The Institute for Supply Management’s (ISM) manufacturing index plunged to 53.5 in May from 60.4 in April. This was a big disappointment as the consensus had been looking for the index to come in at 57.6. Based on historical experience, the May reading is consistent with GDP growth of 3.8%.
Then again, perhaps there has been a change in the relationship, since the average level in the first quarter was consistent with 6.5% growth, and we only grew at a 1.8% rate in the first quarter. Manufacturing has been diminishing in importance to the overall economy for decades now.
This is a “magic 50 index” where any reading over 50 indicates that the manufacturing side of the economy is expanding and any reading under 50 indicates a contraction in manufacturing. The overall index has now been above the "magic 50" mark for 22 straight months.
The key takeaway from this number is that the Manufacturing sector is still expanding, but doing so at a much slower rate than in April. The decline this month is massive, but it was coming off a reading is extremely strong by any historical perspective.
In fact, it was been matched or exceeded in only 89 months since the start of 1948, or 11.7% of the time. Almost all of those instances are ancient history. Since 1980, the current level has been matched or exceeded only 19 times, or 5.1% of the months. The graph shows the history of the overall index since January 1980.
The ISM index has a very long and venerable history; it used to be known as the Purchasing Managers Index, or PMI. The overall index is made up of ten sub-indexes. All of the indexes showed deterioration over last month. On the other hand, eight are above the "magic 50" level, the measures tracking inventories were the only exceptions.
Results by Sub-Index
The sub-indexes are as interesting as the overall index. When one digs below the headline number, this is a very ugly report. In terms of the current state of the economy, the most important of these is the production index. It fell 9.8 points to 54.0.
The decline is bad news. The absolute level is still OK, but this is the second month in a row of sharp declines, albeit from exceptionally strong levels back in March. The production index has been in positive territory for 24 straight months now. Twelve industries reported an increase in production while four saw production fall in April.
Backlog of Orders
However, the index with the biggest impact on the very short term is the backlog of orders, and there the picture is also one of sharp deterioration. The order backlog sub-index plunged 10.5 points, and is now just slightly above the magic 50 level at 50.5.
The order backlog sub-index has been extremely erratic of late. Five industries reported an increase in January, while seven reported declines. The erratic nature of the sub-index so far this year might be the silver lining here, raising the odds for a big increase next month…but I would not take that to the bank.
New Orders
Looking just a bit further out, as existing orders in the backlog are worked off, they need to be replaced with new orders. The new orders sub-index thus gives us the best view of where things will be in the next few months. It is not very pretty to look at.
The new orders index plunged to 51.0 from 61.7. That is the largest drop of any of the sub-indexes, and combined with the big drops in both production and backlog, it is a very disturbing development. It is almost as if someone threw a switch and turned off the expansion in the manufacturing sector this month.
Nature, in the form of the Japanese disaster, might have been the one throwing that switch. That, however, is not likely the entire story, just part of it.
New orders have been on the rise for 23 straight months now. Eleven industries reported higher new orders while just four reported a decline in new orders. The good news is that all three of the indexes are still above 50, indicating they are still expanding, but the shift has been from very robust growth to extremely anemic in just one month. Manufacturing has been one of the bright spots in this recovery, and if it is starting to falter, then the rest of the economy is likely to follow suit.
Will Unemployment Tick Up?
With unemployment at 9.0% in March, and expected to remain there or even tick up a bit when the employment report comes out on Friday, the employment sub-index is of particular interest. This is particularly true given the extremely disappointing ADP report this morning.
The employment index slipped to 58.2 from 62.7 in April. The employment sub-index has been above 50 for a 20 straight months now. Eleven industries reported an increase in employment while two reported declines.
On the other hand, I would point out that the employment sub-index has been pointing to an expansion in factory employment for over a year and a half, and so far growth in manufacturing jobs has been pretty weak according to the BLS (then again growth in manufacturing jobs has been weak for decades, even when the overall economy is doing well). The next graph shows the more recent history (since 1993) of these four key sub-indexes.
The prices paid index fell 9.0 points, but remains at the highest overall level — at 76.5 — of any of the sub-indexes. This is a very clear indication that deflation is not around the corner, and helps explain why the Fed is not going to do a QE3 when QE2 finishes up at the end of June.
Most of the prices paid in this index though tend to be commodities, not final goods. Still, the high prices paid sub-index is be ammunition for those who are critical of Federal Reserve’s quantitative easing program. The general rule on the sub-indexes is that the higher they are the better, but this sort of level is a bit worrisome, and this is the one decline that I see as welcome news.
Given the rest of the data out there, it seems clear to me that we still need more economic stimulus, both fiscal and monetary. The level is very high, even with this month’s decline, however we were higher than the March or April level on this sub-index as recently as July of 2008.
The ISM index also gives a bit of a glimpse into the foreign trade situation. It seems to be indicating a deterioration in the trade deficit. The index tracking new export orders fell 7.0 points to 55.0, while the index tracking imports fell 1.0 points to 54.5. However, the import figure refers to imports of materials or components that domestic manufacturers use, not to finished goods.
While the export index is still higher than the import index, the gap is far smaller than it was last month. Net exports were a slight drag to GDP growth in the first quarter, subtracting 0.08 points from growth, but that was in sharp contrast to the fourth quarter where an improvement in net exports boosted growth by 3.27 points.
In other words, if the trade situation had remained unchanged from the third quarter, GDP growth would have been slightly negative in the fourth quarter, not +3.1%. This would seem to indicate that we will not get a whole lot of help from Net Exports as far as GDP growth in the second quarter is concerned.
Far Worse Than Expectations
Overall, this was a nasty report. It was far worse than the consensus expectation, and the consensus expectation was already calling for a sharp drop. The readings in March and April were consistent with an economic boom in the making. The current level of 53.5 in the overall index seems to point to a continuation of a pseudo-recovery — one where the economy is technically growing, but not enough for anyone, especially the unemployed, to feel it.
Three of the sub-indexes that I consider to be most important — Production, New Orders and Employment — are not just above 50, but above 60. The fourth, Order Backlog, is not that far off the pace at 58.0, and had the biggest increase of any of the sub-indexes. The table below is from the ISM report and provides the summary information.
*Number of months moving in current direction.
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