The Institute for Supply Management’s (ISM) manufacturing index dipped to 60.4 in April from 61.2 in December. This was a positive surprise as the consensus had been looking for the index to come in at 59.7. While down from last month, this is still an extremely strong reading.
Based on historical experience, the April reading is consistent with GDP growth of 6.3%. Then again, perhaps there has been a change in the relationship, since the average level so far this year is consistent with 6.5% growth, and we learned last week that 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. The overall index has now been above the magic 50 mark for 21 straight months. The key takeaway from this number is that the manufacturing sector is expanding very nicely, but doing so at a slower rate than in March.
This reading is extremely strong by any historical perspective. In fact it has 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 below 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 improvement over last month. Nine are above the magic 50 level (the index tracking purchasing managers views of their customers inventories is the only exception).
The sub-indexes are as interesting as the overall index. When one digs below the headline number, this is a very solid report. In terms of the current state of the economy, the most important of these is the production index. It fell 5.2 points to 63.8. The decline is bad news, but the level is still very strong. The production index has been in positive territory for 23 straight months now. Fourteen industries reported an increase in production while three saw production fall in April.
However, the index with the biggest impact on the very short term is the backlog of orders; and there the picture is one of sharp improvement. The order backlog sub index soared 8.5 points, the greatest increase of any of the sub-indexes. That is a good thing since order backlog had fallen sharply last month, but is now back above its January (58.0) and February (59.0) levels. The current reading is the highest since last May. Ten industries reported an increase in January, while four reported declines.
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. The new orders index dipped to 61.7 from 63.3. In other words, new orders are flooding in to the nation’s factories, but not quite as fast as last month. New orders have been on the rise for 22 straight months now. Fifteen industries reported higher new orders while just two reported a decline in new orders.
With unemployment at 8.8% 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. The employment index slipped to 62.7 from 63.0 in March. The employment sub index has been above 50 for 19 straight months now. Fifteen industries reported an increase in employment while none 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 rose 0.5 points, and remains at the highest overall level (85.5) 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 ammunition for those who are critical of the 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 could raise fears of overheating. Given the rest of the data out there, I’m not terribly concerned about that. Even though the level is very high, we were higher 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 an improvement in the trade deficit. The index tracking new export orders rose 6.0 points to 62.0, while the index tracking imports fell 1.0 points to 55.5. However, the import figure refers to imports of materials or components that domestic manufacturers use, not to finished goods.
Still the figures seem to point to a further improvement in the trade deficit and net exports. 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%. Thus, this sign of further potential strength in net exports bodes well for GDP growth in the second quarter.
Overall this was a nice report. It was slightly better than the consensus expectation, and the overall level is consistent with an economic boom in the making, not a return to recession. It is at highs that have rarely been seen over the last 30 years. All of the four 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.