When manufacturing gets this bad it usually drags the rest of the economy down with it

The American economy is a tale of two sectors, and the last two times that’s happened the bad story has overtaken the good.

To recap, the American manufacturing sector is seriously banged up right now. With Wednesday’s ISM manufacturing release, the sector is now considered in contraction.

On the other hand, services from retail to hotels have been doing relatively fine.

This isn’t unprecedented, but it sure is uncommon.

“There is currently a 9.0-point spread between the manufacturing and nonmanufacturing ISM surveys,” said Deutsche Bank economist Joe LaVorgna. “There have been two other historical episodes when the gap between the non-manufacturing ISM and the manufacturing ISM was roughly the same as it is at present: One period was December 2000- February 2001 and the other period was August 2005.”

The slightly worrying aspect of the gap is both times something like this has opened up, things took a turn for the worse.

“In each instance, the divergence between the series was closed because the non-manufacturing ISM ultimately followed the manufacturing ISM lower,” wrote LaVorgna in a note to clients Monday.

This is also worrying because, as LaVorgna notes, both instances preceded the start of declines in both sectors before recessions, though with a longer drop before the 2007 recession start.

Thursday’s readings from both the ISM nonmanufacturing index and PMI Markit Services index showed some slips in the services sector, as both missed expectations but stayed in expansionary territory. Whether this is temporary weakness or proving the historical trend remains to be seen.

Aneta Markowska at Societe Generale, however, thinks there is a possibility that the current gap could buck the past two instances.

“it is important to consider the sources of current manufacturing weakness,” Markowska wrote in a note to clients. “We believe that the sources are purely external.”

The way she sees it, there are two important differences that will probably extend the current gap, but also prevent the services sector from following.

  1. The oil price drop: “The adjustment in energy prices essentially redistributed income from energy producers (and manufacturers who supply the sector) to consumers (households and business that consume energy).”
  2. The Fed diverging from other central banks: “This means that the transmission of monetary tightening will be more skewed towards tradable sectors and less so towards interest rate sensitive sectors… As a general rule, this tightening cycle should weigh more heavily on manufacturing activity and less heavily on services than would normally be the case.”

Markowsa also notes that the divergence in the two sectors has been a source for significant economic volatility over the past few months. This makes sense, as the market is getting news both bad and good, it doesn’t know how to react.

In the end, Markowsa thinks the third time is the charm and it’s “very unlikely” services follow manufacturing downwards, but also says to keep a “close-eye” on services to see if history repeats itself.

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