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It’s fortunate that equity markets have the support of loosening financial conditions because the global economic growth backdrop is deteriorating in a hurry, threatening corporate profit growth and asset prices.

Equity markets and economic growth signals have been going in decidedly different directions in recent weeks. The S&P 500 is hitting new highs despite a planet-wide torrent of weak economic data and declining bond yields suggesting reduced expectations for future growth.

The first accompanying chart shows the remarkable degree to which global equity prices have been following U.S. financial conditions since mid-2018. The Goldman Sachs U.S. Financial Conditions Index uses Federal Reserve policy rates, bond yields and corporate bond yields to gauge the ease of corporate credit.

Importantly, falling rates and yields not only make borrowing for companies easier and cheaper, they also make equities more attractive relative to bonds. This allows for higher valuation levels and stock prices.

Now for the bad news. Equity prices have been following financial conditions while the fundamental underpinnings of profit expansion, the global economy, have been eroding.

The second chart highlights the June reading for the JPMorgan Global Manufacturing PMI Index that showed a year-over-year decline of 6.6 per cent in the purchasing managers index. The index level is now below 50, indicating the first contraction in global factory activity since November, 2012.

The PMI index on the chart is compared with the BMO S&P/TSX Equal Weight Global Base Metals Index to underscore the fact that weaker global manufacturing activity is not good news for cyclical, economically sensitive asset prices such as commodities.

The final chart compares the pace of global trade activity with the performance of Canadian equities. The CPB World Trade Index is the most widely used measure of worldwide imports and exports but it can be a volatile data series. Still, the chart shows a consistently significant relationship between trade and domestic equities.

conflicting signals

MSCI World index

GS U.S. Financial

Conditions Index (inverted)

2,400

98.0

2,300

98.5

2,200

99.0

2,100

99.5

2,000

100.0

1,900

100.5

1,800

1,700

101.0

2018

2019

2017

BMO S&P/TSX Equal Weight Global

Base Metals ETF YoY % change

JPM Global Manufacturing

PMI Index YoY % change (right)

125%

7%

105

5

85

3

65

45

1

25

-1

5

-15

-3

-35

-5

-55

-75

-7

2014

2016

2019

2015

2018

2017

S&P/TSX Composite Index

(YoY % chg.)

CPB World Trade Index

(YoY % chg.)

30%

8%

25

7

20

6

15

5

10

4

5

3

0

2

-5

1

-10

0

-15

-1

-20

-2

2014

2015

2018

2019

2016

2017

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

conflicting signals

MSCI World index

GS U.S. Financial

Conditions Index (inverted)

2,400

98.0

2,300

98.5

2,200

99.0

2,100

99.5

2,000

100.0

1,900

100.5

1,800

1,700

101.0

2018

2019

2017

BMO S&P/TSX Equal Weight Global

Base Metals ETF YoY % change

JPM Global Manufacturing

PMI Index YoY % change (right)

125%

7%

105

5

85

3

65

45

1

25

-1

5

-15

-3

-35

-5

-55

-75

-7

2016

2019

2014

2015

2017

2018

S&P/TSX Composite Index

(YoY % chg.)

CPB World Trade Index

(YoY % chg.)

30%

8%

25

7

20

6

15

5

10

4

5

3

0

2

-5

1

-10

0

-15

-1

-20

-2

2014

2015

2018

2019

2016

2017

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

conflicting signals

MSCI World index

GS U.S. Financial

Conditions Index (inverted)

2,400

98.0

2,300

98.5

2,200

99.0

2,100

99.5

2,000

100.0

1,900

100.5

1,800

1,700

101.0

2017

2019

2018

BMO S&P/TSX Equal Weight Global

Base Metals ETF YoY % change

JPM Global Manufacturing

PMI Index YoY % change

125%

7%

105

5

85

3

65

45

1

25

-1

5

-15

-3

-35

-5

-55

-75

-7

2018

2014

2015

2016

2017

2019

S&P/TSX Composite Index

(YoY % chg.)

CPB World Trade Index

(YoY % chg.)

30%

8%

25

7

20

6

15

5

10

4

5

3

0

2

-5

1

-10

0

-15

-1

-20

-2

2016

2017

2014

2015

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg

The CPB index results are calculated with a lag – the most recent reading is from the end of April. Domestic investors can hope for an improving trend when the May and June reports are issued but recent signals are not promising.

South Korea, a central trade hub for Asian electronics, heavy industry and autos, endured a 13.5-per-cent year-over-year decline in exports in June, according to the most recent results. Government officials slashed forecasts for 2019 exports from a gain of 3.1 per cent to a full-year decline of 5.0 per cent.

The market’s faltering economic backdrop may already be affecting North American profit forecasts. Over the past six months, analysts have cut the forward 12-month earnings expectations by 3.2 per cent for the S&P/TSX Composite and 2.9 per cent for the S&P 500.

In broad terms, equities are rising while the underpinnings of profit growth are fading. Conditions could, of course, improve quickly if the trade tensions that have helped stall the global economy ease.

A positive outcome to negotiations in the short term is unfortunately not a sure thing. American and Chinese officials recently declared a temporary truce in the continuing trade war at the Group of 20 meetings, but as a Merrill Lynch report notes, there are still 25-per-cent tariffs in place on US$250-billion of Chinese exports to the U.S., and almost 20-per-cent tariffs on US$110-billion of U.S. exports to China.

“Tariff termites have been eating away at growth in China and its trading partners in Europe and Asia-Pacific,” Aditya Bhave, global economist at Merrill Lynch, said in in a note to clients.

Until we see a clear positive outcome, investors should keep a close eye on changes to the profit forecasts for their stock holdings.

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