Why Slower Factory Growth Likely Isn’t Cause for Alarm

Fresh off the Q1 GDP release—which many seemed to view as subpar—IHS Markit’s April manufacturing purchasing managers’ index (PMI) fell to 53.9 from March’s 54.9, missing consensus expectations for 55.0.^[i] The gauge, a survey of manufacturing firms’ business activity conducted by economic research firm IHS Markit, hasn’t accelerated since last November.^[ii] In our observation of the media’s reaction, dour takes appeared to dominate, labelling the report “thoroughly disappointing”—evidence the UK economy has “fundamentally slowed this year.” IHS Markit’s director commented that “while adverse weather was partly to blame in February and March, there are no excuses for April’s disappointing performance.” Whilst it is possible (though not automatic) that one weak monthly survey of UK manufacturers could presage a factory slowdown, we don’t believe this means the economy (or shares) are automatically headed for a rough patch.

We don’t mean to sugar-coat this report. New orders—the gauge’s most forward-looking component—decelerated in April, with export orders notching a 10-month low. Moreover, as IHS Markit’s official manufacturing PMI release noted, “Falling backlogs of work, supply-chain constraints and rising stocks of finished goods also signalled that output growth will remain subdued in the coming months.”^[iii]

But we don’t think this, on its own, proves the UK economy is on the ropes. PMI readings over 50 still signal expansion, according to the survey’s methodology, and historical data indicate final output figures frequently diverge from what surveys suggest. PMIs, after all, measure the breadth of growth, not the magnitude. They estimate the percentage of firms growing but don’t attempt to quantify how much their activity expanded (or contracted, for the minority of companies reporting pullbacks). Moreover, manufacturing is only about 10% of UK output, and an occasional softer (but still expansionary) monthly reading has historically been consistent with continued economic growth.^[iv] Conversely, the UK Services PMI—representing about 80% of the UK economy—lifted slightly in April to 52.8 from March’s 20-month low of 51.7, suggesting the sector’s long-running expansion likely continues for now.

One other telling aspect of April’s manufacturing PMI slowdown, in our view, was business sentiment’s detraction as the sub-index fell to a five-month low. We believe this may indicate Brexit negotiations are still stirring some uncertainty, dampening sentiment and weighing on surveys of business activity. But we don’t think sentiment necessarily influences actual economic results. A broad, uncertainty-driven pullback in risk-taking could potentially be a sign of creeping economic weakness. But with new orders growing and business investment still positive as of Q4 (the latest figures available at present), we don’t believe this is the case today. Other measures of risk appetite, including Mergers and Acquisitions activity, also suggest to us corporate executives aren’t feeling particularly gun-shy ^[v]

On the one hand, given the apparent gap between dour sentiment and (in our view) better-than-perceived economic fundamentals, we believe there should theoretically be room for improving sentiment to boost UK shares as uncertainty fades. However, it is entirely possible uncertainty lingers, perhaps dampening relative returns. Given the UK doesn’t appear to be on the verge of recession, we don’t expect UK shares to do poorly. Nonetheless, we believe they may remain caught in a sentiment tug-of-war for a while.

[i] Source: FactSet, as of 8/5/2018.

[ii] Source: FactSet, as of 3/5/2018.

[iii] Source: IHS Markit and the Chartered Institute of Procurement and Supply’s April UK manufacturing Purchasing Managers’ Index, as of 8/5/2018.

[iv] Source: Office for National Statistics, as of 2/5/2018.

[v] “U.K. Deal Bonanza Poised to Hit Record Amid Brexit Concerns,” Manuel Baigorri and Ruth David, Bloomberg, 30/4/2018. https://www.bloomberg.com/news/articles/2018-04-30/deals-bonanza-in-u-k-poised-to-hit-a-record-amid-brexit-fears