Stockwatch: Opportunities among the chaos

What risk a recession? The US Federal Reserve has stalled to raise interest rates, China may be running out of steam, and I notice more UK-listed companies warning on revenue/profits due to tougher trading at home or abroad. As yet the evidence is sketchy, but this is typically how cycles turn down; a gradual accumulation of weaker news towards a moment of truth.

The current business cycle is plenty mature

Some perspective is worthwhile. Taking the US as the benchmark, its National Bureau of Economic Research has identified 11 business cycles from 1945 to 2009, with an average length of about 69 months, or just under six years. The average expansion lasted 58.4 months while the average contraction lasted only 11.1 months. The last expansion started in June 2009 after the recession from December 2007 reached its trough. History may not repeat, but it can chime, hence it is natural to see signs of tougher conditions, a major influence being commodities deflation rippling out. The visceral fear is this happening after years of exceptional monetary stimulus, as if it had little sustainable transmission effect. Moreover, what other tools do the authorities have for any slowdown?

True, the average length of an expansion has got longer: in the three cycles from July 1990 to June 2009 it increased to 95 months or nearly 8 years, while the average recession was 11 months. So it's possible now isn't a major turning point and economies just muddle along. Yet it's wise not to be complacent; if all the stimulus hasn't countered secular stagnation then how has it abolished the business cycle?

More companies warning on revenue and profit

The oil price drop is now affecting engineering and services firms, with Mid 250 shares in Rotork slumping 11% in response to news that August was "particularly weak".

Note how outlook statements are becoming fudged: "We continue to see an encouraging level of quote activity and a large pipeline of opportunities however the timing of order placement and product delivery remains difficult to forecast." So visibility is reducing with economic change. The shares of similar engineers suffered accordingly, e.g. Smiths, Weir and Babcock International. Three Rotork insiders bought stock at about 188p after the fall from 215p, but its price has continued to fester to about 170p. Implicitly the market twigs potential for slowdown to fester further.

What particularly catches my attention is a warning of continued slowing sales momentum by electronics component supplier Premier Farnell.

The board had already cautioned in July, removed its CEO and initiated an operational review; but the market was perturbed by this latest news to de-rate the stock a further 27%. Reading across to relatively stronger performance at Electrocomponents, it is benefiting from eCommerce representing 60% of revenue, where Premier needs to catch up. There is similarity, however, in the way Electrocomponents cites weaker UK business and "a market backdrop of weakening US manufacturing output" which tallies with the Fed's aversion to an interest rate rise. I note all this because electronic components' distribution is a classic cyclical indicator - why stocks trade on modest price/earnings (PEs) - which is not really affected by weaker commodities pricing. Indeed, some customers ought to be benefiting from lower input costs.

Another familiar tell-tale of change is Pace, the international media hardware group. Management cautions: "Due to continuing challenging economic conditions in certain regions, phasing delays at major customers in North America and delayed decisions by customers, revenue growth is indicated lower than expected; however due to improved products and operating efficiencies such as the supply chain, profit and cash flow expectations are unaffected." It's a similar mealy-mouthed outlook as Rotork, where you can't tell precisely what's responsible for weaker revenues (technologies' timing may be affecting Pace), but economic conditions are a consistent factor.

China will continue to dominate macro sentiment

The problem is weak macro numbers streaming out, e.g. manufacturing activity falling to a six-and-a-half year low in September; and whether this centrally-planned economy can defy financial history to escape recession after a record build-up in debt. China's private "non-financial corporations" debt is now nearly 200% of GDP compared with about 150% in the US.

In global context, the wider Asian credit binge has increased total private and public debt from 180% of global output in 2008 to 212% last year, according to the 16th annual Geneva report of economists.

It rather testifies to the Austrian School of economics which cautions that central banks keeping interest rates chronically low means over-borrowing and less-disciplined investing; and if stimulus fails to sustain the real economy then it reaches diminishing returns as these investments fail.

More positively, the China Beige Book - based on interviewing over 2,100 private firms - implies no downturn.

While Q3 2015 is proving weaker than Q2, it actually improved over Q1 and is stable in year-on-year terms. China's public sector is most affected and where growth has slowed moderately, while the private sector is only marginally down and from a higher rate of growth. Manufacturing has seen its weakest performance in two years, but services are growing both quarterly and annually, also mining shows a surprise recovery in Q2. Retail and property are down in Q2 but stable and improving annually. So the "red news" from China significantly reflects an economy in transition to more services and hopefully less of the publicly-funded construction that led to excess.

World trade is weakening overall

South Korea, a bellwether for the global economy, has seen August exports plunge nearly 15% year-on-year in dollar terms; with China, the most important link in global supply chains, down over 5%. To some extent this is due to the strong US dollar (translation effect) and lower Chinese demand for raw materials, hence weaker commodity prices which check the price of manufactured goods. But UK and US exports are also slipping, such that in H1 2015 global merchandise trade fell by over 13%.

This compares with annual trade growth of 7% from the mid-1980s to the middle of the last decade. International trade continues to grow in volume terms, by 1.7% year-on-year in H1 2015, albeit well below the long-run average of 5%, and emerging markets have achieved only 0.3%. So it's hard to escape a sense of lower aggregate demand.

Latest UK data shows manufacturing hit by lower export orders and the strong pound hurting margins. Public finances have recorded their worst August in three years making the budget deficit harder to cut if there is global slowdown; and UK private debt is rising again.

It's quite a barrage of negative data.

Rising chances therefore, of recession ahead

It's time to be alert for defensive measures. What's particularly tricky is deciphering where the safe havens are in an inter-connected world where entire asset classes can re-price; even gold was hit in 2008, and platinum has fallen to a seven-year low as the Volkswagen crisis hits expectations of demand for diesel engines. Wait for much more evidence of a downturn and you risk being caught in it. So it's likely worth tolerating zilch returns on cash, also to take advantage when markets over-shoot on the downside. More positively this will all emphasise robust and meaningful dividend yields.

Amid the macro data noise it's essential to identify and weigh the more significant company updates, as I'll be doing in Stockwatch.