The recent performance of the US manufacturing sector has got the markets talking.
For the first time since mid-2009, activity across the sector contracted in November, raising the prospect of subdued economic growth in the December quarter and, as a consequence, the potential for the US Federal Reserve to yet again postpone raising interest rates for the first time since June 2006.
Following the release of the ISM’s November manufacturing PMI report overnight, the US dollar weakened, treasury yields fell and stocks rallied – the now-clockwork reaction to weak economic data and the prospect for ultra-loose monetary conditions being maintained for a longer period than markets initially envisaged.
Even before the PMI report was released, expectations for US economic growth were weakening, a result of a steady run of lacklustre economic data in recent sessions ranging from business activity surveys, consumer confidence readings and recent personal income and spending data for October. The Atlanta Fed’s GDP nowcast, a gauge on likely economic growth based on economic data inputs received during any one quarter, has fallen steadily, pointing to annualised growth of 1.4% from 2-3% seen throughout November.
While markets are now beginning to doubt whether a US interest rate hike later this month is truly a “done deal”, pricing the odds of a 0.25% rate increase at 70% from 75% seen before the PMI report was released, Richard Franulovich, G10 FX macro strategist at Westpac, suggests that the separate ISM non-manufacturing PMI gauge released on Thursday will provide a more instructive guide on the true health of the US economy at present.
Pointing to the chart below, supplied by Westpac, Franulovich notes that the US services and manufacturing ISM surveys are now showing a large divergence, the largest seen since the late 1990s Asian crisis “where a familiar macro-economic backdrop confronted the US including weakening EM growth, falling commodity prices and a rising USD”.
While the non-manufacturing gauge was not totally immune to the weakness seen in the manufacturing survey back then, it still substantially outperformed and, importantly, was more akin to the pace of US GDP growth recorded during that period.
Although Franulovich believes that US households do not have the same spending capacity as that seen in late 1990s, courtesy of weaker demographic trends and subdued wage growth seen today which is likely to hinder household consumption far more than was the case then, it is clear that based on historic performance, US GDP has had a closer correlation to the performance of non-manufacturing PMI survey rather than that for manufacturing.
That’s an understandable trend, particularly given the US services sector is significantly larger, and employs far more workers, than the US industrial sector.
Given the weakening trend seen in the the manufacturing PMI gauge, those looking for the a US rate hike later in the month will be hoping that the non-manufacturing PMI continues to strengthen. It printed at 59.1 in October, well above the 50 level that separates expansion from contraction, with markets expecting a slight moderation to 58.0 in November.
Given the historic relationship between the services PMI and US GDP, a reading at or around consensus should see expectations for a rate hike firm for December. However, a miss on the scale seen in the manufacturing PMI report will truly see questions asked as to whether the economy is ready for, or in need of, higher interest rates.