Royal Bank of Canada's report on domestic manufacturing activity was terrible in virtually every way, threatening the optimistic thesis that the weak loonie would spur an export-led economic recovery.
Investors can hope that the downturn is temporary, but the implications of the results are clearly negative for equity investors in the short term. Financial stocks appear most at risk and history suggests utilities, as a relative haven, will outperform as long as manufacturing remains weak.
RBC's Canadian manufacturing purchasing managers' index is what's known as a diffusion index. RBC surveys manufacturing executives across the country with a series of questions about current business conditions – "What are the monthly changes in new orders for goods?" for example – to be answered by "better," "worse" or "the same." The results create an index result where 50 indicates no change in anything, and a reading above 50 indicates a general expansion in manufacturing activity.
The economists were blunt in their assessment of February's results: "The RBC Canadian Manufacturing PMI moderated for a third consecutive month in February, falling below the break-even level of 50 to 48.7 in the month. All of the five subindexes contributed to the dip in the headline measure in February, led by declines in the new orders, output and employment indexes that left all three key subindexes below 50." (The other two subindexes are suppliers' delivery times and stocks of purchases).
The disappointing new orders reading is arguably the most relevant for investors – it's the most forward-looking part of the survey. The declining loonie was supposed to create a positive outlook for the manufacturing sector as exports to the United States expanded.
Comparisons between the manufacturing index and the major subsectors of the S&P/TSX composite produced some interesting results, but investors should be careful about how much can be inferred. The RBC index has only been produced for the past three years and it's always difficult to compare diffusion indexes to stock-performance results.
The equity market sectors with the closest relationship to the manufacturing index are energy and financials. The S&P/TSX energy index, however, headed lower long before the weakness in the RBC Canadian manufacturing PMI. The only potential inference in that case is that slower activity in the oil patch contributed to slower manufacturing activity – although, as always, correlation and causation are not the same.
The S&P/TSX financials index is a much different story. Domestic financial stocks have generally climbed along with manufacturing activity until very recently – they are now rising as the RBC index falls sharply.
The S&P/TSX utilities index (not shown) has historically moved in the opposite direction of the Canadian manufacturing PMI. This suggests that investors have sensibly added to investments in defensive utility stocks when the economy weakened in an effort to protect assets.
By no means does the weak RBC report guarantee a coming slide in domestic financial stocks – manufacturing activity is only one of a large number of factors affecting profits in the sector. Investors should, however, take the surprising softness in manufacturing results seriously. Even in bad times, manufacturing is a huge proportion of domestic economic activity – far larger than the weighting of manufacturing stocks in the S&P/TSX benchmark.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at ROB Insight and Inside the Market online.