The US manufacturing economy is in recession, after two successive quarterly declines in the Federal Reserve’s Industrial Production Index. The Purchasing Managers Indices tabulated by the Institute for Supply Management and the business data provider Markit show the lowest reading in roughly a decade. Manufacturing stocks improved in October, with the S&P’s Industrials index gaining 4.1% in October vs. a 3.5% gain in the broad index, on expectations that manufacturing is about to turn around.
The most recent data suggest that although manufacturing has stopped falling, recovery remains elusive. Manufacturing indices compiled by some of the regional Federal Reserve banks tend to anticipate the widely-followed purchasing managers’ reports, and the latest readings from the regional Fed banks are weaker than expected. The most forward-looking indicators available predict no improvement in manufacturing through the rest of the year.
The five regional Fed indices are shown in the chart above. Economists tend to assign special importance to the Philadelphia Federal Reserve index, because it appears to anticipate broader measures of industrial output.
The chart above illustrates how the Philadelphia Fed index anticipate the Markit index. The blue lines show the degree of correlation between past values of the Philadelphia index and the current level of the Markit PMI. A 3-month lag in the Philadelphia Index shows a .25 correlation with the present Markit Index, a 4-month lag in the Philadelphia index shows a .4 correlation, and so forth.
I find that the Dallas Fed index, which is heavily weighted towards energy and semiconductors, also anticipates the purchasing managers’ indices. The other Federal Reserve Bank gauges have little or no predictive value.
Using past values of the Philadelphia and Dallas indices to forecast the Markit PMI, I obtain the following forecast:
A forecast of 51.3 for the Markit Index at the end of 2019 means that 51.3% of US manufacturing firms will expand, and remainder will contract operations. The manufacturing economy is bouncing along the bottom.
The main culprit in manufacturing weakness is the sharp drop in capital investment occasioned by the US-China tariff war. Uncertainty over tariffs, location of supply chains and other issues prompted businesses to postpone capital investment until the dust settles. Although it seems likely that the US and China will arrive at a mini-deal during November, that isn’t enough to un-blow the whistle that has kept corporate investors in the bomb shelters.
The chart below shows manufacturers’ new orders for nondefense capital goods excluding aircraft, against the Federal Reserve’s Industrial Production Index.
It is visually clear that capita goods orders anticipate the index (times series analysis confirms the visual impression).
Until corporations are convinced that the US and China have agreed to a lasting trade deal, the manufacturing sector will remain under pressure. If that is correct, the upside to industrially-exposed cyclical stocks is somewhat limited, and that the best trades in the industrial sector already have been done.