ISM Shows Manufacturing Is At A 13 Year High

In an unusual circumstance, the ISM manufacturing index was one of the most discussed topics in the financial world because it hit its 13 year high. This led to much more analysis done on the report than usually occurs. The ISM saying manufacturing is the strongest in 13 years is a major proclamation which can easily be criticized. It’s easy to find other metrics which aren’t at their 13 year high. I think that analysis misses the point. Manufacturing is strong as shown by many regional Fed reports and many companies. Whether it is the strongest of this cycle or slightly below that is immaterial in my opinion. You invest based on future expectations, so the minor details of the past results don’t matter much.

One of the additional analyses of the manufacturing economy is seen below. The chart shows 8 emerging market PMI reports and 10 developed market PMI reports. As you can see, every report is positive. This goes along with every stock market being up this year. The global economy is in a happy place with demand rebounding, global trade growth accelerating, and inflation staying moderate. Brazil has been one of the countries which has seen the most improvement as it emerges from its recession and the economy is able to get past the numerous political corruption scandals. This indicator has America at 53.1 which is near the 53.2 global average. America catching up to other economies in the past few weeks adds to the bullish narrative on the dollar. The dollar index is at $93.87 which is just 10 cents off its 1 month high.

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Before we go any further with looking at the manufacturing economy, let’s review how great the ISM report was. It came in at 60.8% which is impressive given the weakness that was caused by the hurricanes. This headline report correlates with a 5.5% increase in annualized real GDP growth. Clearly, that’s unattainable unless there is a quick burst in growth from a tax cut. Even the 4.4% growth rate that is based on the year to date ISM reports isn’t attainable. This means that either the manufacturing economy is growing faster than the overall economy or that these numbers are too high. I think both are true because the manufacturing labor market is exhibiting more tightness than the service sector and because manufacturing production isn’t as great as this survey (which we will review later in this post).

The table below gives you a snapshot of this report. As you can see, every subsector of this report looks great and most are showing accelerated growth as you’d expect with such a solid headline reading. Inventory growth slowed and it got to the position of being too low. This is great news for GDP growth as inventory will need to be restocked. Sometimes commentators speak negatively about good GDP reports which are based on inventory growth, but as long as the demand is there, this is a sign of a healthy economy. The headline GDP isn’t being artificially juiced by inventory growth.

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Let’s review the quotes taken from the ISM report. A transportation equipment company said the following: "Labor shortages continue to haunt operational capacity both at [the] local plant [level] and up and down the supply chain.” This supports the point I made earlier which is that the manufacturing economy is in a bind trying to find workers. This doesn’t push the overall wage inflation up because the service sector employs much more people.

A nonmetallic mineral company said the following "Hurricane Harvey, and now Irma, have impacted the business (building materials). Increasing sales but also causing significant price increases on input raw materials.” This is the same perspective we’ve seen from many other firms. Inflation increased and there were delays as a result of the storms. It’s possible that the headline number was improved because of the storms as rebuilding took place. It’s also possible that the reason inventories ran so low is because raw materials couldn’t be acquired.

The chart below explains the point we touched on earlier. The ISM report is too positive compared to actual results. This gets back to the question of whether survey data or real production is more valuable. As you can see from the industrial production index, the manufacturing economy is strong, but it’s still below the peak in 2014. The September report hasn’t been released yet, so we’ll see how much it differs from the ISM report. The conclusion we can draw from this chart is that the manufacturing recovery this cycle wasn’t great as we barely beat the last cycle peak. However, in the past few months there has been a resurgence getting us close to the all-time high set in late 2014.

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The chart below gives you a historical map to understand what the ISM report means in terms of the timing of the business cycle. If the blue line was accurate, a recession would be about a year away. However, the latest results make us question that track. The ISM needs to start weakening sharply in the next 6 months for a recession to be afoot. This depends on the global economy, monetary policy, and fiscal policy. It’s far too early to use this strong report as justification for a 2019 recession prediction. It’s fair to say stocks will already be falling by the time the ISM falls below 50, but it’s also impossible to time the market perfectly. If you sell after minor economic weakness you would have a worse track record than if you miss the first signs of weakness at the end of a bull market because you want confirmation that the economy is actually slowing enough where the recession risk moves up materially. That being said, watching the ISM report closely in the next 4-6 months makes sense because it could be a warning sign that could help you sell early to avoid the pain that a recession brings to the equity market.