The ISM data released this week calls into question all the commonly held beliefs of the Fed, economists, the media, and investors that higher mortgage rates, the fiscal cliff tax increases, and the Federal spending sequestration would all be disastrous for the US economy. They have not been. Not only does the ISM data suggest that the economy has lately been gaining momentum, but this week’s initial claims data was also strong. So were Federal withholding tax collections in September. The data suggest that the current budget crisis won’t be the big deal that the Cassandra crybabies in the financial media are making it out to be.
The September headline Manufacturing Purchasing Managers Index reading of 56.2 was stronger than the consensus expectation of 55. The Non Manufacturing (services) Index reading of 54.4 was below economists’ expectation of 57.2. However, anything over 50 signals expansion. These are seasonally adjusted numbers (see Why Seasonal Adjustment sucks).
Both indexes include eleven subindexes which muddy the water of what the composite number actually means. To get a clearer picture of the manufacturing economy I track the not seasonally adjusted (NSA) ISM Manufacturing New Orders index. It fell from a 4 year high of 63.2 in August to 60.5 which is still extremely strong (See Note 1 below).
The September reading was down 5.2 points from August. September has little apparent seasonality, usually declining, but sometimes increasing versus August. September’s average month to month change over the previous 10 years was -1.3. This year’s September drop was the worst since 2004 but it followed an enormous surge in the prior two months. That move clearly reversed a two year downtrend. Apparently something happened this summer to spur US manufacturing orders.
The manufacturing sector represents about 12% of the economy. The correlation of this indicator with stock prices is poor. While strength in the ISM is associated with strength in stock prices, the stock market has shown that it could go on its merry way for years even as US manufacturing slowly weakened. Aside from its lack of usefulness as a stock market indicator the ISM manufacturing new orders index represents only a small part of the overall US economy. The weakening trend from 2009 to 2013 was slightly misleading in regard to the US economy as a whole.
The ISM Non Manufacturing (Services) New Orders Index has correlated better with the overall US economy, but like the manufacturing gauge, isn’t very useful as an indicator of stock market. While services are by far the largest part of the US economy, this number typically is not a market mover. September’s headline reading of 54 was positive, indicating expansion.
As with the manufacturing data, my focus here is on the not seasonally adjusted (actual) index of new orders. The September reading of 60.75 was down from 64.75 in August. Here again there’s little evidence of seasonality and therefore no real reason to apply a seasonal adjustment. Over the past 10 years monthly changes in September ranged from -10 to +3, with an average of -1.7. The drop this September looks like just a giveback from two extremely strong prior months. It’s still at a very strong level.
Why both manufacturing and services new orders suddenly surged in late summer after downtrending for two years is a mystery. However, it is at least ironic that those surges occurred only after the sharp rise in long term interest rates and mortgage rates that occurred in the first half of the year. The Fed’s theory that only zero interest rates will support a growing economy called into question by this seeming conundrum of the economy accelerating only after mortgage rates rose sharply. The surge also occurred after fiscal cliff tax increases and sequestration budget cuts had plenty of time to impact the economy. Apparently they didn’t.
The negative divergence between these indexes and stock prices from 2009 through the middle of this year proved to be of no value in forecasting stock prices. The strong performance of stocks versus these indicators suggested that the Fed was driving equity prices while having little impact on the economy. The economy could only expand so much. The strong performance of these indicators only after mortgage rates rose adds a puzzling postscript. Did the expectation of higher rates push buyers to move now rather than wait?
It also seems clear that the fiscal cliff and sequester that were supposed to be so disastrous for the US economy have had no negative impact. The spending cuts and tax increases were large enough to reduce the deficit and reduce Treasury supply, which was bullish for stocks because made more Fed printed money available for the stock market. The tax increases and spending cuts were not sufficient to push the mammoth, slow moving US economy off its track. Policy tinkering seems meaningless given the size and momentum of the economy. All the constant gnashing of teeth about policy is a sideshow that traders and investors should ignore. It’s likely to prove the same again with regard to the current budget “crisis.”
Note 1: The ISM reports only the seasonally adjusted data. To derive the actual data we need to divide the reported data by the SA factors applied, which the US Department of Commerce supplies each year in advance. Each year, all of the data SA is benchmarked and restated. In January the ISM issued a restatement of all the Manufacturing and Non Manufacturing indexes since 2009, making the previously reported headline numbers reported for each month essentially garbage.
To get an idea of how good or bad the actual, not seasonally adjusted number is, I compare it to the same month in past years. On the chart, a line connecting the same month each year helps to show the trend.
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