In May, the Institute of Supply Management (ISM) released two surveys on manufacturing. The message is bleak; the contraction in activity remains sharp and firms expect a record decline in revenues and capital expenditures for 2020.
The May composite index for manufacturing rose 1.6 percentage points to 43.1%. The headline reading overstates the activity level in manufacturing. Three key sub-components, new orders, production, and employment, have readings in the low 30s. The low readings on production and jobs speak about the sharp contraction. Pessimism about a recovery is apparent in the low level for new orders.
The ISM manufacturing index was initially created in the early 1980s by Mr. Ted Torda, a colleague of mine at the Office of the Chief Economist at the Department of Commerce. ISM manufacturing index was created to help predict quarterly changes in GDP. The initial launch of the ISM manufacturing index had a weighting scheme of new orders (.3), production (.25), employment (.2), supplier deliveries (.15), and inventories (.1). The current weighting scheme applies equal weights (.2) to the five components.
Using the original weights the May 2020 composite index is estimated at 39.5, up from the 36.9 reading in April. Both readings are about 4 percentage points lower than the published figures.
Why is that important? The ISM composite index is a diffusion index. Both the level and the change in the index level are important. The published figure of 43.1% or the adjusted figure of 39.5% both say the same thing: the manufacturing sector is still contracting.
Yet, the one shortcoming of a diffusion index is that it does not distinguish between the magnitude of change. That means large declines in one industry could be offset by small increases in another industry and vice versa. Also, declines in activity are not linear any more so than increases. In other words, just because a monthly reading moves up or down from the prior month that has no bearing on the next months reading.
In May, the 30% readings for production, employment and new orders indicate that the manufacturing sector is still experiencing a sharp downturn. And the fact that these readings are marginally above the record lows of April
create a false impression that the road to an eventual rebound is just a few months away.
Weakness in the manufacturing sector and pessimism on the outlook is also seen the semi-annual survey of manufacturers. According to the survey results released in mid-May, firms expect overall revenue to decline by 10.3% in 2020. But 58% of those surveyed expecting a crash, with revenues off 20%. Plunging sales have forced firms to plan for record layoffs and to cut capital expenditures by a stunning 19%.
The message from manufacturing is that a severe contraction remains in play and a recovery is a long way off. Both view are at odds with the optimism of the equity markets.