Last week we saw further evidence of continued deceleration in the global industrial cycle, in line with our Fidelity Leading Indicator (FLI), with flash purchasing managers’ index (PMI) readings offering the first glance into the February data. Japan’s manufacturing PMI dipped into contraction territory for the first time since 2016, when it stayed below 50 for six months.

Source: Fidelity International, JMMA, IHS, Nikkei, Feb. 2019

The Euro area’s flash manufacturing PMI also dipped into contraction, for the first time since the sovereign debt crisis, when it stayed below 50 throughout 2011-2013. Germany was the main driver of this weakening in February - and within its PMI components, new orders (including export orders) and prices accounted for most of the move.

Moving to the US, the Philadelphia Fed manufacturing index showed a dramatic plunge, falling below zero for the first time since May 2016. This reading points to the February ISM headline around 52

(below Bloomberg consensus expectations of 55.6).

Sources: Federal Reserve Bank of Philadelphia, Haver Analytics, Institute for Supply Management, Fidelity International, Feb. 2019

This week will bring further evidence on the state of the global cycle, with manufacturing PMIs in focus. But the big picture so far is quite clear - the global industrial slowdown continues.

One driver is the China cycle which shows no signs of bottoming out for now. Those economies that are closely linked to Chinese demand are carrying the burden of adjustment, such as external sectors in Germany. Another driver is the tightening in financial conditions, particularly in the US, that we saw throughout 2018. While some of that has been unwound year to date, the overall drag will continue weighing on global growth through 2019.

Disconnect between markets and fundamentals

Considering the continued deterioration in macro data, the risk-on mood in the markets is puzzling and I am somewhat sceptical. There are three narratives playing out, none of which has real substance beyond pure hope:

1. “China stimulus is going to lead to imminent stabilisation and a rebound in activity”. Undoubtedly, there is some stimulus in the system but we are talking small amounts relative to previous episodes, such as 2015-2016. In addition, the lag between the credit cycle and activity in China is still around six months, with another 3-6 month lag between China activity and early cyclical indicators elsewhere like the Euro area.
2. “Central banks have turned dovish again, policy normalisation is over and ‘bad is good’ again”. Despite a dovish shift globally, the bar to ease policy remains universally high. This is not 2015-2016 where the Bank of Japan and the European Central Bank were in full quantitative easing (QE) mode, the Fed only managed to squeeze in two hikes in two years and there was no quantitative tightening going on. The options for full-on easing are limited in most places, except for the Fed- which ironically will not need to ease and is likely to press on with hiking rates later in the year!
3. “Political uncertainty is getting resolved, with common sense prevailing”. A deadline extension for the US tariff decision has injected more optimism into the market- this is a marginal positive, but some of it was priced in and raises expectations for a proper deal in the short term. Besides, this is not about rolling back the tariffs imposed last year and the trade issue is clearly here to stay for the long term. On Brexit, domestic politics aside, it is unlikely the EU will agree to concessions in the 11^th hour so this negotiating strategy is fundamentally flawed. Anything can happen, but it’s wrong to think the probability of a palatable outcome is automatically rising as the deadline approaches. So far it seems some deadline extension is likely, which does not solve the real issues, with pressure on the economy mounting.

Late cycle slowdown, not recession - but stabilisation not imminent

My base case is that the global cycle will stabilise this year, but we still have a few more negative data points to digest before the ‘all clear’.

There is still room for growth to adjust back to trend in the US. It will take longer for China activity to stabilise and for the European economy to process the related shock. In the UK there are clear domestic issues on top of the challenging external backdrop. This timeline to stabilisation seems too long for markets to continue rallying on ‘hope’, so big swings in risk sentiment are likely in the short term.

At the same time, the dollar should continue to be range-bound (strong and stable), while the downside for yields seems limited given too much dovishness is priced in for the Fed. Thus, financial conditions are unlikely to ease substantially, in the 2016-type fashion, to set the stage for a meaningful bounce in global growth thereafter.

We might not see a ‘proper’ recession for a while, barring big shocks in the system. This start / stop normalisation mode might well be the new normal of policy, implying that policy and economic cycles could be longer than before, and the amplitude of fluctuations much narrower.