|Graphic Source: Bloomberg, 2012|
By Russ Koesterich, CFA, BlackRock
The sharp rebound in stocks since February supports the view of market optimists: The U.S. is not in or on the cusp of a recession. The broad U.S. economy continues to expand, albeit at a sluggish pace.
However, allow me to take the “glass half empty” view, and note the manufacturing sector has yet to recover from the slowdown that began in late 2015. And this has important implications for investors.
The broader implications of a sluggish manufacturing sector
Although recent surveys point to some stabilization in the sector, signs of an actual rebound in manufacturing activity are more scarce. Indeed, the latest industrial production number, released in mid-April by the U.S. Federal Reserve, showed industrial production has now contracted in 12 of the past 15 months and is down 2% year-over-year, close to the worst rate of growth since 2009. Despite an abrupt spike in oil prices and a pause in the dollar’s rapid ascent, manufacturers, miners and factories continue to struggle.
Still, for many investors the response is: So what? Manufacturing is a relatively small portion of the overall economy, they say. The much more important consumer sector is holding up, with households continuing to spend at a decent, if uninspiring pace.
All true, but a rebound in corporate profits is much less likely in the context of falling industrial production. Put differently, falling industrial production is not necessarily indicative of an economic recession, but in the past it has been consistent with a profits recession.
A vital link between industrial production and corporate profits
One reason that industrial production matters for corporate profits is that the composition of the stock market is more geared towards manufacturing, utilities, mining and other “Old Economy” activities than the broader economy. This is why the correlation between industrial production and profits growth has remained stable over the past two decades, despite the overall trend in the U.S. towards a more services oriented economy.
What that relationship suggests is that profits rarely rise while industrial production is falling. Historically, when industrial production is declining year-over-year, non-financial profits typically fall, at an average rate of around 4.5% year-over-year according to Bloomberg data. Absent more financial gimmicks and buybacks, earnings growth is unlikely to improve without a broad-based acceleration in the U.S. economy.
The drop in industrial production also suggests two other conclusions. First, falling industrial production contradicts the argument that the drop in earnings is all about energy. While the collapse in oil company earnings has played its part, the ongoing U.S. profits recession, now in its fourth quarter, reflects a broader sluggishness in the U.S. and global economy.
Second, investors have recently been focusing on the rebound in value stocks. While value as style has indeed done better as recession fears have faded, maintaining the rally will require value companies to demonstrate some improvement in depressed earnings and historically low profitability. That is much less likely in an environment in which manufacturing activity is still contracting. If the value rally is to continue, that will need to change.
In short, future gains in stocks depend on an upturn in earnings growth. In the meantime, investors ignore the manufacturing recession at their own risk.This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners. USR-9104
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