The Institute for Supply Management (ISM) reported last week that the ISM Manufacturing Index contracted in August. The data was terrible across many of its subcomponent indexes, driving investor concern on the news. Importantly, the employment sub-component measure also contracted, which is an ominous sign. Labor market strength has been one of the key supports to the economy and the stock market. Thus, this contraction in the manufacturing sector may offer forewarning of broader weakness to come. Two employment data points also reported last week may have offered a hint of as much. So, the developing recession in manufacturing may prove to be like a canary in a coal mine, forewarning of danger to the broader economy.
Industrial stocks led the way lower after the ISM data release on September 3, 2019, as you can see via the comparison here. Shares with cyclical sensitivity, like the SPDR Dow Jones (DIA) and Bank of America (BAC) and Boeing (BA), were down even more because of what the data may portend about the broader economy.
% Change on September 3
Industrial Select Sector SPDR (XLI)
SPDR Dow Jones (DIA)
SPDR S&P 500 (SPY)
Bank of America (BAC)
Manufacturing Sector Recession
The ISM Manufacturing Index contracted in August, with the Purchasing Managers Index (PMI) marking 49.1%, down 2.1 percentage points from the July mark of 51.2%. Economists had expected a reading of 51.3% for August, so the news was disappointing; thus, the reaction in relative stocks seen in the table above. However, the contraction in manufacturing was not completely without warning. The ISM PMI had been reflecting slowing growth for four consecutive months prior to August. This marks the end of an era. Before this contraction, the PMI had posted 35 consecutive months of readings above 50.0, marking a long period of healthy expansion in the manufacturing sector.
A closer look at the data did not offer any consolation. New orders, which is a foreteller of future business activity, dropped sharply by 3.6 percentage points, to 47.2% in August. It marked the first instance of demand decrease for manufacturers’ goods since December of 2015.
Trade Policy (War) is the Problem
The problems were broad-based, with only 3 of 18 manufacturing industries reporting growth in new orders in August. Most of the ISM subcomponent indexes showed contraction in August, led by New Export Orders, which dropped 4.8 percentage points to 43.3%. Indeed, the trade war was the key cause of the contraction along with global economic softness, as respondents to the survey reported trade as the most significant issue. Many have reported disruption to production because of the movement of supply chains out of China. Clearly, weak business sentiment has impacted investment, and tariffs are impeding fluid trade.
The Canary in the Coal Mine
We already knew the manufacturing sector was being impacted by the trade war. So, you must be wondering why then there is suddenly serious concern being expressed here about the leakage of sector weakness into the broader U.S. economy. After all, the U.S. domestic market is significant enough to offer support to the U.S. economy, especially when the economy is fully employed. But that is precisely the problem.
The ISM data showed that the Employment subcomponent index slipped 4.3 percentage points into contraction at 47.4%. It was the first instance of manufacturing employment contraction in 35 months, or since September of 2016. Just 1 of 6 big industry sectors expanded, while 3 of 6 contracted. I suppose the good news is that despite the data, labor force reduction comments were minimal from the respondents. However, one-quarter of the respondents indicated they were unlikely to hire for expansion.
How Layoffs in Manufacturing Infect the Broader Economy
While the manufacturing sector is far less significant than the service sector for the U.S. economy, we could start to see slippage in employment as layoffs occur within manufacturing. Layoffs and the news of them could start to convert weakened consumer sentiment into softer consumer spending.
First there is the direct impact of those let go from jobs in the manufacturing sector. Because the manufacturing sector is a minor driver of the U.S. economy, weakness therein is often blown off by many experts as nonthreatening. However, for Americans living check-to-check, unemployment benefits are not going to cut it versus the paycheck they had grown accustomed to receiving. Secondly, as the friends and relatives of those who lose jobs hear about those layoffs, and as the stock market likely reacts to increasing signs of economic trouble should it materialize, Americans who are still employed are likely to think twice about spending, especially for big-ticket items.
Stock market reaction to economic trouble matters because of the wealth effect, where consumer confidence is lost because of sudden or sharp decreases in investment portfolio values. Though stocks reacted positively to news last week that trade negotiations would resume between the U.S. and China in October, new tariffs have been employed by both parties recently and more are scheduled to come from the U.S. If economic data continues to show poorly, especially in employment or consumer spending, these effects are likely to accelerate.
Hints of Economic Infection in Employment
Two employment measures reported last week may have offered hints of manufacturing sector and trade disruption infection into the broader economy. First, the Challenger Job-Cuts Report for the month of August showed a spike in announced corporate layoffs in the United States. American firms said they would layoff 53,480 employees in August, which was up 37.7% from July and up 39% from the prior year period. August also marked the eighth consecutive month of year-over-year increases in layoffs, which makes for an ominous trend.
Trade policy disruption is clearly at play. Quoting Andrew Challenger, Vice President of Challenger, Gray & Christmas, Inc, “Employers are beginning to feel the effects of the trade war and imposed tariffs by the U.S. and China. In fact, trade difficulties were cited as the reason for over 10,000 job cuts in August”. He added, "We are continuing to see investor concerns shaking confidence in the market, and employers appear to be cutting workers in response to a slowdown in demand for their products and services."
Industrial Goods Manufacturing announced just 3,822 cuts in August, but layoffs in the sector are up 202.6% year-to-date versus the prior year period. Within industrials, the automotive sector has announced its most layoffs in the year-to-date period since 2009, though this year’s total of 36,148 is still far short of the crisis-era cuts of 128,906 in the January through August period of 2009. The tech sector led the way this August with over 15K layoffs announced. Technology had fired some 341% more people this year versus last year through August. The retail sector is doing worst through the year-to-date period in 2019, with 57,226 cuts, though that is down 28% from the prior year-to-date period. The contrast here seems to expose an inflection point for the labor market.
The Challenger data sure smells a bit like a dead canary to me. Furthermore, the Employment Situation Report for August, reported last Friday, was not so good. Nonfarm payrolls measured just 130K, versus the economists’ consensus expectation for 163K; and August was down from July’s revised figure of 159K. Within the data, manufacturing only added 3K jobs on net, versus expectations for 8K; and the prior month manufacturing payrolls data was reduced to 4K from the initially reported 16K. Importantly, private payrolls, excluding the public sector (government jobs including census workers), only added 96K payrolls versus the 150K expected and the 131K (revised) seen in July.
I do not hear birds singing on the news from the labor market. The latest data might be sending signals here about broader trouble to come. That said, the latest ISM Nonmanufacturing Index, also reported last week, improved nicely to 56.4%, from 53.7% in July. And the new orders subcomponent measure soared more than six points to 60.3%. The employment subcomponent within the index, however, decreased 3.1 percentage points to a still expansionary level of 53.1%. Stocks rallied on the enthusing news but keep your eye on the canary.
The first contraction in employment within the ISM Manufacturing Index is significant because it puts a dent in a key support for the U.S. economy and stock market. It seems that disruptive trade policy may finally infect the broader economy if negotiations do not result in a deal soon, and especially if the trade war escalates or expands to other trade partners (read Europe). Economic contraction in the manufacturing sector may be like a canary in a coal mine, whereby the canary’s death due to poisonous gases warns us of what may harm us as well if we do not act well enough to mitigate the relevant danger.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.