Manufacturing Sector - Now Contracting

Model Of ISM Manufacturing PMI

Based on the rate of change of the recent manufacturing data, it’s clear manufacturing is falling into a contractionary phase. This won’t be one or 2 weak readings. It will be a manufacturing recession like 2015-2016. However, that call won’t generate alpha because it is the consensus at this point. If you want to make the most out of a call, you need to get in early. We are actually closer to a bottom then a top, but I think it’s a bit too early to start betting on a rebound. That’s something you should look out for early next year.

A potential rebound in manufacturing next year would really put a damper on the yield curve’s late 2020 recession call. This is partially why I have stated if there is going to be a recession, it will be in mid to late 2019. However, I always expected the economy to avoid a recession. The latest retail sales report suggests the consumer might prevent one. As I will get into in a future article, the August consumer sentiment report isn’t on the same side as that great July retail sales report.

This brings us to the chart below which compares the ISM manufacturing PMI with a model used to predict it. The model is calculated using the yield curve, BAA yields, the dollar, the China manufacturing PMI, and CEO capex plans. Anything that includes the yield curve is obviously going to be negative. CEOs’ capex plans are also bearish. The uncertainty catalyzed by trade tensions has delayed/prevented some new investments. This is a good model because the uncertainty created by the yield curve inversion and the trade war are precisely what is holding back business sentiment and suppressing the ISM PMI.

The interesting aspect of this model is that it is showing a continued slowdown into the end of the year, but it predicts a higher December PMI than the July PMI because sentiment has fallen quicker than the model expected. I’m fairly confident there will be a below 50 PMI print by the end of the year especially after the weak industrial production report which I will review next.

Industrial Production Barely Grows & Manufacturing Contracts

July industrial production growth missed estimates across the board. Monthly growth was -0.2% which missed estimates for 0.1%. At least the June reading was revised higher from 0% to 0.2% growth. The chart below shows both the short and long term changes to the index as well as manufacturing and the capacity to utilization rate. Yearly seasonally adjusted industrial production growth was only 0.5% which was the worst reading since February 2017 when the economy was just exiting the last manufacturing recession. The comp was 3.9% growth. The comp will get much harder in the next 2 months as August and September yearly growth were 5.3% and 5.4%. It’s highly likely that yearly industrial production growth will be negative in those 2 months. September 2018’s growth rate was the highest since December 2010.

Manufacturing growth and the capacity to utilization rate also both missed estimates. Monthly manufacturing growth was -0.4% which missed estimates for -0.1%. The good news is June’s reading was revised up from 0.4% to 0.6%. That’s a very solid monthly reading. The results don’t look as good on a yearly basis in June as yearly growth fell from a modest 0.3% to a weak -0.5% in July. That’s very slightly above April’s decline which was the weakest reading since August 2016. The comp situation is similar to industrial production growth in that the comp will get tougher in the next 2 months. September 2018’s growth rate of 3.5% was the highest since April 2012.

Finally, as the chart above shows, the capacity to utilization rate fell from 77.8% to 77.5% which was below the consensus of 77.8%. This stat isn’t that useful at this point in the cycle because capacity is nowhere near full utilization. Manufacturing capacity to utilization is 75.4%, mining capacity to utilization is 89.2%, and utilities capacity to utilization is 76.6%.

Details Of The Industrial Production Report

This wasn’t a report where the headline reading was weak, and the details were strong. The details actually imply this sector is doing worse than the monthly headline reading entails. I say this because utilities production growth was 3.1% after falling 3.3% in June. On a yearly basis, growth went from being a drag to being in line with industrial production as it improved from -2.8% to 0.3%.

Construction supplies production fell 1% and motor vehicle production fell 0.2%. Remember, the autos and auto parts segment was the biggest drag on the retail sales report. Maybe the relatively high delinquency rate on auto loans is catching up to the sector. However, vehicle sales are still range bound. They probably won’t significantly fall out of their range unless the labor market weakens. I think housing and autos have gotten as weak as they can get in an economy with a low unemployment rate and positive real wage growth. Mining output was also weak as it fell 1.8%.

This manufacturing weakness is right in tune with the decline in the manufacturing work week and overtime in the July BLS report. I will be watching August’s labor report to see if such a decrease continues. While that decline sullied the BLS report, it’s not enough to suggest the labor market is turning. There still should be strength in healthcare and education which aren’t that cyclical, but are a large part of the labor market.

Conclusion

On Thursday we got a very strong retail sales report and a somewhat weak industrial production report. Manufacturing is probably headed for a recession similar to 2015-2016. It’s interesting because consumer confidence fell, and the Philly Fed and Empire Fed manufacturing surveys were strong. There is disagreement between the soft and hard data going both ways. As I will detail in a future article, the Empire Fed index rose and the Philly Fed index fell, but it was still solid. The Philly Fed index showed significant improvement in July, meaning even though the index fell, it still showed solid results in August. It’s notable that the solid July Philly Fed index wasn’t in line with the contraction in manufacturing production.

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