Strong Markit PMI Services

The Markit PMI services index was similar to the manufacturing survey. Its final reading was very close to the preliminary mid-month reading.

Final October reading of 54.8 beat the consensus and mid-month reading of 54.7. It beat last month’s report which was 53.5. Improved PMI is sharply divergent from the stock market. That's declining because of fears of a slowdown.

To be clear, the stock market is worried about 2019. However, a solid economy in October increases the odds of a strong economy in the first quarter of 2019.

New orders, backlogs, input costs, and selling prices are all increasing. This signals demand is strong and there are capacity constraints.

Production growth increased after weakening in September because of hurricane Florence. Hiring increased at the slowest rate in 9 months. Firms are having a tough time finding qualified candidates. To be clear, this isn’t consistent with the overall labor market.

As you can see from the chart below, the year over year growth in total nonfarm payrolls has been increasing since late 2017. Even though growth slowed slightly in October, 250,000 jobs added is much higher than the 2018 average of 212,500.

The big battle here is whether employers really can’t find workers or they are just stingy. It’s obvious that if an employer raises wages, at some point there will be an influx of qualified applicants.

The key is measuring workers’ sensitivity to wage hikes because there is a limit to how much employers can pay workers.

Strong Markit - Contextualizing ISM & Markit Reports

Combined with the manufacturing PMI, the total Markit PMI came in at 54.9. That's up 1 point from September and down from 55 in August.

The Markit reports see no slowdown. PMI is consistent with 2.5% Q4 GDP growth which is below most estimates. This report is the pessimistic cousin of the ISM report. That's been predicting higher GDP growth than what is reported.

In reading these numbers, I contextualize the reports by looking at the rate of change in the data. This assumes the bias is consistent. That could be an incorrect assumption. But these recent biases have been going on for a while. I check the surveys versus actual GDP growth to see if the biases are consistent.

The chart below shows the ISM composite index recently has been higher than the moving average of monthly GDP growth. The composite index, which includes manufacturing and services, fell from 61.4 to 60.0 in October.

Strong Markit - Strong Non-Manufacturing ISM

The ISM non-manufacturing PMI was very strong in October as it fell from 61.6 to 60.3. As you can see from the chart below, the previous PMI was the strongest in years. A 1.3 point decline from an extremely strong report is positive. This PMI is consistent with 4.1% Q4 GDP growth. That’s above most estimates. If business investment growth accelerates in Q4, we could see growth above the 3.5% rate in Q3.

The business activity/production index fell 2.7 points to 62.5. Keep in mind, the September reading was very strong. But quarter over quarter business investment growth was only 0.8% in Q3. New orders fell 0.1 to 61.5.

Strong Markit - Just like the Markit report, the ISM report had a weak employment reading. 

It fell 2.7 points to 59.7. Unlike the Markit report, the prices index fell 2.5 points to 61.7. It’s clear the tariffs and tight labor market are impacting manufacturing firms. ISM manufacturing prices index was up 4.7 points to 71.6.

Tariffs first impacted primary metals. It will be interesting to see if inflation and this non-manufacturing ISM price reading increase as the tariffs are implemented on other goods. The manufacturing labor market is extremely tight.

As you can see from the chart below, the employment to population ratio for those without a high school diploma is at a record high. But the rate is still down for college grads.

For college grads, the ratio is only up about 1% from the cycle trough. The recession caused it to fall by about 5.5% from the previous cycle’s peak. That ratio still much higher for those who are educated, but the gap is shrinking.

Strong Markit - Quotes from businesses included in the ISM reading. 

A retail trade company stated, “Business has been strong. Continuing momentum seen in past month. Anticipating continued strong sales through remainder of the year”.

It’s no surprised retail is doing well as real consumption growth accelerated to 4% in Q3. Nominal wage growth is accelerating and headline inflation is weak.

A finance and insurance firm stated, “Wrapping up fiscal year budgets [and] seeing modest increases in volume and spend. Some price increases due to tariffs on computers/peripherals”.

Those tariffs are only the beginning of what is to come as the rate will increase from 10% to 25% in 2019.

A construction firm stated, “Tariffs are beginning to impact business. We ask our suppliers to hold pricing for six months, but we are experiencing difficulties”.

Suppliers can’t hold prices with tariffs. This isn’t like increasing commodity prices. Tariffs increase once the law is in place. And there’s nothing businesses can do to get around them.

Strong Markit - Tariffs Having A Big Impact

The tariffs already had a big impact in September according to a coalition called Tariffs Hurt the Heartland.

American businesses paid $4.4 billion in tariffs in September which is over 50% more than September of last year. Tariffs on China were $800 million. They will increase by a lot in October. The bulk of tariffs were implemented at the end of September.

Steel and aluminum tariffs cost businesses $545 million.

Strong Markit - Conclusion

Both the Markit and ISM services indexes were strong in October. But investors aren’t concerned with the economy now.

They are worried increased rate hikes and tariffs will hurt the 2019 economy.

The bull case on stocks is that these negatives are already priced in. This is since the forward PE multiple of the S&P 500 is below the long run average.

However, keep in mind estimates will likely be lowered if the tariffs and rate hikes continue.