The goal of these pages is to discuss long-term trends and risks affecting financial markets and the broader economy rather than to analyze the torrent of monthly data hitting newswires. But the data flow of the past week merits a look as it ties into the running narrative of recent postings. Last week saw the release of the ISM’s Purchasing Managers’ Indices for both the manufacturing and non-manufacturing sectors. These reports feature components considered leading indicators, thus able to predict the economy’s health over the coming months. While Friday’s government jobs report is more of a backward-looking indicator, it does provide an accurate snapshot of economic conditions relative to past periods of recovery. The conclusion is not pretty, which is why the information imbedded in the forward-looking indicators is of such importance. These data also continue to build the case for the Fed to reveal perhaps the worst-kept secret in financial markets, which is its impending decision to undertake further extraordinary action to support growth despite the diminishing returns of such steps and the potential for unleashing longer-term unintended consequences. So much for the Hippocratic Oath’s central premise of first do no harm.
The PMI: Straight from the Trenches
The Purchasing Manager’s Index (PMI) for the manufacturing sector is a diffusion index meaning readings above 50 represent expansion in the sector and those below signal contraction. Data are collected via a survey of industry decision-makers regarding activities such as production and staffing expectations, new orders and inventories among other sub-series. In other words, the respondents have skin in the game. As with other indicators, recessionary periods are usually followed by a string of strong data as the economy plays catch up on the back of pent-up demand. That was indeed the case during late 2009 and into 2010. Since 2011, however, growth as measured by the PMI has sputtered, with the past two months coming in negative. (note: given manufacturing’s diminishing role in the U.S. economy, a negative PMI does not necessarily translate into broader economic contraction, but given the sector’s magnifier effect, negative readings do send up a red flag).
As seen in the second chart, the PMI itself along with key subcomponents have all tapered off from 2011’s pace. The Non-Manufacturing PMI measures activity in the 80-plus percent of the economy outside the manufacturing sector. Recent data here also have slowed, though the index has remained positive (above 50). Back to the manufacturing sector, the early stage of the recovery was fueled by growth in factory production, partly due to strong exports thanks to robust demand from emerging markets. Recession in Europe, which accounts for one-fifth of U.S. exports, along with a slowdown in emerging Asia, ended that party. Indeed, during latter-2009 and through 2010, often one-half of quarterly GDP growth was attributable to rising exports (though much of the boost was offset by import growth….a constant thorn in the side of the U.S. economy).
The Inventory Situation
A particularly telling component of the PMI is the New Orders sub-index, by definition forward-looking. New Orders for both the PMI and the Non-Manufacturing PMI have fallen over 2012 with the manufacturing version dipping into contraction territory. Analysts often reference the relationship between new orders and inventory levels to determine whether future demand merits increased production (thus greater economic activity) or if weaker orders signal slower growth as suppliers draw down existing inventory. As seen below, the difference between the two sub-indices turned (very) negative during the crisis and again has reached negative territory, far below the difference’s long term average of 8.5. The take-away: the second quarter’s positive contributor to GDP by inventory build-up may be reversed in the latter half of the year unless demand rises to absorb products sitting in the nation’s warehouses and loading docks.
The ability of America’s factories to calibrate production in order to meet future demand is more of an art than a science and thus results in something of a yo-yo effect on GDP as firms build up then eat through inventory depending upon the level of demand for products. This process has become all the more arduous given the economy’s tepid growth, cautious consumers and tight lending standards, not to mention attempts to divine how loose monetary policy will impact these demand-dynamics (this answer so far: it hasn’t).
One way to gauge the underlying demand of the economy is to factor out quarterly inventory changes. One such measure worth paying attention to is final sales to domestic purchasers. In the past we have harped on how GDP growth since the nominal beginning of the recovery in mid-2009 has lagged growth from earlier in the decade. The situation is even starker for the final sales figures. As seen below, when tossing overseas sales and inventory effects out of the equation, home-grown demand has simply not returned. May have something to do with a traumatized labor force and the end of easy credit for much of middle-America.
Back to Jobs
Friday’s jobs report showed an increase in payrolls of 163,000, a strong rebound after three months of sub 70,000 growth. The July figure is above the accepted threshold of what is necessary to keep up with population gains. Still one cannot forget that growth should be dramatically higher during a recovery in order to draw idled-workers back into the nation’s factories and offices. It has been 55 months since the country officially entered the great recession. Despite a few blips, job growth has remained positive since early 2010. But the pace has been nowhere near sufficient to quickly bring down the ranks of the unemployed. At this stage of the recession-recovery cycle, this period has been the only one of the past four U.S. recessions to have yet recovered the jobs lost.
Although the July jobs report exceeded (low) expectations, one month does not a trend make, especially when seasonal factors could lead to revisions. The longer-term data, some of which has been highlighted here, illustrate the tenuous position of the U.S. economy. It is for this reason that most analysts expect the Fed to mount its horse and chase down a few more windmills by purchasing additional bonds, perhaps before the autumn leaves begin to turn (and Americans go to the polls….oh what a political hornet’s nest that move will be). By policy-makers’ own admissions, continued accommodative steps will likely have diminished impact. Rates are, after all, at historic lows. As evidenced by Friday’s market rally, the Fed’s repeated attempts to resuscitate the economy are mainly felt by creating whippy trading opportunities. Short-term gain (depending upon which side of the trade you are on), longer-term ambiguity. The tall-task of expecting such measures to solve deeply-rooted economic ills is best captured by the adage: The good news is that the ambulance is here. The bad news is that you need an ambulance.