Temperature rising!

Temperature rising!  The temperature is not the only thing rising as domestic manufacturing picked up adding to the already sizzling US economy.  This according to the ISM manufacturing PMI that was released yesterday.  The index came in at 61.3 up from last month’s 58.1, with economists expecting 57.6.  What does that all mean?  Well for starters, the economists got it wrong but it also may indicate that Trump’s trade tactics may be working.  To better understand the index we need to delve a bit deeper and it is, after all, geek-out Wednesday.  First let’s go over yesterday’s market reaction to the number. Yesterday’s session started out weak with all major equity indices opening lower reflecting traders’ renewed fears over trade.  The long weekend gave traders time to contemplate last week’s failure to reach an accord with Canada and the growing possibility that Congress will not approve the Mexico-only solution reached in the prior weeks.  While US markets were closed, foreign markets were the first to display weakness which led to a softer open in the US with the Dow trading off as much as 150+ points early in the session.  Then came the unexpected manufacturing data which pulled all of the major indices off their session lows.  The numbers, while they were able to stop the bleeding, were not enough to get positive closes on the session.  All equity indices remain constructive but we need to keep a close eye on the Dow Jones Industrials as weak closes in the prior two sessions have left the index in a weaker technical position.  Bonds showed a much greater respect for the economic release as they traded off led by longer maturities.  Remember that an increase in the manufacturing index can lead to inflation and that almost always causes a sell off in the bond markets.  Yesterday’s bond sell off brought 10 year yields as high as 2.90% and caused the 2/10 yield curve to steepen to as much as 25 basis.  Yields have since come back and will start the session at around 2.88 (10 year YTM) and the 2/10 curve starts the day around 23 basis points.  Now to the quick lecture.

The Institute for Supply Management (ISM) compiles, amongst other things, a monthly manufacturing index which is based upon a survey of 300 manufactures.  At a high level it gives us a read of production, inventory, new orders, deliveries of supplies, and employment.  The survey is constructed to reflect a diverse national geographic base as well as industrial classification.  The index is weighted by the respective industries’ impact on GDP.  Surveys are completed by purchasing managers and supply chain executives and include queries related to 19 categories which reflect an overall picture of manufacturing. For example, executives may be asked if new orders are increasing, decreasing, or unchanged.  These answers are all compiled into a composite index which will ultimately indicate whether production is growing, receding, or stagnant.  An index reading greater than 50 indicates that manufacturing is growing and an index reading below indicates a pull-back.  Yesterday’s reading of 61.3 represents a 14 year high for the index (see attached chart of historical readings back to 2004).  Below the surface, manufacturing employment rose 2% and new orders climbed 3.2% with 16 out of 18 diverse industries tracked reporting an expansion for the month of August. What can be the cause of this growth?  To start, companies tend to increase activity in response to positive sentiment toward economic conditions.  Recent fiscal policy moves by the administration and congress, namely last year’s package combined with rollbacks on industrial regulations, make for a fertile growth environment for domestic production.  Another factor, though it is too early to tell, may have come from the Administration’s trade policy.  At a high level, if foreign goods (AKA stuff made in China) is more expensive due to tariffs, rational consumers and other producers will turn to domestic producers.  Domestic producers will respond to the increased orders by ramping up production, increase hiring, and purchasing more raw materials.  All of these are factors in the ISM index, so restricted trade can, if it already hasn’t, have a positive impact on industrial production. What is the impact of increased production on the US economy, which is already running at a good pace? Well, as you might suspect, there is a number for that too and that number was 11.7% in the first quarter of this year.  So manufacturing represents 11.7% of US Gross Domestic product and to get a better idea of what that means, we have to look at where it has been historically.  I have attached a chart, which shows that it has decreased from 13.2% through that last recession (shaded in grey) to a low of 11.5% in 2017.  So it has decreased over the past 13 years but not significantly.  But wait, what if we look back further and see what it was historically.  I have a chart for that too (see attached).  In 1960 manufacturing represented about 28% of US GDP!  By 1980 the number receded to 20%, which still represents a significant impact to the national economy.  So, in contrast 11% shows a significantly smaller impact relative to its historically larger role.  

The greater than expected increase in manufacturing represents some hope that perhaps some of the Administration’s trade policy, relaxed environmental regulations, and stimulative fiscal policy’s are working to make American industry great again.  Manufacturing is on the rise, which should be good for stocks, especially if it continues.  What may not be so good for stocks is the inflation that also comes from increases in the manufacturing index, but that is a topic for another geek-out Wednesday.

daily chartbook 2018-09-05