Strong Manufacturing ISM Report Signals Stocks Should Rebound

Solid Manufacturing ISM Report

The ISM manufacturing report for March was solid as the PMI was 59.3 which is 1.5 points below February’s result and 0.9 point above the 12 month average. The table below gives you a summary of the data. As you can see, the growth mostly slowed down. The orange boxes highlight the weakness in rate of change terms. Personally, I don’t love to use that because there are many times where rate of change gives a false signal. The economy and data points aren’t a perfect sine wave. There are many fits and starts which make the data jumbled. For example, the PMI fell from September to November, but since then, it has never been below November’s result. Furthermore, the February PMI was the best in over a year, so that’s a tough comparison. I’d need to see a PMI in the low 50s to make me nervous.

The other important aspect is that this survey report was consistent with the strong manufacturing sector in February. The overall economy was weak in February, but manufacturing was a bright spot. The PMI in March is consistent with 4.9% GDP growth which is beyond even the highest estimates for growth. Other areas are weighing GDP growth down. As you can see from the blue box, the prices index increased 3.9 points which shows inflation accelerated in this sector.

Furthering the notion that this wasn’t a weak report, the chart below shows the historical results of the manufacturing backlog. As you can see, the backlog is the same as the last report which was the largest since 2004. This signals the demand exists; there just needs to be more production in the next few months to meet it. This data quells my concern that the manufacturing sector will weaken towards the end of the year. I don’t expect the average of the year to be as high as the Q1 average which was 59.7, but it shouldn’t contract.

As I discussed in a previous article, the inventory weakness and trade balance prevented the Q4 GDP growth from being 4.5%. As you can see from the chart below, 23.7% of ISM respondents stated inventories were too low which is much higher than the 7.8% of respondents who said inventories were too high. Inventory investment cut GDP growth in 2017 by 0.3% per quarter. In 2018, it looks growth will be helped by inventory investment since inventories appear to be low. The inventory situation is a lagging indicator as the 2017 economy accelerated, but excess inventory needed to be worked off because the weakness in 2015 and 2016 built it up. Now since the economy was strong in 2017, inventory needs to be created. This could help the weakening economy in the first half of 2018. For the reports so far this year, it looks like that’s the case as inventory investment caused the Atlanta Fed Q1 GDP Nowcast to increase from 1.8% to 2.4% last week.

As you can see from the chart below, the ISM manufacturing report is signaling economic improvement while the S&P 500’s difference from the 200 day moving average is signaling economic weakness. Given the shrinkage of the manufacturing sector’s employment share, I think it’s impossible to see stocks fall and the economy weaken while manufacturing strengthens. This exact scenario has played out in the past few months. I think the chart below is interesting because it implies the correction in stocks signals the economy is expected to have a sharp slowdown. While I think the stock market is a great depiction of how the economy is doing when you look at medium term performance, short term performance doesn’t mean much. Stocks have a correction every year on average; that doesn’t mean the economy weakens every year. If the stock market falls 20% or doesn’t increase in 2018, that’s a signal of a weakening economy, not a normal correction.

The chart below shows a four quadrant depiction of the economy based on growth and inflation. The yellow line and dots show the recent information reported in the ISM survey. As you can see, the current economy is in the top right quadrant, which signals the economy is in a boom/expansion, because of heightened prices and strong headline growth.

Now let’s look at the quotes from the businesses who were surveyed in the ISM report. A computer and electronic products firm stated “Supply constraints, extended lead times, capacity constraints [and the like], particularly in the electronics components markets, continue to frustrate and drain needed resources, have delayed production schedules and, in some cases, caused missed or delayed sales opportunities.” Most firms are having trouble getting materials from the supply chain because inventories are low. There was also concern about the tariffs. A machinery company stated there was “panic buying, driving near term prices higher.” This was probably why U.S. Steel stock initially increased after the announcement. I’m guessing the panic buying is over now. I will discuss the latest announcements on the tariffs in a separate article.

A firm in the food, beverage, and tobacco products industry stated “In the U.S., we continue to struggle with finding carriers and drivers for shipments.” This could’ve been General Mills which had big trouble finding truckers. As you can see from the chart below, the EVRISI truckers survey is matching the strength in the manufacturing PMI. The Evercore Trucker survey has an 80%+ correlation with GDP, signaling GDP will be strong this quarter.

Conclusion

The manufacturing sector and the trucking industry signal inflation and economic growth are picking up. I don’t think this is enough to push GDP growth to a 3 handle, but it surely isn’t consistent with the stock market which has had a few bad weeks. The economy weakened in some areas, but not enough to justify a bear market or worries about a recession. The weakness in stocks is temporary in my opinion. Obviously, I don’t have a crystal ball and can’t say when stocks will hit a new all-time high, but my best guess is it will happen sometime this year.

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