Submitted by Peter Tchir of Brean Capital,
The Manufacturing Economy versus The Service Economy
As we start the new year, there is a debate raging within the market. No the debate isn’t whether there is weakness in the manufacturing economy, that is taken as a given, especially after Friday’s awful Chicago Purchasing Manager number of 42.9.
No, the debate boils down to this:
The bears will argue that
The U.S. economy has always done poorly when manufacturing has turned this weak
That never before has the Fed initiated a tightening cycle with manufacturing so weak
That making matters worse, it isn’t just the U.S. that is experiencing a manufacturing slowdown, but it is global in nature
Etc.
The bulls will argue that
The manufacturing economy is now dwarfed by the service economy and is to a large degree irrelevant
That the recovery that has taken place since the financial crisis has been without much support from the manufacturing sector, so why should it get derailed now
That even within the services sector, so many secular trends, like on-line shopping and the “sharing” economy don’t get picked up appropriately, understating the growth
That the clear definition between “manufacturing” and “service” has blurred as companies like Apple are far more difficult to characterize than what we consider “traditional” manufacturing or traditional “services”
Etc.
Which camp is right? That is the big dilemma facing market participants, along with the ongoing question of liquidity across all markets.
I believe that ultimately this question will be resolved by what I will call “The Wealth Economy” but before we get there, the path will include some more volatility.
Is the Service Economy a Closed System?
I think it is very easy to see how a strong manufacturing sector leads to a strong service sector. Someone produces something, they sell it to someone, generating profits, and at some point that person no longer has the time or desire to mow their own lawn or cook their own food (yes, overly simplistic but I think we all see how this positive feedback loop could work).
The question then, at least as far as the market is concerned, is can the service economy sustain itself without a strong manufacturing sector?
The Bear View
This is the “bear” case. That the manufacturing economy and the service economy act in conjunction with each other – that one cannot turn, without the other.
The Bull View
The bulls view each segment of the economy as relatively independent and they highlight the size of the service economy relative to the manufacturing.
But does this image make sense? Can the service economy really function on its own?
I keep thinking about the service economy as a closed system and I just can’t make it work. I do think the various parts of the economy are intertwined. Yes, this is an overly simplistic construction, but even if I was to analyze the service economy as its components, I would struggle to get past the concept that there is enough momentum within services on its own, to continue to generate the growth (or at least stability the market needs).
So while I can’t agree with the bulls under the simple view of the world, I also do not believe the weakness in the manufacturing sector will be enough to drag down the economy – so I will adapt the model to include the “Wealth Economy”.
The Wealth Economy Is The Missing Cog
I hate to use terms like “wealth” and “trickle down” as they seem to have so many political ramifications these days, but ultimately I think it is the “Wealth Economy” that can drive services regardless of the manufacturing economy.
What I term as the “Wealth Economy” includes
- The obvious, those wealthy enough that they just need or want stuff done, the exact level of wealth is not important, it is the concept that there is a portion of the population that will spend regardless and will start “priming the pump” so to speak
- Then there is the “global wealth” that is ever more important to the domestic economy. One trend we read a lot about, largely in regards to property prices, is the rush by rich people across the globe to buy property in the United States. What doesn’t get discussed is how much that feeds into the services economy. Not just the obvious real estate commissions or the attorney’s fees, but all the other people who earn a bit directly from such a transaction – especially if the person (or family) bothered to come to America to see what they were buying. Then how those fees trickle to the rest of the economy.
- Finally, the simple retiree who is getting a pension or. As baby boomers are retiring there is real money being paid to them that is making its way into the economy, and largely to services. As you add in products like HECM’s (which Brean is active in) you are seeing a variety of ways that money is coming into the system.
So in summary, I do not see the services economy as being able to be self-sustained, but as the manufacturing economy has shrunk in relevance, the wealth economy has been rising to take up the slack.
So maybe the right question isn’t whether the overall economy can withstand the slowdown of the manufacturing sector, but whether the wealth economy can continue to pick up the slack?
How Does This Play Out?
I will not inundate you with graphs demonstrating the weakness in the economy. You have probably seen a hundred such reports over the past two weeks, that I cannot improve on. You will also have seen a number of reports (though not as many) refuting the implications of recent manufacturing weakness, and even some weakness in various reports on the consumer. Again, I cannot improve on them.
So the starting point to the year is one where the evidence is pointing to serious manufacturing weakness, on a global basis, with hints that it could be hurting the consumer.
That is coming right as the Fed embarks on further “policy normalization”. Certainly the policy change was well telegraphed and arguably long overdue, but any weakness in economic data, or the markets will come with an added level of “fear” that the weakness is a result of a policy mistake. It doesn’t matter that it is almost impossible for the recent hike to have impacted the global economy significantly in such a short time, what matters is the perception that it could and the fear that it could get worse. So any weakness will create a lot of reports highlighting the possibility that the Fed made a mistake, which will accelerate any move to the downside.
The Santa Rally that never came has affected positioning. While I would agree that sentiment seems awful, I think that the risk of a rally into year-end has ensured that market bears are not positioned as bearish as their sentiment would have you believe. Shorting into a quiet period with strong seasonality is hardly a recipe for success, so look for bears to come out swinging given any excuse. Those who “bought the market for a trade” will be extremely nervous that the rally never really came, and the last two trading days of 2015 ended rather poorly. So while sentiment would indicate investors are underweight the market, I believe actual positioning coming into 2016 is overweight (or less short than they would like to be).
Then we need to figure out what is going on in the credit markets. For the past two weeks I have been arguing in favor of high yield (the view that the dispersion trade is overdone) and for at least two months I have been arguing that equities (at least large cap and tech) can largely ignore the weakness in high yield, but investment grade would be another story.
IG Bond Fund Flows
This chart makes me a little nervous. I think the market remains well positioned to soak up supply in the IG new issue space, but if retail starts exiting in real size it could hamper the IG market. So far this has been small, may be mixed up in some broad based bond funds flows – i.e. not IG specific, and hasn’t hit the IG ETF’s where LQD shares outstanding remain near their all-time highs. CDX IG remains well offered as well (looks like it closed the year 11 bps rich to fair value).
So right now, I continue to like high yield and don’t think that “credit is leading the way” but am closing watching the IG market to see if it gets hit at all – and if it does, that will hurt equities much more because
- The “buy back” piggy bank would be closed, taking away what has arguably been the biggest driver of many U.S. stocks
- It would signal growing concern about the economy
The Bottom Line
Expect weakness to start the year as all of the factors above come into play and push on the fear and positioning in the market, but be careful getting too bearish.
This will be more about the end of dispersion and the outperformers with extreme long positions getting hit, while the sectors that have been beaten down the most will offer some real opportunities.