U.S. manufacturing flashing warning signs

September 29, 2015

U.S. manufacturing may be in trouble. Nearly all key indicators measuring the health of manufacturers in the world’s largest economy have disappointed over the past year.

If manufacturing remains a solid leading indicator of where the economy is headed, this spells bad news for the wider economy and prospects for a Federal Reserve interest rate hike any time soon.

The Institute of Supply Management’s manufacturing index, the most widely watched of the lot, has mostly missed the Reuters consensus forecast each month since the start of the year.

More worryingly, the slide in the new orders sub-index, which gives a very reliable reading on future activity, over the past year suggests things are probably going to get worse, with order books at firms filling up at a feeble pace.

U.S. manufacturing heatmap

The ISM index for September, due Thursday, is expected to dip to 50.6 from 51.1 in August according to economists polled by Reuters. The consensus based on the top ten most accurate forecasters is almost exactly the same, at 50.5. There were three forecasts below 50 – one as low as 48.6.

Something close to consensus and the top forecasters would mean barely any growth at all. (Anything above 50 denotes expansion while below implies contraction).

The Chicago PMI for September plunged to 48.7, suggesting manufacturing in that region is shrinking, undercutting even the lowest prediction in a Reuters poll and a 5.7 index point drop from 54.4 in August. 

Over the past year, other indicators measuring the health of manufacturers have told a similar tale — and sometimes worse.

US manufacturing data table

Tim Quinlan and Sarah House, economists at Wells Fargo, wrote:

A meaningful pickup in manufacturing does not appear to be in the cards anytime soon. The first three regional purchasing managers’ indices released for September all showed activity contracting over the month.

Even though it is rare for the noisy regional surveys to move in the same direction, they say it is clear that industry remains under pressure — and particularly for exporters, because of the strong dollar, which makes goods relatively more expensive abroad.

Deutsche Bank’s Nick Lawson and Gael Gunubu wrote:

U.S. equities rarely maintain a prolonged sell-off without ISM in contraction mode (<50). The last print was 51.1, the recent Markit PMI was stable, but the last two NY Empire imply a drop to as low at 46.

ISM vs equities

By that theory, if the downward trend in ISM continues, it could extend the 9 percent drop in U.S. stocks so far this year. And it could also tap the brakes on economic growth, which is already widely expected to have slowed this quarter from 3.9 percent in Q2.

A persistently stronger dollar makes that possibility more real. The greenback has been strengthening against a basket of other currencies almost uninterruptedly since mid-2014 in anticipation of higher interest rates.

Dollar index

That rally paused after the Fed passed up an opportunity to hike rates two weeks ago, but the dollar is firming again.

If manufacturing continues to weaken, the Fed’s decision to leave interest rates unchanged near zero for longer could prove prudent, rather than a missed opportunity as many economists called it in a Reuters poll.

Fed Chair Janet Yellen listed various global factors – from an economic slowdown in China to Canada’s woes due to falling oil prices – explaining why the central bank left policy steady.

What escaped notice was the lack of mention, even in passing, in the Fed’s rhetoric of how manufacturers are stumbling back home.

Over 17,000 manufacturing establishments have shut shop between the end of the Great Recession and the beginning of 2013, according to a paper published by Washington D.C.-based Information Technology and Innovation Foundation.

American manufacturing has shed over a million jobs during the same period, the paper published early this year by the public policy think-thank goes on to state.

And U.S. manufacturers are not alone in experiencing trouble. China’s factory sector activity shrank to a 6-1/2 year low in September, data released last week showed.

Economists at JP Morgan note:

One hallmark of the global economy in 2015 has been the persistent slump in manufacturing production. Factory output advanced at just a 0.7 percent (annual rate) in H12015 and it looks on pace for a similar outcome in Q3.

Yet economists were surprisingly dismissive when the Empire State index shocked all predictions by plunging 20 points in one go in August, saying such weakness would not show up in the national ISM reading. 

ISM’s report card over the past year and charts mapping the indicator with Philly Fed and Chicago PMI suggest otherwise.

ISM Philly and Chicago

One main reason why forecasters have been dismissive of the alarming trend in manufacturing is the ongoing strength in activity at services firms, which make up a much larger proportion of activity. 

ISM’s sister survey of non-manufacturing companies suggests things are much better on that front. That reading was at 59 in August, below a recent peak but not far off levels seen in late 2005, during boom times.

Still, manufacturing makes up 12 percent of the U.S. economy and accounts for over 72 percent of industrial production.

Fed policymakers are either as skeptical as some economists of the recent series of disappointing manufacturing reports or know more than they are letting on, as Neil Dutta at Renaissance Macro in New York put it while describing the surprisingly dovish tone at their meeting two weeks ago.

This has sparked a “the Fed knows something we don’t” trade in the markets.

Whether the Fed sees this slowdown as a serious risk or not, what is clear is that investors and those closely tracking global monetary policy ignore the condition of U.S. manufacturers at their own peril.

(This post was updated with Chicago PMI data for September).

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