Second Order Consequences

05 May 2025

The price action in equities has been encouraging since “capitulation day.” Incrementally positive news flow on trade negotiations likely contributed to a self-reinforcing or reflexive collapse in volatility, unwind of hedges and a rally in equities. As we noted last week, the interest rate markets have also priced in Fed rate cuts and the Donald backed away from the hyperbolic criticism of Jay Powell. On the negative side, macro conditions have deteriorated over the past few weeks. Shipping data suggest that there has been a collapse in trade between China and the United States (down by around 33% year on year). The episode was also evident in first quarter GDP data (surge in imports ahead of the tariffs) and real time manufacturing surveys.

Despite the encouraging news flow on trade negotiations, we fear that there has already been a non-trivial impact on activity, investment, hiring and future corporate earnings. The US ISM Manufacturing index fell to 48.7 in April (the ISM is a diffusion index so 50 marks the expansion-contraction line). While the report was not as bad as feared (consensus was 47.9), the subcomponents and especially the difference between new orders and inventory continued to deteriorate on a trend basis. As we have noted previously, the new orders to inventory ratio is a decent leading indicator of corporate profits and equity prices (chart 1). While manufacturing is a small share of aggregate final demand, the inventory cycle is the cyclical component of GDP. Moreover, it is a much better representation of S&P500 industrial earnings.  

Chart 1

The employment sub-index, a decent leading indicator of non-farm payrolls was 46.5 consistent with a contraction in manufacturing sector payrolls. The April employment report came out on Friday better than expected but probably before any real damage has been done to the economy. The good news on the ISM report was that it was not consistent with a “sudden stop” or complete freeze in orders and activity post liberation day. However, the S&P500 still trades at 21.1 times forward earnings. Consensus estimates +7.7% earnings growth over the coming 12 months. That feels heroic given the probable deterioration in activity underway. While the weaker activity also warrants rate cuts by the Fed, recent communication suggests that the Fed remains in “wait and see mode.”

The final troubling element of the ISM report was the prices paid sub-index. That surged to 69.8 in April and has historically been consistent with an acceleration in headline consumer price inflation (chart 2). The sharp rise in prices paid was also unusual in the context of the large decline in crude oil prices (-25% from the January high). Typically, lower oil prices would be consistent with a fall in the prices paid index. Of course, that suggests other factors (tariffs) are driving the increase in prices paid. The big picture point is that the April ISM report was consistent with a poor growth-inflation trade off that is likely challenging for corporate profit margins.

Chart 2

As we noted earlier this week, the internals of the stock market suggest that enthusiasm for a durable rally are misplaced. Cyclical sectors of the stock market remain soft relative to defensives. On the positive side, although the macro news flow is very weak, it is not consistent with a sudden stop in activity. Equities might rally further in the near term on hope of a trade deal between the United States and China, lower interest rates, and potential tax cuts in the US. As we have often noted in this episode, the key challenge was the risk-reward starting point for US equities and credit. That remains problematic with the S&P500 still around the 85th percentile of valuation history. In contrast, the equity in our portfolio trades at 10 times earnings, with strong cash flow and very low balance sheet leverage.

20250505_Second_Order_Consequences.pdf

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