Markets Signaling Strong Growth Now, But Weak Growth Later

Posted by Vident Financial on 1/17/22 9:30 AM

The data show a major collapse of GDP growth during the worst of the pandemic, a rapid bounce back, and a period of elevated growth after that until the third quarter of 2021, around the time that the delta strain of COVID was causing concern. This likely means that the 4th quarter will be stronger due to deferred economic activity. What COVID Classic did in terms of a hard stop last spring, delta appears to have done in a more subdued form late last summer. If the pattern holds, there should be a bounce-back in the fall.

The Purchasing Managers Indices seem to be telling the same story. Here's the purchasing managers survey for manufacturers (PMI):

(Source: Nasdaq Data Link / Institute for Supply Management, March 1968 – November 2021)

If the relationship between manufacturing purchasing managers surveys and simultaneous growth holds as it has in the past, Q4 2021 growth is likely strong, in excess of 5%.

PMI vs GDP Scatter

(Source: Nasdaq Data Link / Institute for Supply Management, World Bank, 1961 - 2021)

Non-manufacturing purchasing managers surveys are also reasonably optimistic:

ISM Non-Manufacturing

(Source: Nasdaq Data Link / Institute for Supply Management, July 1997 – November 2021)

Those surveys are real time. They ask planners what they are seeing now. Markets, on the other hand, are forward looking. We frequently use the difference between U.S. stock market earnings yield and treasury yields to measure market sentiment about future growth. Here's what it is signaling about subsequent years growth:

GDP Growth vs Equity Yield Premium

(Source: Bloomberg, Factset, World Bank, 2006 - 2020)

It's signaling a lackluster sub-2% growth rate in the next year.

We also use a similar metric which uses corporate bond yields instead of stock yields. It is signaling stronger growth than the stock market:

GDP Growth vs BAA 10 Year

(Source: FRED, World Bank, 1989 - 2020)

The investment grade bond yield data is indicating something closer to 3% growth rates. But since bonds are less growth-sensitive than stocks, stock performance varies more with growth. The risk is lower profit growth and lower dividends. But with bonds, the risk is default. Defaults tend to occur when business is bad, but especially when business is bad and prices are deflationary. Deflation means that the companies have to pay back dollars that are worth more than the dollars they borrowed. But inflation is good for debtors, because the debtors repay the lenders with dollars that are worth less than the dollars they borrowed. So even when growth is lackluster, corporate borrowers are helped out a bit if inflation is high. So if inflation expectations are high, corporate bonds will likely send out a mixed message. The implied growth outlook will tend to be higher than reality because part of the value of the bonds will reflect the tailwind that comes from inflationary subsidies of debtors and not just growth expectations.

If we're entering an inflationary period, the stock market is historically a better indicator than the bond market, which means growth will be lackluster.

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