Did some economies give misleading signals?

Yesterday’s PMI survey from the euro zone saw the composite index record a sub-50 print in August which is the third month in a row that this has happened.

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The weakness has rekindled speculation that recession could be just around the corner. But so far at least, data such as the PMI surveys have sent false signals about the chances of negative growth and we’re not convinced that this will change going forward.

Yesterday’s PMI survey from the euro zone saw the composite index record a sub-50 print in August which is the third month in a row that this has happened. In the UK, the fall to 47.9 on the composite PMI was the first sub-50 print since January. And, while the composite PMI in the US remained above 50, where it has been since February, its head was barely above this boom-or-bust line at 50.4.

The outcomes were all much weaker than the market expected and seemingly add to concerns that any soft landing might not be so soft after all. Understandably, perhaps, beleaguered bond markets went wild with a sharp rally in prices and short-term interest rate futures, particularly in the UK, rushed to price in a more benign monetary policy outlook. But does such data imply that growth has come to a grinding halt?

We say this because PMI surveys have been below the 50 level before in the last year, or so, and yet growth has broadly continued. Of course, it might have continued at a slow pace but we still think it is fair to say that PMI surveys have pointed to recessions that have not materialised – at least not so far. However, this is not to have a go at the PMI data. Lots of other such indicators have proved overly pessimistic.

For instance, leading indicators have slumped and would generally seem to be at levels that imply a recession. In the US, for instance the leading indicators has fallen by over 10% in the last 15 months; more than enough to suggest a recession given its accuracy in coinciding with previous downturns. In the euro zone, the so-called COIN indicator produced by the Bank of Italy, which is meant to be a contemporaneous measure of economic growth, has put quarterly growth below the zero line so far this year but actual GDP data was flat in Q1 and grew 0.3% in Q2.

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We can go on to say that it is not just these manufactured leading or coincident indicators that have been wrong so far. Other indicators that we might look at to tell us whether recession looms have also been incorrect. For instance, data on bank lending has been abysmal and easily consistent with recession based on what we’ve seen during recessionary periods of the past, particularly in the euro zone. But, as we’ve just mentioned, the euro zone has grown, not shrunk.

The false signals sent by such data does not make the task of the central banks any easier, nor the profit-making ability of investors. But why are these indicators so wrong? Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said one explanation might be that they underestimate the importance of historically tight labour markets in holding growth up. Another is that inflated balance sheets of central banks, due to prior quantitative easing, could be cushioning firms and consumers from the surge in policy rates. So, while bank lending data may suggest credit growth has fallen off a cliff, the overall credit situation, taking into account bond financing and mortgage cost increases may not be as punitive as we’ve seen in the past.

“We will never know why many leading indicators have predicted recessions that have failed to show up. Another possibility, of course, is that significant economic weakness is just taking longer to show up than usual and recessions will arrive, perhaps later this year or early in 2024. Whatever it is, we doubt that investors will lose their faith in these sorts of indicators to predict recessions, whatever their recent record. This, in turn, seems likely to keep investors nervy of risk assets like equities and corporate credit, and more disposed towards safer assets like cash and the dollar”, said Mr. Steve Barrow.