The recent ISM print of 56.3, which was so ridiculous, not one economist had predicted a number as high, and was therefore sufficient to validate that the US government is now actively managing the Department of Truth, managed to send stocks surging, and disconnect completely form all other correlations, as yet more stat arb desks imploded. Yet what goes up, must come down, especially in an economy gripped by the greatest Depression in history. Which is why, here is Goldman's Andrew Tilton, member of what has now become the world's most bearish economic team, explaining why the very next ISM, and certainly as soon as within a few months, will be sub-50, which will be the catalyst to plunge stocks even as all hedge funds have gone all in chasing last minute September beta with the Fed's blessing.
From Goldman Sachs:
The vigorous rebound in industrial activity that began in mid-2009 has begun to fade in recent months. This is already quite evident in the growth rate of industrial production, and to a lesser extent in the decline of the ISM manufacturing index from its peak in April.
We expect the ISM index to decline to 50 or below by early 2011. A significantly weaker ISM manufacturing index would be more consistent with a) the detail of the ISM report, specifically the small gap between the new orders and inventories indexes, b) the weighted average of regional factory surveys, c) the current rate of inventory growth, which has stabilized the manufacturing I/S ratio, d) the typical behavior of the ISM index after large inventory cycles such as the one we have just experienced, e) the recent sub-1% pace of final demand growth.
The vigorous rebound in industrial activity that began in mid-2009 has begun to fade in recent months. After a peak growth rate of 16.2% on a three-month annualized basis, manufacturing output has slowed to a 2.3% rate over the past few months. We expect a further slowdown to 1% over the remainder of the year, with some modest downside risk to this forecast.
Historically, the 2.3% run rate of manufacturing production observed over the past three months would be consistent with an ISM manufacturing index of about 51, and the 1% growth rate we expect for the trough later this year would suggest an ISM manufacturing index closer to 50. Yet the latest reading, for August, was a robust 56.3. Is it realistic to expect a decline to 50 or even below in coming months? We still think so, for the following reasons:
1. Details of the ISM report. The ISM headline index is a composite of more specific indicators, some of which have predictive power for future activity. As we have explored in previous research, the “new orders” index has the most statistical significance for future levels of the ISM, with the inventories index also providing some information (note that, somewhat confusingly, lower levels of the inventories index are more positive for future activity). The latest ISM report was somewhat misleading in that the headline index moved higher, but the key details moved in the “wrong” direction: the new orders index declined and the inventories index rose. The gap between the two indexes was only 1.7 points in August, down from 28.1 points in late 2009, and a quite low level outside of recession periods. This orders-inventories gap has its highest correlation with the headline index two months later; given current values, this simple relationship suggests a level of only 46.8 for the headline ISM in the October release. (We emphasize that other factors are relevant too, as discussed below, so this should not be misinterpreted as a forecast.)
2. Regional surveys. Each month, the various regional Fed and ISM surveys collectively reveal a large part of the national manufacturing situation before the national ISM index is released. In general, the regional surveys point to a weaker manufacturing sector than the headline ISM suggests. For example, the New York and Philadelphia surveys are both below their averages of the past decade, while the ISM index is almost one standard deviation above. If we create a “geographic composite” of the regional Fed manufacturing surveys and the Chicago purchasing managers’ index, weighted by the share of US industrial production in each of those regions, the August value implies a level of 52.8 for the ISM headline index rather than the 56.3 we actually observed. So far, the only regional factory survey in hand for September is the New York manufacturing survey, and it has declined further (though key details did improve somewhat).
3. Rate of inventory accumulation. As we never tire of repeating, the pace of inventory accumulation provides a useful signal for future industrial growth. Changes in the inventory-to-shipment (I/S) ratio in the durable goods manufacturing sector (we typically look at changes over the past six to twelve months) presage decelerations or accelerations in manufacturing output, with a rising I/S ratio generally a warning sign of slower growth ahead. After a rapid decline in 2009, in recent months the I/S ratio has stabilized, and using the simple correlation of I/S ratio with the ISM, the latest data (for July) would have suggested an ISM reading of 53.8 in August (again, vs. the 56.3 we observed). If we broaden our scope to include not just inventories at durable goods manufacturers, but goods inventories throughout the supply chain, recent data suggest somewhat faster growth in inventories and consequently have more negative implications for the future growth of manufacturing output.
4. Size of the inventory cycle. Over the longer term, inventory cycles—periods of inventory liquidation followed by a return to inventory accumulation—trace out major swings in the ISM index. A pronounced downturn in demand leads to cuts in production and a decline in the ISM index. Eventually, production falls enough that inventory liquidation begins. Once companies have gotten inventories down to desired levels, the stage is set for production to increase again, driving the ISM index higher. We have found that the magnitude of this inventory cycle—the difference between how fast inventories are falling in the downturn and how fast they are rising in the early recovery—is highly correlated with the extent of the decline in the ISM index after its peak (see “The Inventory-Cycle Boost to the ISM Begins to Fade,” US Daily, July 1.) Given the relatively pronounced cycle we’ve just experienced, a decline in the ISM manufacturing index of 12-13 points over 10 months would be typical. This would put the ISM in the 47-48 range in early 2011.
5. Pace of final demand growth. Another way to think about where the ISM “should” be is simply to look at the underlying growth rate of demand in the economy—in other words, leaving aside all the inventory gobbledygook, how fast would production need to grow to satisfy demand? Using monthly estimates of final demand from Macroeconomic Advisers, we calculate the annualized real final demand trend through July (the latest data point available) as a meager 0.8%. This has a looser short-term correlation with the ISM than the indicators discussed above, but implies an ISM manufacturing index at roughly the 50 level.
The table below lists the implications of each of the indicators discussed above; it is organized chronologically so the shortest-lead indicators are shown first. The simple message is that our cross-checks of manufacturing activity paint a picture of slower, and declining, growth, with a significant possibility of a reading below 50 later this year or early next. Of course, these are just point estimates and there is huge uncertainty around them. It may be that the headline ISM manufacturing index is sending the “right” message about the growth rate and the other indicators are leading us astray, but all of our other indicators point to a weaker ISM index over the next few months. Therefore, we have high conviction that the ISM manufacturing index and manufacturing activity will slow somewhat further, with less certainty about the exact level and timing of the trough.