The first major economic report for August offers no comfort for thinking that we’ll break free of the economy’s sluggish growth phase any time soon. Today’s update on the ISM Manufacturing Index reflects an expansion in the sector, but only slightly. The index slipped to 50.6 last month, down from 50.9 in July. A reading above 50 indicates expansion, but with the index declining to its lowest level in more than two years there’s nothing dazzling here.
Yes, it could have been worse, and a number of analysts thought it would be. The Bloomberg News survey advises that the median forecast from economists anticipated that ISM would drop to 48.5. By that standard, we’re doing ok, but that’s like saying you expected to drive off a cliff and instead you only had a flat tire. Sure, it’s better, but no one’s going to celebrate the relative improvement.
But let’s not get too worked up over ISM. This index has a history of going to extremes, but the frequent peaks and troughs (relative to the neutral 50 level) don’t routinely coincide with major turning points in the business cycle, as defined by NBER. No indicator is perfect, of course, but if you’re looking for clues about the next recession, there are more productive benchmarks to consider. Since 1990, the ISM Manufacturing Index has slipped under the 50 mark at least eight times, even though there have been only three formal recessions during that stretch. By comparison, monitoring the 12-month percentage change for the U.S. stock market (S&P 500) has been a far more reliable early warning system of a new recession, to cite one example. Indeed, there are a number of other metrics with stronger records of anticipating the cycle vs. ISM Manufacturing. But that’s a story for another day.
Don’t misunderstand: the ISM Manufacturing Index deserves routine monitoring. Manufacturing is still a critical component, albeit one of diminishing influence as the economy evolves. As economist Richard Yamarone explains in The Trader’s Guide to Key Economic Indicators:
From the 1940s through the 1970s, manufacturing activity was a much greater influence on the total U.S. economy than during the 1980s, when the economy became less industrialized and more services oriented. So, in earlier times when manufacturing fell into a slump, it dragged the entire economy in recession. Today, manufacturing accounts for only 20 percent or so of total economic output. As a result, declines in manufacturing don’t always result in macroeconomic recessions.
That doesn’t mean that a dip below the 50 level for the ISM index would be irrelevant. In the old days, that almost surely would have been a nail in the cyclical coffin. But we’d need to see a fair amount of corroboration from other indicators to make the ISM warning persuasive in 2011. For some perspective, let’s compare the 12-month percentage changes for the ISM index with U.S. stocks, new orders for durable goods, and industrial production. As the chart below suggests, ISM looks considerably weaker vs. the other three metrics. Of course, durable goods orders and industrial production are only updated through July. But based on the numbers in hand, there’s still room for debate about the implication of the ISM’s recent descent.
None of this changes the fact that the economy continues to struggle, regardless of what the ISM report suggests, or doesn’t suggest. You can make a statistical case that the odds of a new recession are still minimal, but we’re still stuck with a weak recovery that is vulnerable to macroeconomic things that go bump in the night.
The true antidote for all this anxiety is a stronger labor market. But expectations remain muted on that front. Net private-sector job growth is expected to be in the neighborhood of 100,000 via tomorrow’s update from the Labor Department. That may be enough to keep us out of another downturn, but no one will confuse it with economic strength.