High price of old-fashioned volatility

September 6, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — If you thought you’d found someplace that was insulated from the economic weakness coming from the U.S. and Europe, well, chances are you are wrong.

Around the world, manufacturing is taking a hit, and the rate of slowing and the suddenness of the move pose a threat not just to the economy, but to financial market valuations.

Take Canada, long held up as a model of economic and financial system management, and supposedly well positioned due to great demand from emerging markets for its natural resources.

Well, Canada’s economy actually shrank at an 0.4 percent annual clip in the three months to July, data on Wednesday showed, the first such fall since the last recession. Exports fell by 2.1 percent from the previous quarter.

While wildfires and an auto manufacturing slowdown linked to Japan’s recent natural disaster played a substantial role, that may not be the whole of the story. Growth returned in June, possibly because the automotive industry recovered, but manufacturing as a whole was down in the month.

Or look at India, one of the coming giants of the new global economy. India’s economy this week recorded growth in the last quarter of 7.7 percent, down from the 8.8 percent rate seen in the same period a year earlier. Manufacturing growth fell rapidly, expanding at a 7.2 percent clip compared to a previous 10.6 percent. Those figures still seem heady compared to the United States, but the rate of slowing, which may actually have been masked by a change in the way India calculates its growth, is also large.

China too is showing signs of weakness, with the HSBC/Markit survey of purchasing managers indicating two straight months of manufacturing decline. Market forecasts of future growth have been cut, with most analysts citing expectations of weaker exports to the U.S., Japan and Europe.

While China perhaps has more room for domestic stimulus, the unfortunate truth is that even a small decline in demand in the west has a large impact in China.

The common denominator across the three countries is slackening demand for manufactured goods, which considering that manufacturing led the world out of recession is a poor sign.

“Global growth since March 2009 has had a distinctly old-fashioned feel to it. Manufacturing has led the way, we would argue primarily because it fell the most in 2008 and because of policy in emerging markets and developed markets around government spending on infrastructure investment,” Nomura strategists Kevin Gaynor and Bob Janjuah wrote in a note to clients.


Gaynor and Janjuah make an excellent point: manufacturing is by its nature more cyclical than services. That has important implications for economic volatility, and, by extension, for financial market valuations.

Manufacturing works on a capital expenditure cycle and growth will generally ebb and rise more dramatically than services or consumption. After all, someone might buy a car only every five years, but needs medical care and uses a mobile phone on an ongoing basis.

That shift over time in the global economy towards more services, in particularly in the developed world economy, has tended to make economic growth less volatile. It was helped by increasing access to credit among consumers, who borrowed more when income fell. That smoother growth, what economists used to call the “Great Moderation,” while an illusion based on increasing use of debt, was manna to financial markets.

If consumers use debt less to smooth consumption, well then consumption, and manufacturing, will be more likely to bump up and down.

Investors hate volatility and penalize it by paying less for things which go up and down in performance violently. For a good example of this consider the stocks of what we used to call investment banks, which traded at very low multiples of earnings even before the crisis.

If we are living in a world more reliant on manufacturing to take up the slack, then we are looking at a more volatile world, with sudden drops into recession and surprising, if weak, recoveries. That’s not too far from how things worked in the 19th century. It also fits very well with the data we’ve seen, and with the sudden drop off in US economic data. That will translate into company performance, and via that, into the volatility and prices of stocks and bonds.

What’s left then, is for investors to figure this out. As they do, and they arguably are already doing this, they will be less willing to pay high prices for all sorts of assets, extracting better terms in compensation for holding things that are more likely to melt in their hands.

That process, of realization and repricing, is going to take a good long time, and will accentuate what already looks to be a bumpy ride.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)


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