The Institute For Supply Management’s (ISM) manufacturing index rose to 56.3 in August from 55.5 in July. This was a big positive surprise, as the consensus had been looking for the index to fall to 52.9.
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 13 straight months. Unlike most of the other data we have been seeing in recent weeks, the rise in the ISM index actually indicates that the growth in the manufacturing sector accelerated in August.
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. Overall, six of the indexes showed improvement over last month and four showed deterioration. Nine are above the magic 50 level, while only the index tracking purchasing managers views of their customers inventories was below the 50 level, and it showed the largest single gain on the month.
The sub-indexes are as interesting as the overall index. In terms of the current state of the economy, the most important of these is the production index. It jumped 2.9 points to 59.9, which is a very strong reading. The production index has been in positive territory for 15 straight months now. Eleven industries reported an increase in production while just four saw production fall in August.
However, the index with the biggest impact on the very short term is the backlog of orders, and there the picture is not nearly as good. The order backlog sub index fell to 51.5 from 54.5. While that does mean that order backlogs are still rising, they are doing so at a much slower pace than they were in July. Backlogs have been rising on balance for 8 straight months now. Eight industries reported an increase in backlogs while seven showed a contraction.
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 fell slightly to 53.1 from 53.5. In other words, new orders continue to rise but at a somewhat slower pace than last month. New orders have been on the rise form 14 straight months now.
With unemployment at 9.5% in July, and expected to rise when the employment report comes out on Friday, the employment sub-index is of particular interest. It was strong in August, rising to 60.4, an increase of 1.8 points. Ten industries reported an increase in employment, while only one reported decline.
In Contrast to ADP Report
I would note that this is in direct contrast to the ADP report that showed that manufacturing employment fell by 6,000 in July. While ADP does not break out manufacturing by firm size, it does so for the overall goods producing sector, which includes manufacturing. That showed more strength among the large firms (over 500 employees) than among small firms. The ISM respondents are probably more weighted towards large firms than small firms. I suppose that the BLS will have to break the tie on the manufacturing employment situation on Friday.
Prices Paid Also Up
The prices paid index posted the second largest increase, up 4.0 points, and the highest overall level at 61.5. This would be an indication that deflation is not around the corner as some of the other price indexes like the CPI have seemed to be indicating. The bond market has clearly been worried about the potential for deflation, as that is the only macro scenario in which 10-year t-note yields of under 2.5% make any sense. This report should be good news then for the short bond ETF’s like the ProShares UltraShort 20+ Year Treasury (TBT).
On Foreign Trade
The ISM index also gives a bit of a glimpse into the foreign trade situation. It seems to be indicating that overall trade is still increasing. The index tracking new export orders though fell 1.0 point to 55.5 while the index tracking imports rose 4.0 points to 56.5. However, the import figure only refers to imports of materials or components that domestic manufacturers use, not to finished goods. Still, the figures seem to point to a further deterioration in the trade deficit and net exports.
Net exports were a huge drag on GDP growth in the second quarter, subtracting 3.37 points from growth. In other words, if the trade situation had remained unchanged from the first quarter, GDP growth would have been 5.0% in the second quarter, not 1.6%. Thus this sign of further potential weakness in net exports does not bode well for GDP growth in the third quarter.
Bullishness Prevails
Overall, however, one must count this report as a big win for the bulls. The details are not as great as the top line would suggest — particularly the weakness in the order backlog and new orders components — but they are still showing expansion, just not as much as they were in July.
Manufacturing has been a bright spot in this otherwise dim recovery. This report shows that the light is still on, an actually burning somewhat brighter than it was in July. Given the tone of the rest of the data we have seen lately, that is very welcome news.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
