canadian investors will also face those headwinds directly on their U.S. holdings.
Rebound in global manufacturing ahead
We believe the best way to look at the economy’s rhythms for investment purposes is to track manufacturing activity for the global economy and key large economies (U.S., euro area, and China). While manufacturing’s share of most economies is declining, it remains the tail that wags the economic dog.
Figure 1 shows two key indicators of global manufacturing activity, Markit’s global manufacturing purchasing managers’ index (PMI) and the Organization for Economic Cooperation and Development’s (OECD) global leading indicator (GLI). The latest readings (April for the PMI and March for the GLI) reveal that the slowdown in global manufacturing that began in early 2018 continues. There are tentative glimmers of hope that the slowdown is losing momentum, helped by the U.S. Federal Reserve’s shift away from further short-term interest rate increases and several pro-growth Chinese policy initiatives. However, international trade is very weak and trade frictions between the U.S. and China, the U.S. and the European Union, and problems along the U.S.-Mexico border are a major concern.
Figure 1: Global Manufacturing Indicators
Energy Stocks and Canadian Dollar Will Follow Manufacturing Upward
Manufacturing is a leading indicator for the overall economy, just as equity and bond markets are. Turning points in global manufacturing correspond to shorter-term trend changes in equity prices, government bond yields, corporate bond spreads, commodity prices, and the Canadian dollar.
Figure 2 shows that the cycles in global manufacturing as measured by the OECD’s GLI correspond to the twelve-month change in Canadian energy stock prices. The same relationship holds for the broader equity markets, other economically-sensitive equity sectors, commodity prices, and the Canadian dollar.
Figure 2: OECD Global Leading Indicator and Canadian Energy Stocks
The continued downtrend in manufacturing activity over the first four months of 2019 has kept us cautious on the investment outlook as markets rebounded strongly from their December weakness. Equity markets look like they are heading into another intermediate correction and that the summer months could be volatile.
We expect global manufacturing to bottom this summer and recover over the second half of the year, signaling a buying opportunity in equity and commodity prices, and in the Canadian dollar. Figure 3 shows that Canadian energy stocks tend to rise strongly in the two years after a trough in global manufacturing activity. The same will be true for other economically-sensitive sectors and industries in Canada and abroad. However, energy stocks have been really beaten down and are viewed pessimistically by most investors and analysts, even though global, U.S., and Canadian energy sector earnings have held up very well in this latest global slowdown, and in Canada they are growing again. Energy is also getting by-passed in the ongoing trade skirmishes, and will be a hedge for investors against elevated Middle East tensions.
Figure 3 also shows that the Canadian dollar tends appreciate versus the U.S. as manufacturing recovers. A stronger loonie in later 2019 will create headwinds for U.S. investments.
Figure 3: Canadian Energy Stocks and Canadian Dollar After Trough in Global Manufacturing
What Could Go Wrong?
The risk to this idea is that the trade picture blows up and whacks the economy, deepening the slowdown and delaying the trough in manufacturing until late 2019 or 2020. The decline in asset prices would be more severe and the buying opportunity would be delayed, but when it does arrive, the opportunities will be greater than anticipated.
John Johnston is the Executive Vice President and Chief Strategist at Davis Rea in Toronto