ISM Service Index Expansion: Good, But Narrowly Focused

by: Zacks Investment Research

The ISM service index came in at 50.9 for September -- a 2.5 point increase from the 48.4 it registered in August, and better than the 50.0 consensus expectations. This is the first time the Services index has been above 50 -- the dividing line between expansion and contraction -- in 11 months. The index hit a record low of 37.4 back in November of 2008.

Last week, the Manufacturing survey also showed expansion at a reading of 52.6, but at a slower rate than in August, and was a significant disappointment. Services covers a much larger part of the economy, but the ISM services index has a much shorter history.

The table below compares the two surveys. In the Services index, the most dramatic improvement was in the backlog of orders and in new orders. The backlog jumped 10.5 points to 51.5 from 41.0, or to a slight expansion from a strong contraction. The rate of new orders rose 4.3 points to 54.2 from 49.9, or to a solid expansion from stagnation. The rate of business activity, which would be equivalent to the rate of production on the manufacturing side, and a measure of current rather than future conditions, rose to 55.1 from 51.3, an increase of 3.8 points.

Prices, however, tumbled to 48.8 from 63.1 -- a 14.3 point decline. In other words, there is much less pressure on prices and more evidence that inflation will remain subdued. While total new orders were up, a very welcome sign, new export orders contracted with a reading of 48.5 after showing solid expansion with a reading of 54.0 last month. While exports are generally less significant for service firms than for manufacturers (they tend to be much more domestically focused; for example, we don’t export a lot of Utility services) the decline is a bit of a disappointment given the weakness of the dollar, which should have been helping to boost orders. Manufacturing export orders, however, are still showing a nice expansion, if at a somewhat slower rate than in August.

While the increase in the overall index is very welcome news, and it is good to see actual expansion, the expansion was very narrowly focused. The survey tracks 18 different industries, and only five of them showed expansion: Utilities, Health Care, Retail, Construction and Wholesale trade. Changes in Utility output are often a function of the weather as much as economic activity, and Health Care has continued to expand throughout this recession, being the only area that has actually added jobs each month as the overall number of jobs has plunged by over 7 million since the recession started back in December of 2007.

The overall employment index showed some improvement, but is still very much in concretionary territory with a reading of 44.3, up 0.8 points from 43.5 in August. This sub-index has been below the 50.0 dividing line for 20 or the last 21 months. In all, 13 of the 18 industries reported a decline in employment for the month, while only three saw an expansion (two were unchanged). If employment is still declining in both services and in manufacturing, it is hard to see how the rebound in retail can be sustainable.

Overall, the increase in the services index is welcome news. It shows that the economic recovery is still on track, albeit very slow and anemic -- but better an anemic recovery than continued contraction. However, given the narrowness of the reading, there is still plenty of reason to be cautious.

One industry that appeared to be weak in most of the sub indexes was Accommodation and Food Service. This would seem to confirm what we have been seeing in terms of declining occupancy and room rates for the hotel industry. The hotel chains like Marriott (NYSE:MAR) and Starwood (HOT) still face a serious uphill climb.