slumping durable goods orders (core) go hand-in-hand with a equity bear market

7/31/2019 Slumping durable goods orders (core) go hand-in-hand with a equity bear market

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Global StrategyAlternative view

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WeeklySavage acceleration in downgrades reflects acknowledgement of US recession

(44) 20 7762 [email protected]

Equities 30-80 60 35

Bonds 20-50 35 50

Cash 0-30 5 15

Source: SG Cross Asset Research



The quiet sideways move in the S&P during August masks a torrent of cross-currents

raging under the surface. Better-than-expected July non-farm payrolls certainly seemed to

calm investors going into August.

Yet the profits deterioration in the US (and indeed elsewhere) continued at a ferocious

pace a pace entirely consistent with a renewed global recession. Thomson Reuters

reports that negative US company pre-announcements going into the third quarter are now

running at their fastest pace since Q3 2001.

But the metric which really stood out for me over recent weeks was a truly awful US

durable goods report. For although the headline July data rose by over 4%, both mom andyoy, the core measure of new orders has slumped (core is capital goods orders excluding

the volatile aircraft component). Core orders fell 4% in July mom and 6.2% yoy. July was

not a one off. This is now the fourth month out of the last five that core new orders have

fallen sharply and is entirely consistent with the rapidly deteriorating profits backdrop.

If as I suspect, this is further evidence that the US economy has already entered

recession, it will not be long before the US equity market reacts. Certainly, the recent pop in

the market above 1425 to a post-crisis high sits badly with the facts on the ground (see

chart below). Irrespective of any prospect of QE3, the market will not resist this recessionary

data for long. The S&P will be led hand-in-hand by the economic cycle over a cliff into free-

fall. That will be the third phase of this secular valuation bear market.

Source: Datastream

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Global Strategy Weekly

My Quant colleague Andrew Lapthorne drew my attention to the torrid rate of profits

downgrading at both the global and individual regional level (see Global Earnings Estimate

Analysis available on request). Analysts are currently slicing around 2% a month off the level

of earnings forecasts which have now fallen some 15% yoy (see chart below).

Source: FactSet, MSCI, SG Quantitative Research / Note: figures are computed from bottom-up I/B/E/S consensus earnings estimates

The good news is that analyst eps downgrades are nothing unusual. Normally analysts will

ALWAYS have to downgrade their eps forecasts because they tend to be a jolly optimistic

bunch of guys and gals, seeing the world through rose-tinted glasses. As the year progresses,

they have to scramble back into the real world the rest of us humans live in.

The bad news is that August is typically not a month which sees much in the way of

downgrading. It is in the period from September to April that analysts are forced by reality to

slash and burn their eps estimates (see chart below). So an almost 2% downgrade in August

can be seen as very serious indeed and reflective of deteriorating underlying economic

conditions. But on seasonal grounds alone we should expect to see the earnings downgradesaccelerating over the next few months.

Source: SG Quant

The weakness in corporate investment as shown by core durable goods orders may relate to a

couple of key developments. Many will point to the expiry of enhanced depreciation

allowances at the turn of this year as a reason investment is now weak. In addition,

confidence in the economic outlook, or the lack of it, will be key determinates to the

investment cycle. The prospect of the US fiscal cliff cannot be helpful in this regard.

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Average monthly revision

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But in reality we need to look no further than the profits cycle to explain weak investment. One

of the key determinants of corporate investment is the growth rate of profits. To be sure, the

level of profits, the free cash flow and the rate of profitability (however measured) all also help

to determine investment, but history suggests that the primary driver for the change in

investment seems to be the change in profits.

As Thomson Reuters reports we are seeing the fastest pace of profits deterioration since Q32001, then we should also expect capital goods orders to be falling off a cliff which is

exactly what is happening. There is worse to come. The July durable goods report shows that,

despite a collapse in new orders, production and hence shipments continue at a rapid pace.

The current imbalance is entirely consistent with a US economy in recession (see chart below).

For it is capital goods shipments, not new orders, that go into the GDP data, as what is not

shipped just piles up in inventories until capital goods producing companies bite the bullet

and slash their own production schedules in line with the weak new order flow.

Source: Datastream

We also know the weakness in orders continued in August. The US ISM manufacturing data

just released showed another slippage to 47.1 from 48.0 while inventories rose from 49.0 to

53.0, the highest level for the last 12 months. Taking both ISM orders series together (new and

unfilled) we can see the gradual stop/start nature of the cycle since the peak in late 2009

with orders on a clear declining recessionary trend (see chart below, dotted line). What makes

this new cyclical low so worrying this year, as opposed to mid-2012 or 2011, is that the core

durable goods orders/shipments ratio also shows a major problem and profits are being

downgraded at a savage pace.

Source: Datastream

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

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core durable goods orders/shipments

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The Q2 US reporting round was most notable for the torrent of misses on the top line.

Revenue growth slowed sharply and stood at only 1% yoy for the S&P 500 companies in Q2.

This rapid slowdown was also visible at the whole economy level, with nominal business sales

slowing to 3% yoy in June (latest data!).

Once again, the gradual slowdown in the yoy rates belies the slump that has occurred in sales

towards the end of the second quarter. No wonder then that new orders were so weak in Julyand August.

Source: Datastream

Despite the recent weakness in the corporate sector data, most leading indicators turned

upward slightly in July. The US Conference Board is fairly typical, rising 0.4% on month. The

rise was led by stronger initial unemployment claims, building permits, the shape of the yield

curve and stock prices which all contributed positively, offsetting the impact of weaker ISM

new orders.

The Conference Board themselves look at their leading indicator as a 6 month percentage

change, but in the chart below we use a 3 month change, which is more timely for catching

turning points. It also shows a bounce up in July even having excluded the shape of the yield

curve (which we do, believing it is nonsense to include the shape of the yield curve as 10y-Fed

Funds since it will never be able to contribute negatively to the leading indicator with this

construction).

Source: Datastream

Returning to the topic of analysts earnings projection, we can see the close similarity between

the descending wave-like pattern of the leading indicator (above) and the level of analysts

earnings optimism (as measured by the % of eps estimate changes that are upgrades, dotted

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line in chart below). Analyst optimism similarly registers an uptick in the latest data point, but

from a lower low compared to last year in contrast with the leading indicator above.

This underlines the fact that the profits situation is somewhat worse than the overall economy.

But that should not leave investors sanguine on the economys prospects as we have long

believed that the profits cycle leads the economic cycle a fact often ignored by many

economic commentators.

We show also below the change in analyst optimism - 6 percentage point month change in

this instance, red line. This also has ticked up but is still just in negative territory. We find it is

the change in optimism which tends to drive equity performance

Source: Datastream

For while most commentators are attributing the S&Ps recent performance to hopes of QE3

etc, we can show that actually it is entirely in line with the earnings fundamentals of recent

months (see chart below). The problem is that Andrew Lapthorne suggests that the latest

uptick in the red line in now being washed away in a torrent of red ink.

But that red ink is flowing even before the US government recognises that it too, like every

other major western government, will have to bite the fiscal bullet in some shape or form. And

for an economy either in recession (my view) or bouncing along the bottom (the optimists

view) and with profits alreadyfalling, this will surely be the straw to break the camels back.

Source: Datastream

And finally, while the market awaits QE3 and digests Ben Bernankes extensive justification for

his unprecedented actions, I am once again reminded of that quote from Boris Johnson, the now

world famous Mayor of London, who said "My friends, as I have discovered myself, there are

no disasters, only opportunities. And, indeed, opportunities for fresh disasters."

2003 2004 2005 2006 2007 2008 2009 2010 2011

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slumping durable goods orders (core) go hand-in-hand with a equity bear market

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