There’s been a bifurcation of the economic survey data from the so called hard data which measures real production and economic activity. My theory is optimism about the new administration is causing this difference. The consensus is this optimism means 2017 will see accelerated growth. In the consensus’s defense, optimism usually does mean growth will improve in the future. My projection would be an abnormal result. Therefore, I could be wrong. The biggest test for my thesis is whether the hard data remains weak or starts to follow the survey results higher in the next two months. In this article, I will look at the past two economic reports to determine the direction of the economy.
Today the industrial production and manufacturing output report was released by the Fed. The headline of manufacturing growth in December of 0.2% was weak while the headline of industrial production growth was 0.8% which beat estimates for 0.6% growth. However, as with most reports, the headline numbers don’t tell the whole story. The manufacturing growth for the fourth quarter was 0.7%, mainly driven by mining growth of 11.9%. Mining output was flat in December. The tepid manufacturing growth went against the ISM survey which hit a two-year high. The PMI rose because of strong demand and improved consumer sentiment. When the ISM reports came out, I was willing to accept the economy was improving, but given this weak report of actual production, I am more hesitant to get on the bull bandwagon.
The chart below shows this difference between the ISM survey and the manufacturing output report. It’s tough to say which is the better indicator because the ISM better reflected the manufacturing slowdown in 2015. I’m saying the ISM was more accurate because of what firms like Caterpillar reported in 2015. It’s possible the ISM is more sensitive to changes than the manufacturing output report because it had a big decline and then a big rebound while the manufacturing output has been range bound. It would be disingenuous of me to claim the ISM report is only correct when it goes down. The reason why I am more skeptical of it now than before is because the part of the survey which shows expectations has gotten out of line with reports of the current environment. This is what makes me question the soft data. Hard data and current environment surveys are the best measure of economic activity.
The industrial production growth was the part of the survey in which the good headline didn’t reflect the underlying weakness. Industrial production fell 0.6% in Q4. The reason why it beat expectations for December was due to the weather as a colder December was a change from the warm November. November industrial production fell 0.7%. There was a 6.6% increase in the utilities index in December. This was the biggest jump in utilities since 1989. Natural gas utility output increased 12% year over year. Finally, the capacity to utilization increased 0.6% to 75.5%. This is below the 80% long-term average. This shows the economy has excess capacity and doesn’t need new investment. It’s the so called ‘slack’ in the economy driven by weak demand. The overall report was framed as a beat, but I’d say it wasn’t a signal of an acceleration of growth in the economy.
Just because survey data can lead you to draw the wrong conclusions, doesn’t mean we shouldn’t look at it. The best way to protect yourself from mistakes is to analyze how the metrics are broken down in the report. The Empire Fed Manufacturing Survey fell to 6.5 in January from 7.6 in December. It was below the expectations for 8 by economists. The chart below provides further evidence of my point that expectations have gotten ahead of themselves as expectations are near cycle highs while current results aren’t.
The breakdown of the metrics in other reports showed moderate growth combined with extreme excitement about the future. The headline data in the NY Empire State Index for January is similar, but it looks worse when you look at the details. As you can see from the chart below, the new orders index took a sharp dip from 10.4 to 3.1. The index is jagged, so this decline is not enough to signal another slowdown like we saw in 2015. We’d need to see a few more months of weak data to make that assertion. What I am pointing out is the fact that there was an 8.4% drop in those reporting higher new orders, yet optimism is near cycle highs. You would think if a business wasn’t getting as many new orders, it wouldn’t be excited about the future. This optimism is all on the basis Trump will deliver tax cuts and regulation reform. I think they have their hopes too high.
The chart below shows an even more extreme move happening as inventories are now increasing after decreasing at a high rate. The net change was 16.4% as only 16.8% of firms reported lower inventories. This increase in inventories is the first one in almost 2 years. It signals weakening demand. This could be a problem because the prices paid index showed 53.8% saying prices increased. This means firms could be left with expensive inventory which they have to discount and maybe sell for a loss. This is while only 32.8% of firms stated prices received were higher in January.
Conclusion
We’re seeing interesting data come out which makes the bullish narrative look wrong. Before buying stocks because of optimism about the future, look at the declines in new orders in the Empire State Index and the meager 0.2% growth in manufacturing output. While the stock market rallied to end the year, there wasn’t enough data to signal an all clear sign. Today the Fed stated the economy is nearing the phase where it can stand on its own. I disagree with this viewpoint, but at the same time I welcome the monetary normalization process so we can have real price discovery in a free market not manipulated by the Fed.
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