Manufacturing Turns South

by: Tim Duy

Monday's ISM manufacturing report revealed clear signals of global weakness. Does it point to an impending U.S. recession? Not necessarily. Does it point to additional Fed easing? Also not necessarily. In short, I don't think this data is yet sending a particularly clear signal about the U.S. economy.

First, the headline number: (Click on graphs below to enlarge)

I marked the initiation of Fed easing cycles since 1995. Notably, multiple sub-50 ISM readings have traditionally triggered Fed easing, with the 2007 rate cut being something of an outlier. Of course, we have yet to start the tightening cycle this time around, but it is safe to say that ongoing sub-50 readings were generally consistent with ongoing easing. On balance, a first look of the data thus suggests additional Fed easing. Notice, however, that a sub-50 reading does not always indicate a fresh recession is on the way. Not by a long shot.

Two not-necessarily exclusive issues are likely at play. First, the drop in the ISM index might be indicative of external issues that are insufficient to trigger a recession in the U.S. In other words, recessions are domestic events; the external sector alone is simply too small to overwhelm the internal tide. Second, the appropriate application of monetary policy might have been sufficient to safeguard against recession given the relatively small external threat.

I think it is clear that new orders sagged as a result of external weakness:


Both the 1998 and 2001 easings followed sharp falls in the export index. Less so for the 1995 easing, but some external weakness was clearly at play. The 2007 easing was primarily a domestic issue; at the time, the external sector was source of strength. The general story, however, is that the Federal Reserve has tended to lean against external weakness. Not because, as some Fed officials have erroneously suggested, policymakers believed they could "solve" the external problems, but because they hoped to minimize the domestic impact. Yet another reason to believe additional Fed easing is on its way.

As always, however, the story is not clear cut. Note the employment index:

Fed easing has traditionally been associated with labor market weakness. Soft weakness is not evident in this report, consistent with the belief (also identified by Nomura, via FT Alphaville) that manufacturers do not believe the external weakness is sufficient to derail the recovery. This should be particularly important with regards to additional Fed easing at this juncture, as policymakers have made it clear that progress, or lack thereof, in the labor market is a critical indicator. By this measure, then, the ISM report would not trigger additional easing. Much more important is the next employment report and the initial weekly claims reports leading into the next meeting.

Finally, when considering the recession implications of the ISM report, I also watch the imports component:

The theory is that a sharp drop in domestic demand - the type associated with recessions - should cause a drop in imports. By this measure, the domestic-side of the coin is not yet joining in the external weakness. A strike against seeing this ISM report as an indicator of impending recession.

Bottom Line: The ISM report is murkier than the headline drop would suggest. It is clearly consistent with external weakness. The global economy is obviously struggling. As of yet, however, the story told by the employment and import sub-indexes is that the domestic economy is proving relatively resistant. Maintaining that resistance, however, may be dependent on additional monetary easing. Indeed, in the past, the Federal Reserve has tended to take out such insurance. But in the past, the zero bound has not been a constraint. This time it is. Will the Fed deliver easing with the necessary force to serve as adequate insurance? I am wary that this report gives us much direction on that point, especially given the relatively solid reading on employment. Ultimately, this report is probably a small piece of the puzzle; the employment data remains the key.