Monday, August 1, 2011


The Institute for Supply Management’s (ISM) manufacturing index dropped to 50.9 in July from 53.3 in June. This was a big negative surprise as the consensus had been looking for the index to fall to just 54.0. In other words, the manufacturing economy is still expanding, but just barely.

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 24 straight months.

Manufacturing had been one of the stars of the recovery, but it is clearly fading. We were above 60 for four straight months earlier in the year -- an extremely high level -- but now we are stalled. Not moving backward into recession, but we have no forward momentum either. In fact, the April reading had 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 April level been matched or exceeded only 19 times, or 5.1% of the months. The graph shows the history of the overall index since January 1971.
The ISM index has a very long and venerable history; it used to be known as the Purchasing Managers Index, or PMI. However, this is simply a survey of purchasing managers at various firms in different industries, and it does not weight by the size of the firm.

Results by Sub-Index

The overall index is made up of ten sub-indexes. Just two of the indexes improved while eight showed deterioration over last month (well, one of those was down, but it was for prices, so that really isn’t bad news). On the other hand, six are above the "magic 50" level.

The sub-indexes are as interesting as the overall index. When one digs below the headline number, this is a very ugly report. In terms of the current state of the economy, the most important of these is the production index. It fell 2.2 points to 52.3, it was as high as 63.8 in April. The decrease is bad news and the absolute level is anemic.

The production index has been in positive territory for 26 straight months now. Seven industries reported an increase in production while seven saw production fall in July.

However, the index with the biggest impact on the very short term is the backlog of orders, and there the picture is also one of deterioration. The order backlog sub-index fell 4.0 points, its third decline in a row. It was at 61.0 in April. The order backlog sub-index has been extremely erratic of late.

Four industries reported an increase in July, while nine reported declines. This points to more short-term softness in the manufacturing sector.

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 provided some very bad news as it fell 2.4 points and fell below the "magic 50" level for the fist time since June of 2009, the month the Great Recession officially ended.

This is not a good omen for the next few months. Back in April, the new orders index was at 61.7. The current level of 49.2 indicates that new orders are falling, but not plunging. Nine industries reported higher new orders while seven reported a decline in new orders.  

With unemployment at 9.2% in July 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 fell to 53.5 from 59.9 in June, a plunge of 6.4 points and the second largest decline among the ten sub indexes.

The employment sub-index has been above 50 for a 22 straight months now. Nine industries reported an increase in employment while five reported a decline. 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.
Prices Paid Index

The prices paid index fell 9.0 points, its third straight month of sharp declines, but remains at the highest overall level, at 69.0, 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. However, its rapid decline, coupled with other weak data, might help tip the scales in favor of more action by the Fed.

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 Federal Reserve’s quantitative easing program. The general rule on the sub-indexes is that the higher they are the better, but the level it was at a few months ago was a bit worrisome, and this is the one decline that I see as welcome news.

Given the rest of the data out there, it seems clear to me that we still need more economic stimulus, both fiscal and monetary, but we sure are not going to get it on the fiscal front. The level is still high, even the declines, however we were higher than the March or April level on this sub-index as recently as July of 2008.

A Look at Foreign Trade

The ISM index also gives a bit of a glimpse into the foreign trade situation. It seems to be indicating a bit of a pick-up in the growth of world trade. The index tracking new export orders rose 0.5 points to 54.0 while the index tracking imports rose 2.5 points to 53.5.0. Keep in mind that it is net exports, not just raw exports, that are important to economic growth. However, the import figure refers to imports of materials or components that domestic manufacturers use, not to finished goods.

Net exports were a  help to GDP growth in the second quarter, adding 0.58 points from growth. Prior to the dramatic revisions we got on Friday, we had thought that net exports were a small positive contributor to growth in the first quarter, but now it looks like they were a 0.34 point drag on growth. We are going to need a lot of help from net exports if we are going to have solid GDP growth in the third quarter.

Another Bitter Disappointment

Overall this was a very nasty report. It was much worse than the consensus expectation. The level, while still positive, is consistent with very slow growth. While the index has a very long history, its accuracy in forecasting economic growth seems to be breaking down significantly. The readings in the first four months of the year were consistent with an economic boom in the making, yet after the revisions, the economy grew slower than population in the first quarter.

This month and last month taken together point to a more plodding recovery. Let’s hope that the index has simply broken down as an economic indicator, not that it has suddenly become biased to the upside.

The current level of 50.9 in the overall index is near stall speed, and at best seems to point to a continuation of a pseudo-recovery. One where the economy is technically growing, but not enough for anyone, especially the unemployed, to feel it.

All of the four sub-indexes that I consider to be most important -- Production, Backlog, New Orders and Employment -- fell by over 2 full points. Two of them, Backlog and New Orders, are now below the "magic 50" level. The other two are so-so at best. The table below is from the ISM report and provides the summary information.