In the US economy, the big story is the divergence between the manufacturing and services sectors.
Services has been holding up thanks to the healthy US consumer. Manufacturing has been struggling as much of America’s manufactured goods are exported to regions where growth is slowing, and unfavorable foreign exchange is making US goods more expensive to foreign buyers.
The latest ISM manufacturing purchasing manager index (PMI) fell to 48.2 in December from 48.6 in November. Any reading below 50 signals contraction in the industry.
But is that a sign of contraction in the US economy?
Two Wall Street pros looked at a chart of the ISM PMI overlaid with bars that highlight recessionary periods.
The glass half-full take
Renaissance Macro’s Neil Dutta shared it in a client note on Monday and observed that a contractionary ISM is far from an omen of outright doom.
“In the last three decades, it has not been uncommon for the ISM to signal manufacturing contraction for a period of time even as the broader economy remains in expansion,” Dutta said. “During an expansion, when the ISM dips below 50 it tends to stay there for roughly 7 to 8 months. The longest stretch in recent memory was the mid-cycle slowdown of 1995, when the ISM was stuck below 50 for ten months. The shortest stretch under teh breakeven was back in 2003, when the ISM dipped below 50 for five months before returning to strong growth.”
“If past is prologue, the ISM rebounds above 50 in Q2 2016.”
This is not to say there isn’t trouble. All it means is that it’s no guarantee of doom.
The glass half-empty take
Bank of America Merrill Lynch’s Michael Hartnett shared it in a client note on Wednesday. But his tone was way more cautious.
“Investors should be long cash & volatility, and be prepared for a short sharp pullback in risk assets (e.g. SPX to 1850-1900), at least until one of the following conditions is met: PMI’s back over 50 in China & US, 2-way risk emerges in CNY & oil inducing value buyers of HY & EM debt, A spike in volatility and/or an asset price reset induces Fed to pause.”
Cash is about the safest place you can be as an investor. To be long volatility is to be betting that things are going down.
Hartnett thinks that the market just does not appreciate how serious that sub-50 ISM PMI is.
“Recession risks remain mispriced: profits highly correlated with PMIs and in both US & China PMI’s weak,” he said. “Note ISM <45 level has coincided with US recession 11/13 times since WW2.”
Because Hartnett is considering an ISM PMI below 45, the measure becomes a much more robust leading indicator.
Keep in mind that manufacturing accounts for just a little over 10% of the US economy.