The latest ISM manufacturing and non-manufacturing releases suggest that the US economic activity is growing at a somewhat slower pace. This is similar to the economic outlook portrayed by the ISM releases last month. This time, the two ISM releases are tad confusing as the manufacturing index showed contracting manufacturing activity while the non-manufacturing index showed that non-manufacturing activity was growing faster. These figures, nonetheless, continue to present a bleak economic scenario compared to what it was at the beginning of this year.
Both the weakness in the global economy and the trade uncertainty have started having visible impact on the domestic economy of US. The Fed had indicated in the press conference held by the Fed chair in July that risks had started showing up in manufacturing and investment data. This week’s ISM data releases support that evaluation. The Fed didn’t mention much about the non-manufacturing sectors and the labor market in the press conference. The few mentions continued to present the labor market as being quite strong. So, Fed will not be much surprised with ISM data as they, perhaps, were already expecting manufacturing activity to continue to decline.
In the light of ISM data, would the Fed continue to refer to its July rate cut as an “insurance cut” and a “mid-cycle adjustment”? Or, would Fed change its overall monetary policy stance?
ISM Data and Market Reaction
ISM manufacturing index, as reported by the Institute of Supply Management, for Aug was 49.1, a decrease of 2.1 points compared to the previous month’s figure of 51.2, and a decrease of 2.0 points compared to the expectation of 51.1. In fact, the figure was lower than even the minimum expectation of 49.5 signifying the weakening manufacturing activity in the US economy and slower growth of the overall economy. The Aug figure was also lower compared to 60.8 in Aug 2018, which was not only the peak of the current economic cycle but also the highest peak in last 15 years, and the 2nd highest peak in last 32 years.
The immediate reaction in US dollar was down, in line with the surprisingly weak data. US dollar went down by approximately 0.2% within the 10 minutes of the data release and then ended the day lower by almost 0.3% compared to where it was just before the data release. The reaction in the S&P 500 was different as they went down by approximately 0.7% in the first 10 minutes of the release but that actually proved to be the lowest point of the day as S&P 500 ended the day lower by just 0.2% compared to where it was before the data release.
ISM non-manufacturing index, also reported by the Institute of Supply Management, for Aug was 56.4, an increase of 2.7 points compared to the previous month’s figure of 53.7, and an increase of 2.4 points compared to the expectation of 54.0. In fact, the figure was higher than even the maximum expectation of 55.3 signifying continued, faster and better-than-expected growth in the non-manufacturing sector and faster growth of the overall economy. The Aug figure was, however, lower by 2.4 points compared to 58.8 in Aug 2018.
The immediate reaction in US dollar was up, in line with the surprisingly strong data. US dollar went up by approximately 0.2% within the 10 minutes of the data release and then ended the day by almost 0.3% up compared to where it was just before the data release. S&P 500 also went up by approximately 0.2% within the 10 minutes of the data release and then ended the day up by 0.1% compared to where it was before the data release.
Following graphs show the year-on-year (YoY) changes in the ISM manufacturing and non-manufacturing indexes. The YoY changes in the two indexes indicate the cycles clearly, with the manufacturing index being more lucid than the non-manufacturing index.
Historical Significance of the ISM Data
The ISM manufacturing and non-manufacturing indexes are considered significant economic indicators for they provide the very first assessment of the changes in the economic activity in the corresponding sectors of the US economy for the immediately preceding month. Not only the ISM indexes have the shortest reporting lag, they have also historically been very effective in indicating which direction the economy is picking. Following chart shows the relation between 3-month simple moving average of ISM manufacturing index and GDP year-on-year growth rate for the US economy: -
We take a 3-month moving average of the ISM manufacturing index since GDP is released 4 times in a year while ISM is released every month. A 3-month simple moving average helps relate the average ISM manufacturing index to the corresponding quarter’s year-on-year GDP growth rate.
As per an updated research, cited on the ISM’s website, the ISM manufacturing index can explain about 60% of the annual variation in US GDP, with a very low margin of error. So, the timeliness and the historical effectiveness of these indexes make them a widely watched economic indicator.
Amongst the sub-indexes of the manufacturing and non-manufacturing reports, one of the most important ones is the New Orders index. It is considered a leading indicator of growth in the economic activity.
Breakup of the latest ISM figures
The headline ISM manufacturing and ISM non-manufacturing indexes are also known as the PMI (i.e. Purchasing Managers’ Index) and the NMI (i.e. Non-Manufacturing Index) respectively. The PMI and the NMI are composite indexes based on the equally-weighted diffusion indexes of 5 and 4 sub-indexes respectively.
The maximum reduction in the ISM manufacturing PMI was contributed by the Employment Index i.e. -0.85 points. This was closely followed by the New Orders Index i.e. -0.7 points. The ISM manufacturing index is part of a report that releases 11 other sub-indexes that, for Aug, indicate the following: -
1. Demand contracted due to a heavy reduction of 3.6 points in the New Orders Index,
2. Consumption contracted even more,
3. Inputs continued to move lower in Aug, and
4. Prices continued to deteriorate lower in Aug registering their 3rd consecutive monthly decline.
The maximum increase in the ISM NMI was contributed by the Business Activity Index i.e. 2.1 points. This was closely followed by 1.55 points contributed by the New Orders Index.
Overall, the respondents to the ISM surveys were concerned by the escalating US-China trade war but they were mostly positive about business conditions.
Interpretation of the ISM Data
Till the last FOMC meeting, the ISM manufacturing index indicated that the manufacturing activity was increasing but at a slower pace. With this latest release, the ISM indicates that the manufacturing activity is now declining although ISM non-manufacturing presents a different picture.
Overall, these figures do suggest that the US economic activity is increasing but at a slower pace. We believe the decline in the ISM manufacturing index (but not necessarily the magnitude) is anticipated by the Fed; but the increase in the non-manufacturing index is not enough in light of weakening global economic conditions and trade uncertainty.
As a result, we believe this report shouldn’t make a big dent in the economic assessment of the FOMC. However, since this keeps the pace and the heat on in the negative direction, we do expect a 25-basis points rate cut in the Sep meeting as was expected for the Jul meeting, unless the data deteriorates further and requires a larger cut. Additionally, we also expect Fed chair to move away from the wordings of “mid-cycle adjustment” and acknowledge the decline in the manufacturing activity.
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