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Global equity markets were treading water for much of September as signs of a slowdown in worldwide economic growth continued to mount. Then came October, and that complacent tone changed.

An extremely weak reading on U.S. manufacturing activity on Tuesday sent equities into a two-day tailspin that saw the S&P 500 drop 3 per cent and the S&P/TSX Composite decline by 2.1 per cent. On Thursday morning, the S&P 500 quickly dropped another 1 per cent as traders reacted to news that the services sector was starting to deteriorate as well, before mounting a recovery and finishing up 0.8 per cent on the day.

The Institute for Supply Management’s U.S. Non-manufacturing Index slipped in September to a lower than expected 52.6, from 56.4 in August, the lowest reading since August, 2016, and signalling that slower global growth, rising trade tensions and persistent uncertainties may now be spilling into services industries.

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The U.S. economy had been resilient through most of this year despite flagging growth overseas. This week’s negative data surprises were widely interpreted as a sign the American economy and the S&P 500 are no longer immune from the global slowdown.

The focal point of the market’s concern this week was Tuesday’s ISM U.S. Manufacturing Purchasing Managers Index (PMI), a compilation of survey results from prominent U.S. goods providers who report monthly on business activity, hiring and new orders for products.

The ISM index level of 47.8 represented a significant contraction in U.S. business activity and, alarmingly, the worst result since late 2009. A reading above 50 indicates business growth.

U.S. equities no longer immune

S&P 500

year-over-year % chg.

ISM Manufacturing

New Orders Index

30%

70

25

65

20

15

60

10

55

5

0

50

-5

45

-10

-15

40

‘14

2015

2016

2017

2018

2019

MSCI World Index

year-over-year % chg.

JPM Global Manufacturing

PMI index

30%

55

25

54

20

53

15

10

52

5

51

0

-5

50

-10

49

-15

-20

48

‘14

2015

2016

2017

2018

2019

john sopinski/the globe and mail

source: scott barlow; bloomberg

U.S. equities no longer immune

S&P 500

year-over-year % chg.

ISM Manufacturing

New Orders Index

30%

70

25

65

20

15

60

10

55

5

0

50

-5

45

-10

-15

40

‘14

2015

2016

2017

2018

2019

MSCI World Index

year-over-year % chg.

JPM Global Manufacturing

PMI index

30%

55

25

54

20

53

15

10

52

5

51

0

-5

50

-10

49

-15

-20

48

‘14

2015

2016

2017

2018

2019

john sopinski/the globe and mail

source: scott barlow; bloomberg

U.S. equities no longer immune

S&P 500 year-over-year % chg.

ISM Manufacturing New Orders Index

30%

70

25

65

20

15

60

10

55

5

0

50

-5

45

-10

-15

40

‘14

2015

2016

2017

2018

2019

MSCI World Index year-over-year % chg.

JPM Global Manufacturing PMI index

30%

55

25

54

20

53

15

10

52

5

51

0

-5

50

-10

49

-15

-20

48

‘14

2015

2016

2017

2018

2019

john sopinski/the globe and mail source: scott barlow; bloomberg

The importance of the ISM manufacturing data to equity investors can be seen in the first accompanying chart. The blue line plots the most forward-looking component of the broader PMI – new orders for goods.

The chart, showing monthly data to Sept. 30, underscores the consistent and strong correlation between the S&P 500 and PMI new orders. While latest reading of the ISM Manufacturing New Orders Index latest is up – by a blip – it remains in contractionary territory and explains why stock prices reacted so harshly to the broader negative data surprise, and why many strategists are signalling caution.

The PMI number "reaffirms our expectation of a weaker growth outlook,” commented Morgan Stanley strategist Wanting Low in a research report on Wednesday. “We stay cautious on risk assets, maintaining an underweight in global equities and global credit, and an overweight in cash.”

Even before Tuesday’s data were released, Ms. Low’s colleague Mike Wilson argued that the stock-market rally stage of the business cycle is almost at an end. In a research note Monday, he recommended going long on defensive investments while shorting high valuation, growth-oriented stocks.

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Defensive sectors such as utilities, consumer staples and high-quality real estate usually outperform in the market cycle’s late stages. Mr. Wilson’s reference to shorting high valuation stocks is an allusion to expensively valued technology companies.

The second accompanying chart emphasizes the global nature of the economic slowdown. The blue line represents the JPMorgan Global Manufacturing Purchasing Manager Index (also updated this week). In the past, I’ve shown the strong connection between this index and base metals prices. In this case, the close relationship between global manufacturing activity and the performance of global equities is highlighted.

It’s clear at this point that stock prices are adjusting lower to reflect the slower growth environment.

So, what now?

It’s always dangerous to extrapolate economic trends too far into the future – in this case that would involve assuming economic data would continue to get worse deep into 2020.

In my view, Mr. Wilson’s observation that the outperformance of defensive market sectors signals the end of the business cycle provides investors with a key trend to watch closely. The longer consumer staples, utilities and real estate stocks lead the market, the more portfolio derisking – reducing high valuation, volatile stocks and adding to cash positions, for example – will be required to sidestep an impending bear market.

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A resumption in global growth – possibly as a result of success in U.S.-China trade negotiations – would see defensive sector returns fall back relative to the overall market. That would signal an extension in the post-financial-crisis market rally and a far more positive investing backdrop.

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