In a new economics brief, Deutsche Bank braces its clients for a contractionary, sub-50 reading on the ISM in the months ahead.
But don’t be alarmed! It doesn’t necessarily mean the double dip arrive:
Commentary for Thursday: Based on what we have gleaned from the details of the ISM, the headline series is poised to break 50 some time within the next couple of months. While this may make some investors worry that a double-dip is at hand or a period of soft economic growth afoot, it would not be unusual for this to occur. Hence, absent other weaker than expected economic news, a sub-50 ISM reading would not change our relatively bullish (at least relative to Consensus) forecast of 2011 real GDP growth prospects which we envision around 3.25%. We have found that one of the best short-term tracking tools for estimating the headline ISM is to take the spread between the new orders and inventory subcomponents of the ISM. As shown in the chart below, this spread is highly correlated with the ISM and tends to lead the ISM by two months on average.
Taken literally, the spread suggests that the ISM should decline to a 48 reading within the next two months. Should we be worried? At the moment, the answer is no. This is because it is not unusual in the early stages of economic recovery/expansion for the ISM to break 50 to the downside after having broken 50 to the upside earlier on. After the 1990-1991 recession it happened in November 1991, September 1992, and June 1993. (The ISM broke 50 again in the mid-1990s but it, too, was temporary.) The same early stage ISM pattern occurred following the 2001 recession as well: the ISM broke 50 to the downside in October 2002 and then again in February 2003. Consequently, a sub-50 reading is not necessarily a sign to hit the panic button. Remember that sub-50 means that the factory sector is declining, not the broader economy.
For the ISM to foreshadow negative GDP growth, the index has to be down around a 43 reading, in our view. One other key point is worth noting. The spread between new orders and inventories has been extraordinarily noisy over the past 12 months. We think this could be due to the equity market. We have observed a high and rising correlation between the percentage change in stock prices and the level of ISM new orders two months forward. Hence, the compression of the spread could be due to declining new orders that are a lagged response to the sharp sell-off in equity prices in May, June and July. In other words, when stocks go down, purchasing managers get cautious and likely slow down or cancel order flow. If so, the rise in stock prices since the beginning of September could bode well for a recovery in ISM new orders later this year.