April 1, 2016
No, this is not an April Fool’s Day joke. For the first time in 18 months the factory sector is showing clear signs of life. The one piece of information that has altered the outlook for the manufacturing sector is the Institute for Supply Management’s (ISM) survey of economic conditions for March.
Throughout 2015 GDP growth was led by consumer spending and housing. But growth in those sectors was partially offset by weakness in manufacturing and mining. Factory employment was hit by the 20% increase in the value of the dollar between the middle of 2014 and the end of 2015. This caused U.S. goods to become more expensive for foreigners to purchase and led to a drop in exports. The mining sector was clobbered by falling oil prices which eventually dropped from a peak of $110 per barrel to $30. That, in turn, caused oil drillers to close down their least productive wells and contributed to the slower pace of economic expansion last year. We expected the drag on growth from these two sectors to disappear during 2016 – and that may actually be happening.
What has gotten us excited is the overall ISM index for March which rose from 49.5 to 51.8 which is the third consecutive increase in this series. After having been below the break-even level of 50.0 since October of last year, the gains in recent months provide clear evidence that the factory sector is finally turning itself around. The ISM group indicates that the average level of this index for the first three months of this year is consistent with GDP growth of 2.1%. If the March level can be sustained that would be consistent with GDP growth of 2.7%.
The increase in the overall index was led by orders which surged from 51.5 to 58.3. That is the highest level for this particular component since November 2014 – 16 months ago.
With an increase in orders of that magnitude the backlog of orders has climbed above the break-even level of 50.0 for the first time since May of last year. If the backlog picks up an increase in factory output cannot be far behind. And if manufacturing firms begin to boost output, employment in the manufacturing sector will also turn upwards. Thus, one piece of the economic jigsaw puzzle that had been weak is finally emerging from the doldrums.
Then there is the mining sector which was hit by the dramatic decline in oil prices. In October 2014 oil prices were $114 per barrel. But the big increase in oil production caused by hydraulic fracturing and horizontal drilling created a global oil glut which eventually triggered the dramatic slide in the price of oil. Oil prices hit a bottom of about $30 in February before partially recovering to their current level of $37. If, in fact, oil prices have finally touched bottom, then the drag on GDP growth in the mining sector will soon come to a halt and another weak sector in the economy will be eliminated.
What does all this mean? First, GDP growth for the year, if anything, could be somewhat stronger than the Fed expects. Currently, it anticipates 2.2% GDP growth this year. It could be closer to 2.4%. While that is not a big difference either number is higher than potential growth which is currently estimated to be about 2.0%. As a result, there will be increasing upward pressure on the inflation rate which is where we have our biggest difference with the Fed.
This past year the CPI inflation rate was pulled down by the sharp drop in commodity prices – oil in particular. But now commodity prices have stopped falling, and the downward bias to the CPI will soon disappear. We expect the overall CPI to increase 2.2% this year (versus 0.7% in 2015) and the core rate (excluding the volatile food and energy components) to increase 2.6%. That appears to be about 0.5% faster than the Fed’s expectation.
If the weakness in the manufacturing and mining sectors is truly coming to halt, then the drag on GDP growth and the downward bias to the inflation rate will soon disappear. While the ISM report is only a piece of the puzzle the dramatic increase in the past couple of months is truly impressive. The Fed may be comfortable for now, but that may change as the year progresses.
Stephen Slifer
NumberNomics
Charleston, SC
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