US: What is the manufacturing ISM survey telling us and will the Fed heed its message? - Natixis

Joseph Lavorgna, Research Analyst at Natixis, explains that the manufacturing side of the US economy is booming, thereby pointing to strong economic growth in the quarters immediately ahead. However, because most of the strength is projected to derive from faster capital spending, inflation should remain fairly quiescent, he further adds.

Key Quotes

“The manufacturing ISM survey is an excellent proxy for measuring overall economic activity. While the goods sector accounts for only one-third of total output, its movements are highly correlated (and hence predictive) of overall economic activity. Last month, the manufacturing ISM rose 1.5 points to 59.7. This produced a quarterly average of 58.9, which is an extraordinarily high level especially for this late in the business cycle. This is consistent with year-over-year real GDP growth near 4%. We are a bit more cautious and expect growth closer to 3%.”

“In point of fact, the last time the series was this high was Q1 2011 (59.7), which was only two years into the economic recovery. The unemployment rate was 9.0% at the time compared to 4.1% at present. Normally such readings tend to occur earlier in the business cycle: generally it tends to be in the first half. This is particularly true for the new orders component, which is a leading indicator of future capital spending plans. Its performance last quarter was even better than the overall index. New orders averaged 65.6 in Q4 2017. That is the highest reading since Q1 2004 (67.2).”

“The dramatic improvement in new orders suggests the following: One, underlying demand for manufactured goods is strong. Otherwise, why would order flow be increasing? Two, some of the jump in orders was likely due to anticipation that Congress would pass corporate tax reform. The reduction in the corporate statutory rate from 35% to 21% combined with the ability of companies to fully expense capital outlays, no doubt caused firms to increase their orders for delivery in 2018. Three, the dramatic anticipated improvement in capital spending that is being foreshadowed by rising order flow is inherently disinflationary.” The last point is worth elaborating on.”

“What does all of this mean for the economy? The ISM data tell us that real GDP growth should continue to expand at a 3% rate (and possibly faster) and that inflation pressures should be relatively minimal. However, we are very concerned that monetary policymakers will have a different view. Because our forecast of 2018 economic growth implies an unemployment rate down near 3.5%, the Fed will worry about incipient inflation pressures. This would be a major mistake on behalf of the Central Bank.”

“If wage gains accelerate from their current 2.5% to 3% range, it will be due to faster productivity, meaning companies are paying more because workers can produce more. In fact, the last time the economy experienced any notable wage pressure was in the late 1990s, which is also when the unemployment rate was near 4%. However, what oftentimes goes unstated is the fact that productivity growth was very strong as well. What about inflation?”

“At no point during the back half of the 1990s did the year-over-year growth in the core PCE deflator, the Fed’s favorite inflation measure, hit 2%, which is now today’s target rate. The core PCE deflator was under 2% from Q2 1996 until Q3 2004. But by the latter data point, the US economy was already in another business cycle. Consequently, the dramatic orders-led improvement in the manufacturing ISM survey, which is bodes well for US real GDP growth should also be welcomed by the Fed. Hopefully, monetary policy hawks will take note.”