The ISM schism

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Please note that this article contains technical language. For this reason it is not recommended to readers without professional experience of this topic.

 

The US manufacturing and mining sectors have continued to face a challenging environment due to weak global demand, low energy commodity prices and a strong US dollar. As Dan Singleman wrote in the FFTW weekly commentary on 13 November, earnings per share for US companies are expected to decline over the next two quarters, with a good portion of the weakness coming from the energy and materials sectors. In addition, in October, the mining sector shed jobs for the tenth consecutive month and employment growth was flat in manufacturing.

More broadly, as seen in Exhibit 1 (below), external-facing sectors of the economy have seen a notable step-down in payrolls growth this year. Given broad expectations for continued US dollar appreciation over the medium term, a lackluster outlook for global growth, and little support for the domestic oil and gas sector from the expected trajectory of energy prices, the manufacturing and mining sectors will continue to face headwinds in the months ahead.

Exhibit 1: Growth in US monthly payrolls,  three month average for the period from December 2013 through December 2015

FFTW1

Source: Bureau of Labor Statistics, Author’s sector classifications, as of 4 December 2015

Weakness in the manufacturing sector is evident in the hard data, but also in industry surveys such as the Purchasing Managers Index (PMI) produced by the Institute for Supply Management (ISM). Over the past year, as oil prices declined and the trade-weighted US dollar appreciated, the Manufacturing PMI has fallen and now stands at 50.1%, hovering just above the breakeven level between expansion and contraction.

Still, the service sector of the economy has remained resilient to the slowdown in manufacturing. Jobs growth in internal-facing sectors—largely services—has remained strong. This along with low gas prices has supported solid if unspectacular consumer spending. The resilience of the service sector is also evident in the ISM PMI index for non-manufacturing portions of the economy. At 59.1%, the Non-Manufacturing PMI remains firmly in expansion territory. But it is worth considering that since the ISM began publishing the Non-Manufacturing PMI in 1997, such divergences between the two PMIs are rare and tend to be short-lived (see Exhibit 2 below). This may reflect the notion that it is difficult for the two broad sectors of the economy to disengage from each other for long; strength or weakness in one sector may eventually spill over to the other, and both sectors are likely influenced by a number of common factors.

Exhibit 2: The ISM schism: spread between purchasing manager indices

FFTW2

Source: Institute for Supply Management, as of 4 December 2015

In this regard, the prior divergence in the two ISM indices in 2000 merits review as it bears some similarities to the present, with an expanding services sector and struggling manufacturing. In the second half of 2000, the Non-Manufacturing PMI continued to reflect a services sector expansion, with index readings averaging 56%. However, the Manufacturing PMI had already begun sliding sharply earlier in the year as the collapse of the “dot com” bubble led to a significant retrenchment in corporate investment and a foundering labour market. Ultimately, consumer spending fell as unemployment rose, and the bursting of the equity bubble cut into household wealth. By the end of the year, the manufacturing sector was clearly contracting; the services sector soon followed suit, and by March 2001, the economy officially entered a full-blown recession.

Could the economy follow a broadly similar path as the one seen in 2000, with weakness in manufacturing eventually impacting the services sector and crimping overall payrolls growth and consumption? Some spillover should be expected, though it is likely to be limited. There is some evidence that states experiencing job losses in the oil and gas extraction industries are experiencing weaker jobs growth in other industries. In such regions, consumer confidence and spending could weaken. As of yet, though, there is no evidence that service sector job growth is being impacted in states with a relatively large manufacturing base. But this could change, particularly if the start of Federal Reserve (Fed) tightening and growing policy divergence with other central banks lead to a second round of significant US dollar appreciation. Still, given the relatively small size of manufacturing in the US economy, short of a deep and protracted manufacturing recession, GDP growth should on average remain modestly above trend in the coming quarters. At the same time, the pace of monthly payrolls growth is likely to step down to the 150,000 to 200,000 range next year, but this should be sufficient to take the unemployment rate below the Federal Open Market Committee’s (FOMC) long-run estimate of 4.9%, possibly by the middle of next year. At the end of the day, the fortunes of the US economy are primarily tied to the services sector, not manufacturing.

Steven Friedman

Senior Investment Strategist

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