Investing with Manufacturing Cycles (Part I)

Introduction

Historically, the global stock market, as represented by the MSCI ACWI Index in the chart below, has exhibited an upward bullish trend over the long run. However, approximately every 3~4 years, the index experiences a correction of more than 15%. Besides declines triggered by global recessions (e.g., the dot-com bubble or the financial crisis), downturns in manufacturing cycles (like those during the European debt crisis and the U.S.-China trade war) can also lead to a global market correction of over 15% or a prolonged consolidation phase lasting six months to a year.

Given how cyclical corrections can stem from manufacturing cycles, understanding these cycles could give investors a critical advantage. In the first part of this article series, we explain what manufacturing cycles are, and in the second part, we will delve into how to incorporate them into your investment strategy.

I. What Are Manufacturing Cycles?

The concept of the manufacturing cycle can be traced back to the early 20th century when British economist Joseph Kitchin identified short business cycles averaging around 40 months in his paper Cycles and Trends in Economic Factors. Termed “minor cycles” in his paper and now known as Kitchin cycles, these cycles are driven by how businesses adjust inventory levels to match changing demand in the market. In this article and most of our analyses, we call these cycles manufacturing cycles.

As shown in the chart above, the manufacturing cycle can be divided into four phases, each corresponding to different states of inventory levels and business profitability:

1. Passive destocking phase: The first phase of the cycle, this period is characterized by a natural (thus termed passive) decline in inventory levels, driven by a recovery in downstream demand and evidenced by increasing orders. Inventories decline as increased demand outpaces production, marking the beginning of an upswing in the manufacturing cycle.

2. Active restocking phase: Manufacturers notice the strong demand, and to boost profits, they begin to actively expand production capacity and stock up on inventories, entering the active restocking phase.

3. Passive restocking phase: Demand remains strong, but supply gradually becomes excessive, causing inventories to accumulate, thus termed as “passive restocking.” This marks the onset of a downturn in the manufacturing cycle.

4. Active destocking phase: Noticing orders are declining, upstream manufacturers actively cut back on production to reduce excess inventory, entering the active destocking phase, which corresponds to the trough of the downswing phase and is typically associated with a more pessimistic outlook for the global economy and stock market.

Once downstream demand gradually recovers, the cycle returns to the first phase of passive destocking. On average, the upswing and downswing phases of the manufacturing cycle each last around 1.5~2 years, so a complete cycle usually takes around 3~4 years.

II. Key Indicators for Monitoring Manufacturing Cycles

1. ISM Manufacturing PMI

One of the most well-known and long-running indicators for business activity in the manufacturing sector is the ISM Manufacturing Purchasing Managers’ Index (PMI). The Institute for Supply Management (ISM) conducts a monthly survey of purchasing managers in the manufacturing sector to produce the composite index, which is calculated as the equally weighted sum of five diffusion indexes, as per following formula:

Manufacturing PMI = 0.2New Orders + 0.2Production + 0.2Employment + 0.2Supplier Deliveries + 0.2Inventories

2. MM Manufacturing Cycle Index

Besides the ISM Manufacturing PMI, there are many other indicators relevant to the manufacturing sector. To better assess trends in the global manufacturing industry, the MacroMicro team has developed the MM Manufacturing Cycle Index, which integrates data on global manufacturing, retail, transportation, trade, among other aspects. Unlike the ISM Manufacturing PMI, which focuses on the U.S. economy only, the MM Manufacturing Cycle Index tracks the global manufacturing industry. Moreover, the index not only takes into account soft data (e.g., survey results) but also hard data (e.g., real output, exports), providing a more comprehensive measure of business conditions in the manufacturing sector.

III. Leading Indicator for the Manufacturing Sector

After discussing the significance of the manufacturing sector to the economy, let’s look at one key leading indicator for the manufacturing sector: net proportion of central banks cutting rates.

The red line in the chart above represents the MM Manufacturing Cycle Index, while the red line shows the net proportion of central banks whose last move was a rate cut. When the proportion rises, it means more central banks around the world are in easing cycles, signaling ample liquidity and accommodative monetary conditions in the market.

Note: The red line in the chart is shifted forward by 6 months to show the leading-lagging relationship. Historically, central bank rate cuts have overall led turning points in the manufacturing cycle by 6~12 months, making the former an effective indicator for reversals in the manufacturing sector.

MM Takeaway

Now that we have covered the concept of manufacturing cycles, the key indicators to watch, and a crucial leading indicator, in the next part of the article, we will explore how one single manufacturing cycle indicator can inform your investment strategy across various assets like equities, currencies, bonds, and commodities.

Author: MacroMicro (Steven)
Editor: MacroMicro (Owen, Emilia Wei)