Economic outlook: what a weakening services sector means for investors

A key economic model used by Pendal’s multi-asset team is forecasting tougher times ahead. ALAN POLLEY explains what it means for investors

• Economic cycle model turns negative
• Caution warranted for second half
• Find out more about Pendal’s multi-asset funds

A LEADING economic indicator used by Pendal’s multi-asset team has turned negative after being positive for most of 2023 — a sign that tougher times may lie ahead for investors, says Pendal PM Alan Polley.

The first half of the year surprised markets with better-than-expected economic conditions, despite many forecasters earlier in the year anticipating that higher interest rates would have a significant detrimental impact on the economy.

Pendal’s economic cycle model has been one of the few forecasting tools to predict a robust economy, making its move into negative territory an important signal for investors.

“The model pretty much got it right for the first half,” says Polley, a portfolio manager with Pendal’s multi-asset team.

“It started the year suggesting we were in a positive economic environment — which is noteworthy because most people had a more bearish outlook.

“But it has recently ticked over onto the negative side.”

How it works

Pendal’s economic cycle model analyses the level and rate of change of leading economic indicators such as consumer and business surveys — while also examining how economic data surprises either positively or negatively.

The model is one of three key indicators that inform the multi-asset team’s active asset allocation process – alongside a valuation model and a model that analyses market trends. It has a successful long-term track record of picking turning points in the economic cycle, Polley says.

Services show signs of weakening

The key to the economy’s surprising resilience this year has been the strong performance of the services sector which has off-set a contraction in the manufacturing sector.

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“The manufacturing side of the economy has been in contraction for close to a year, so what’s surprised economists this year is that the services sector has been very strong,” says Polley.

“There’s still a lot of pent-up demand for services post-Covid lock-downs and there have been very high household savings rates.”

There are now early signs of that changing.

The household saving ratio — which was exceptionally high during the pandemic due to government payments and limited spending opportunities — has fallen to lows not seen since the GFC.

“The tide may finally be turning for the economic outlook,” Polley says.

“The services side of the economy may have peaked. In in our model, while it’s still in expansion, the rate of change is now on the negative side.

“So, the risk is that we are yet to truly feel the effects of rate increases, which generally take a one-to-two-year lag.

“We think it’s more likely that the services sector moves towards the manufacturing sector, than the other way around.”

Time for caution

The economy’s strength in the face of rate rises has been an important factor in this year’s surprising rally which has left markets largely pricing out the chance of a deep recession.

“The market isn’t the same thing as the economy, but normally they support each other. So, what’s been going on economically has provided some justification for markets rallying so hard,” says Polley.

“If you look back to earlier this year, pretty much everyone got this wrong.”

“Our economic cycle model has pretty much got it right up to this point. Now they’re turning negative.

“That makes us more cautious on the second half of this year, so we’re slightly underweight equities in response.”

About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal key account manager here