John Lynch Chief Investment Strategist, LPL Financial
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Strong manufacturing growth is a bellwether for overall economic health. Even though manufacturing is a dwindling part of domestic output, accounting for about 12% of gross domestic product (GDP), strong manufacturing growth has consistently preceded significant phases of GDP growth. Because of this, the Institute for Supply Management’s (ISM) U.S. Purchasing Managers’ Index (PMI) survey is one of the gauges we monitor in our Recession Watch Dashboard. Over its past five cycles, the U.S. economy has fallen into a recession an average of 46 months after the ISM index peaked [Figure 1].
ISM’s U.S. PMI just posted its strongest reading in 14 years, a sign to us that the current cycle still has fuel left in the tank. The ISM gauge jumped to 61.3 in August, its highest point since May 2004.
DOMESTIC DEMAND
Growth in manufacturing output last month was primarily driven by domestic demand. ISM’s gauge of new orders jumped 8.1%, the strongest monthly growth since August 2014. The jump in new orders is a strong sign that the impact of $350 billion in fiscal stimulus continues to outweigh trade concerns, a theme we’ve emphasized this year. New orders are also viewed as a leading component (rising orders will typically lead to increased production), so the robust increase in new orders could forecast future manufacturing growth.
Looser tax policy has boosted business and consumer spending this year, driving second quarter GDP to its strongest growth since 2014. Spending also buoys manufacturing—if demand picks up, the manufacturing industry must respond by producing more inventory. We expect these forces to continue to lift business and consumer spending, likely to the benefit of the manufacturing sector.
However, manufacturing may be especially susceptible to future weakness from trade tensions. Respondents to ISM’s survey were still “overwhelmingly concerned” about the impact of tariffs on revenue and manufacturing locations. Cooling in trade activity has also emerged in the divergence in ISM data on domestic and international orders. Even as new orders soared last month, ISM’s new export orders fell to a 10-month low and new import orders dropped to an 11-month low [Figure 2], providing further evidence that recent manufacturing growth has been driven by domestic demand.
As shown in Figure 2, new orders have historically moved in tandem with export and import orders, highlighting the importance of international demand on U.S. manufacturing activity. If domestic demand wanes and global demand remains weak, U.S. manufacturing activity may decline at a much quicker pace than expected.
SUPPLY CHAIN CONSTRAINTS
While the most recent ISM PMI signals more economic gains, other data hint to potential weakness and pricing pressures. Details in the report point to continuing supply chain disruptions, or difficulties for manufacturers in getting the supplies necessary to produce goods, a trend we’ve noticed in other recent economic reports.
ISM’s measures for supplier delivery times and order backlogs were near cycle highs last month as supply chain constraints strapped production. New orders, boosted by strong demand, are growing at an unusually fast pace relative to inventories. New orders outpaced inventories by 9.7 percentage points in August, higher than the average of 7.8 percentage points since June 2009. Supply chain disruptions have not yet weighed meaningfully on manufacturing, but if these trends persist, demand may temper as firms combat inventory shortages with higher prices.