Tale of two ISMs: another reason for the Fed to pause?

September 1, 2015

Depending on which report you read from the same source, the U.S. economy is doing extremely well and also in danger of slowing sharply.

The Institute for Supply Management’s closely-watched readings on the vast service sector showed it was booming in July, but it also just reported that manufacturing was quickly losing momentum in August. We’ll have another update on non-manufacturing performance in a couple of days.

Federal Reserve policymakers, who appear to be on the fence about whether to proceed with the first interest rate hike in nearly a decade in a few weeks, will take note.

On the one hand, having confirmation that the biggest part of the economy is doing well should encourage them to proceed with the first step towards lifting interest rates from emergency levels.

But manufacturing, which is most sensitive to both global trade flows as well as currency movements — meaning the strong dollar — is a leading indicator that few economists would recommend you ignore, no matter how small a share of the economy it now takes up.

The August ISM factory index wasn’t as much of a shock to the downside as the last services index surprised the other way. But the headline index fell sharply to 51.1, its lowest in over two years. Employment growth also stalled.

ISM manufacturing August

Crucially, the new orders index, the best forward gauge there is of business activity in coming months, fell sharply too. It has steadily come off a high of 63.0 last October down to 51.7, getting dangerously close to the 50 mark that divides growth and contraction.

Rarely does the ISM index, one of the longest-running and most reliable U.S. economic indicators, do that without broader economic trouble ahead.

US ISM 1950

This also came alongside a barrage of reports on manufacturing from around the globe that showed a widespread slowdown, with only a few exceptions.

All of this follows strong Q2 GDP growth of 3.7 percent, which came in better than expected, but also alongside a massive inventory buildup throughout the first half of the year. So growth in the current quarter in all probability is going to look much slower than that.

Joshua Shapiro at MFR called the plunge in the ISM index a “warning signal”:

Taken alone, the August composite index is at a level consistent with soft real GDP growth. While this is just a single monthly data point, it does raise a warning flag concerning overall real economic growth, particularly should the weakness be sustained in September.

So, after four months of improving results, August saw a sharp setback in this key indicator of demand for U.S. manufactured goods. If sustained (or a harbinger of even more weakness to come), the August reading would not be good news for the near term outlook for underlying capital goods orders. Moreover, weakness in export orders remains an Achilles heel, and weak growth abroad promises to weigh on demand for U.S. goods.

Jim O’Sullivan at High Frequency Economics, one of the most accurate U.S. data forecasters and also one of the most optimistic about the recovery, had this to say:

In short, weaker than expected. Moreover, the orders index fell even more than the headline number.  While the data are still signaling growth, the implied pace is very weak. In interpreting the data, manufacturing is much more exposed than non-manufacturing to weakness in foreign demand. Meanwhile, manufacturing directly accounts for just 12% of GDP and the last non-manufacturing ISM index reading was the highest since 2005. That said, these data will undoubtedly help the case of Fed officials arguing for holding off on tightening pending more information.

Jesse Hurwitz at Barclays Capital was more direct:

The decline was led by the components of the survey that tend to be most indicative of future activity. As such, we view the August report as confirming our recent view that output and employment for the domestic manufacturing sector are likely to remain sluggish through the end of the year. 

Jay Morelock at FTN Financial wrote:

While the strength of the dollar and lower global trade levels will certainly hit exporters, the recent weakness is more due to falling commodity prices than structural weakness in the U.S. economy.  With that said, if weakness in commodity prices and global trade do not prove to be transitory, the manufacturing sector will struggle to contribute meaningfully to growth in the second half of the year.

Of course, none of these reports should ever be taken in isolation. The ISM report was accompanied by a strong reading on construction spending. But some indicators are better at giving leading signals of developments in the economy in the others, and the ISM manufacturing index always has been one of them.

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