ISM Manufacturing PMI - Markit PMI Shows Moderation

The August Markit manufacturing report showed slight weakness. It was overshadowed by the remarkably strong ISM PMI report which I will review later in this article. As you can see from the chart below, the Markit PMI was 54.7 which was down from 55.3 in July. It beat estimates for 54.5.

As you can see, the Markit PMI has been the lowest in the grouping outside of one month in early 2018. The Markit PMI shows a sustained slowdown which both the ISM and regional Fed reports have not shown.

The ISM and regional Fed reports have been highly correlated outside of this past month as the regional Fed average fell and the ISM PMI rose sharply.

ISM Manufacturing PMI - The final Markit reading was slightly above the mid-month reading which was 54.5. 

Production growth was the slowest since November 2017. New orders slowed moderately. Backlogs and employment growth were strong, but slowed as well. Export sales increased. Business confidence increased to a 3 month high. Input costs and selling prices slowed and delivery times fell.

This all means capacity constraints eased. I’d rather see strength paired with inflation. At least we don’t have the worst case scenario which is inflation and slowing demand. Two thirds of firms who saw higher input costs blamed tariffs.

This report implies August factory orders will weaken. Manufacturing production growth could fall to 0.2% in Q3.

ISM Manufacturing PMI Explodes

I have been following the regional Fed reports to project the ISM report because they have been highly correlated. As I explained earlier, the correlation broke in the August report as the PMI came in at 61.3.

This beat the consensus for 57.7 and the highest estimate which was 58.1. It beat the July PMI which was 58.1.

As you can see from the chart below, this was the highest PMI since May 2004 and it’s very close to being the best PMI since 1984. Even though the PMI isn’t hard data, it is widely followed and effects investors’ view of where rates are going and where stocks are going.

(Click on image to enlarge)

Before I review the details of this report, it’s notable that this report doesn’t go along with other data we’ve seen from August.

As you can see from the chart below, the August divergence between the ISM PMI and the regional Fed reports is the 3rd largest in the past 20 years.

The regional Fed reports are surveys with small sample sizes, but so is the ISM report. I’m skeptical the current manufacturing economy is the best since 2004 as I don’t even think it is better than early this year.

ISM Manufacturing PMI - The ISM and regional Fed index are highly correlated. 

However, the ISM and manufacturing output haven’t been as correlated. This goes along with the statistics which measure the relationship between hard data and soft data.

Some bears act as if bullish soft data is always meaningless. However, the relationship varies, meaning nothing is a guarantee. I’d still rather see strong soft data than weak soft data. But obviously I would rather see strong hard data than strong soft data.

As you can see from the chart below, the qualitative ISM PMI production component has been higher than the Fed’s quantitative manufacturing output report for most of this year.

(Click on image to enlarge)

Now let’s look at the details of this report. The new orders index was up 4.9 points to 65.1. The production index was up 4.8 points to 63.3. The employment index was up 2 points to 58.5.

This was the perfect report because even though demand increased, the prices index fell 1.1 to 72.1. To be clear, the prices index is still running very hot. It’s a modest improvement which was unexpected given the improvement in orders.

Imports also fell 0.8 to 53.9. GDP is hurt by imports and helped by exports.

ISM Manufacturing PMI - This PMI reading is equivalent to GDP growth of 5.6%. 

I don’t think there’s any chance of GDP growth exceeding 5%.

The Nowcast projections which include this PMI report see GDP growth of 5% as a possibility. Once the hard data reports come out, it will be unlikely. I would be impressed with anything 3% or above because of the negative year over year ECRI leading index.

Let’s see the quotes taken from businesses. A food, beverage, and tobacco products company said, “Suppliers appear to be bracing us for cost increases, given increased talk of tariffs and inflation. We are budgeting for 2019 accordingly.”

All companies are discussing tariffs, but the overall inflation stats and the Bloomberg commodity index don’t show pricing pressure. There’s talk, but not much inflation outside of a few items.

ISM Manufacturing PMI - Demand is still strong according to this report. 

It is disconcerting that tariffs are playing into 2019 plans because some investors including myself, hope the trade skirmishes will be resolved in the next few months.

Ground zero for the tariffs is fabricated metals.

A firm in this industry stated, “The toughest thing we deal with is the unknown. Dealing with tariffs on steel purchases and not knowing if or when they will end makes planning difficult. We are entering the period when we begin our pricing negotiations for next year and will likely treat the tariffs as if they will be here for the entire year. It’s challenging, but not insurmountable.”

It clearly isn’t insurmountable since new orders increased so much in August.

ISM Manufacturing PMI - Conclusion

Even though correlation doesn’t equal causation, I’m all over any metric which shows a consistent correlation over many years. The ISM isn’t correlated with the hard data, but it has been correlated with stock returns.

As you can see from the chart below, the December ISM manufacturing PMI has been close to the S&P 500’s performance. The colored lines tell us the implied returns based on each ISM PMI level.

If the ISM PMI ends the year at 61.3, the S&P 500 is projected to end the year at an astounding 3,400. I think neither are close to reality. It will end somewhere in between 55 and 58.1.