Recession? The PMI as a Useful Economic Indicator

By Michael Zoller on September 6, 2022

In the U.S., attention is increasingly focused on the economy: Is the country headed for a recession or just a mere slowdown? To answer this question, it may be helpful to look at key economic indicators, how they are trending and what that says about the current economic state.

On the first business day of every month, the Purchasing Manager’s Index (PMI) is released, providing an indication of the status of the U.S. manufacturing sector. The headline number and its subcomponent summarize whether market conditions, as viewed by manufacturers, are expanding. The purpose of this blog to explain what this key economic indicator is, if it is an accurate predicator of growth, and should investors care?

Background

The Purchasing Managers’ index is a diffusion index built around a survey of business conditions among manufacturing firms, which is conducted by the Institute for Supply Management (ISM). A monthly survey is sent to more than 400 companies in 3 manufacturing industries across the United States, covering all 50 states. Ten indicators are tracked, and compiled into a headline number, where anything over 50 suggests expansion and anything below suggests contraction.

As a tool for estimating growth, the PMI has several appealing features. Foremost is its timeliness: the data covering the previous month are released on the first business day of the following month. In terms of turnaround between data collection and release, few major indicators have a smaller time gap. Further, since the data comprise a survey, the series are not subject to significant revisions beyond an annual adjustment to seasonal factors, which are generally small. Compare this to the significant revisions that beleaguer the payroll and GDP reports, reducing the inherent value of their initial releases. And finally, the PMI and its subcomponents fill in some of the holes unavailable in other timely indicators, such as the payroll role and industrial production numbers.

The Current Situation

The index has been souring from its post-COVID high of 63.7 in March 2021. This year alone, the index has lost more than 5 points, but at 52.8 as of July, it remains firmly on the expansion side of the index. And, to be sure, the index still has a ways to go before it signals a broader U.S. recession. Even though a reading less than 50 indicates a contraction in the domestic manufacturing sector, it is not until the index reaches the low 40s that a broader U.S. recession is indicated[i]. Indeed, in each of the recessions since 1950, the PMI fell below 45, suggesting this may be the threshold for broader economic travails.

Just as important as an indicator of expansion or contraction, the index is also an accurate coincident indicator of economic growth. A comparison of quarterly-average PMI against quarter-on-quarter growth of real (inflated-adjusted) GDP shows a strong, but far from perfect, correlation of 0.64. With the final reading of GDP estimate lagged by several months, investors may be able to use the PMI as a proxy for current economic growth.

Even as the indicator appears to have economic importance, is it important for investors to follow as well?

Goldman Sachs found the PMI trails only nonfarm payrolls and GDP in its impact on the financial markets[ii]. Indeed, they found a one standard deviation surprise in the PMI pushes up 10-year Treasury bond yields by almost 2 basis point and increases the S&P 500 by about 0.2%. This puts the influence of the PMI data release on par with that of the initial GDP release, and about half as influential as the nonfarm payrolls release. Further, research from the CFA Institute suggests that surprise changes (that is, increases/decreased significantly larger than consensus expectations) in the PMI have a direct relationship in stock market performance[iii]. Thus, for both short- and long-term investors, this indicator may help predict market movements.

Conclusion

For investors looking for an early and timely indicator of where broad economic growth is headed, it appears that few measures are as good as PMI. Even though its only focused on the manufacturing sector, it appears as if it can still provide robust information on the broader US economy. As such, keeping an eye on this indicator is an important part of the investing toolkit.

As always, if you have any questions about the PMI as an economic indicator, its implications for investing, or any broader economic topic, please consult with your advisor.

[i] Kajal Lahiri and George Monogroussos, “Nowcasting U.S. GDP: The Role of the ISM Business Surveys,” Department of Economics, University of Albany, SUNY (November 2011).

[ii] Jan Hatzius, Alec Philips, Jari Stehn, Kris Dawsey, David Mericle, Shuyan Wu, and Michael Cahill, “Payrolls, Schmayrolls: Market Impact vs Economic Reality,” Goldman Sachs US Economic Analyst, 13/32 (August 9, 2013).

[iii] Mark A. Johsn and Kevin J. Watson, “Can Changes in the Purchasing Managers’ Index Foretell Stock Returns? Ad Additional Forward-Looking Sentiment Indicator,” Journal of Investing 20, no. 4 (Winter 2011): 89-98.