Data released yesterday indicated that US manufacturing activity remained subdued in September. The Institute for Supply Management (ISM) Report on Business came in at 47.2, marking the sixth consecutive month that the gauge remained below 50, which is the demarcation line between contraction and expansion in manufacturing activity. To be sure, only readings below 42.5 have historically been associated with economy-wide recessions, while readings between 42.5 and 50 have been consistent with mid-cycle slowdowns.
Looking underneath the surface, the details of the survey were also generally on the weak side, but there were some encouraging signs:
- The new orders and production components, while still below 50, improved from the prior month.
- The inventories component fell to the lowest level so far this year, alleviating concerns of an inventory buildup.
- The prices paid component fell below 50 for the first time this year, indicating an easing of inflationary pressures.
- The decline in the employment component indicates producers are still in the process of “rightsizing” their headcount.
YTD monthly readings of the ISM Manufacturing PMI and its main components
Source: Institute for Supply Management, Bloomberg, as of 10/1/2024
As we head into 2025, we think it is more likely that manufacturing activity will pick up rather than slow down further. The two factors most cited by respondents as reasons behind the weakness in activity were election-related uncertainty and high cost of capital. While we are about to get a resolution on the former issue in just over a month, we are already making significant progress on the latter issue. In fact, the US manufacturing sector is about to receive a jolt of stimulus not just from the recent decline in long-term interest rates, but also from recent declines in energy prices and the US dollar:
- While the Fed has only cut rates by 0.5% so far, the 10-year treasury yield has already fallen by over 1.25% since its peak of ~5% late last year. This has significantly lowered borrowing costs for businesses.
- Crude oil prices have fallen by ~43% since the ~$123/bbl peak in 2022, and by ~24% in the past year alone. This has significantly lowered energy costs for businesses.
- The US dollar index has fallen by ~11.3% since its peak in late 2022, and by ~5.4% in the past year alone. We expect the dollar to weaken further as the Fed delivers more interest rate cuts. A weaker dollar results in a positive currency translation effect for businesses with revenue from overseas.
The dotted blue line on the chart below is a composite of the recent rate of change in these three variables. It is advanced by two years, inverted, and plotted against the ISM Manufacturing PMI in orange. The blue line has risen to the highest level in recent history, indicating a significant amount of stimulus is currently in the pipeline. As this stimulus works its way through the system, we expect manufacturing activity (the orange line) to accelerate higher along the same path, as it has in prior cycles. While manufacturing only makes up ~10% of GDP, its reacceleration at this juncture after nearly 2 years of stagnation would go a long way towards allowing the economy to achieve a soft landing.
A decline in interest rates, oil prices, and the US dollar tends to stimulate manufacturing activity down the line
Source: CW Advisors, Bloomberg, as of 10/1/2024
Sauro Locatelli CFA, FRM®, SCR®
Director of Quantitative Research
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