The strength in global equities and other risk assets in recent months is, in part, due to optimism that a global cyclical recovery is beginning to take hold, following the severe manufacturing-led downturn in 2018 and 2019. However, this optimism in the financial markets contrasts with the much more pessimistic tone still emerging from economic forecasters about global growth prospects in 2020.
The January update of the IMF’s World Economic Outlook, released last week, remained rather downbeat. It described the recent signs of stabilisation in global activity data as no better than “tentative” and said that any recovery this year would be “sluggish”. In fact, the IMF forecast for real gross domestic product growth in the advanced economies in the 2020 calendar year was downgraded to only 1.6 per cent, slightly below the 2019 figure.
It is true that reported hard data from the major economies remained mixed at best in the final quarter of 2019. So have the markets got ahead of themselves?
The encouraging news is that the recession in the global manufacturing sector may now be ending. While manufacturing represents only about a fifth of the global economy, its enduring importance in driving the business cycle has been reinforced in the past two years, because several of the large shocks that have hit the global economy have been specifically focused on the goods sector.
These include the drop in fixed investment linked to trade policy uncertainty, the large reductions in inventories in the advanced economies in the second half of 2019, the decline in IT production in Asia, the struggles of the German auto industry, and the drop in infrastructure spending caused by the tightening of credit policy in China.
The combination of all these elements resulted in a particularly large drop in manufacturing output relative to services and overall GDP in 2019 (see box). In fact, for much of last year, the key question was whether the manufacturing recession would eventually lead to an erosion of labour market and consumer confidence, taking the service sector down with it.
At times, that bad outcome appeared to be happening. However, more recently there have been more encouraging indications from surveys that business confidence in the manufacturing sector has started to rebound. This seems to have been triggered by a softening of several of the negative shocks, including that in trade, and by a significant easing in monetary conditions following the major change in direction by the Federal Reserve and the European Central Bank in 2019.
As a result, global activity data have definitely improved in recent weeks:
- The flash IHS Markit purchasing manager output indices for January, published on Friday, maintained the improvement seen since last July. China’s PMI has not yet been released, but Fulcrum estimates that the global manufacturing PMI will be 0.7 points higher than the December reading. The global services output PMI also seems likely to be up by about 0.7 points on the month. (Figures above 50 in these diffusion indices indicate economic expansion.)
- The Fulcrum nowcast for the global economy, updated after the flash PMIs were released, indicate that global real activity growth is running at a buoyant 4.1 per cent, about 1.6 percentage points higher than three months ago. The improvement in the advanced economies has been 0.5 points over this period, while the emerging economies have jumped by a remarkable 2.5 points.
- Activity appears to have bottomed out in the Asian economies, which are good indicators of the global cycle. This includes China, where the stronger activity reports for December 2019 have taken the nowcast growth rate up to 7.6 per cent. (At present, I assume there will be no meaningful impact on GDP from the coronavirus.)
- Forward-looking indicators and nowcasts for Germany, another cyclically sensitive economy, have shown a sharp rebound since last autumn.
Business surveys in the manufacturing sector, along with the economy-wide nowcasts, have frequently provided the first reliable signals of turning points in the global business cycle. It seems that the world economy is past the worst.
Manufacturing and global economic activity
The share of manufacturing in the total output of the advanced economies has been shrinking for decades. For example, in the US it has dropped to only 11 per cent,and is still falling steadily. In emerging economies, the share of manufacturing in the overall economy is much higher (standing at 28 per cent in China) but it is also now falling on trend.
Why, then, do economists and investors spend so much time focused on the goods sector?
One reason is that manufacturing output varies much more during the economic cycle than does services output, so the former contributes more to changes in GDP growth than to the level of GDP. Because hard manufacturing data are available in a more timely fashion than in services, and the sector moves contemporaneously with GDP, it provides an excellent indicator of the business cycle.
A further reason is that, in most economies, official data on the real output of goods are believed to be more reliable than that on real services output, in part because the definition of price deflators in the goods sector is conceptually more straightforward.
The latest hard data indicate that the growth rate of industrial production in official data for the seven advanced economies continued to plummet up to October 2019, though this was depressed by extreme weakness in auto production due to a typhoon in Japan. Much of the downturn in the official figures for industrial output has been accompanied by similar weakness in exports, but services and real GDP growth have been much less affected.
PMI data from business surveys are available up to January 2020, and are therefore more timely than the official data shown above. According to Fulcrum, the flash PMI results published on Friday indicate that the final PMI for global manufacturing will rise by 0.7 points in January, taking it a healthy 1.7 points above the low point in July.