Understanding The Purchasing Managers Index

No one variable provides the key to the future direction of the economy or market. However, one economic data point that tends to get a lot of attention is the Purchasing Mangers Index for both manufacturing and non-manufacturing parts of the economy. In fact in an article I wrote earlier this week I highlighted the optimism being expressed by manufacturers and small businesses. Many of my articles get republished on Seeking Alpha as did this one. One reader comment to the article stated I must not be "paying much attention to the manufacturing PMIs, which are showing a severe turn to pessimism." PMIs are important variables we do review; however, we believe many misinterpret the meaning behind the PMI's.

A key misinterpretation revolves around contracting manufacturing versus a recession level PMI reading. PMI readings below 50 do indicate manufacturing is generally contracting but it does not mean with certainty that the economy is headed for a recession. According to the Institute for Supply Management that reports PMI data, they note,

• "A reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally contracting."

As it relates to economic expansions though, ISM states,

• "PMI^® above 42.9 percent, over a period of time, generally indicates an expansion of the overall economy [emphasis added]. Therefore, the May PMI^® indicates growth for the 121st consecutive month in the overall economy and the 33rd straight month of growth in the manufacturing sector. 'The past relationship between the PMI^® and the overall economy indicates that the PMI^® for May (52.1 percent) corresponds to a 2.7-percent increase in real gross domestic product (GDP) on an annualized basis,' says Timothy R. Fiore, CPSM, C.P.M., Chair of the Institute for Supply Management^® (ISM^®) Manufacturing Business Survey Committe."

As the below chart of the PMI data shows, PMI readings below 50 occur frequently and a recession does not always follow. 

Last week several additional manufacturing reports exhibit weakness. The Empire State Manufacturing Survey's General Business Conditions Survey Index was reported at -8.6, below  the consensus expectations of 10.0. The drop from the prior month reading was 26.4 points, the largest drop in the index's history which dates back to 2001.

Thursday's Philadelphia Fed business Outlook Survey missed expectations at .3 versus consensus of 11.0. Econoday noted though,

"Yet outside of the headline which is not a composite but a general sentiment reading based on a single question, details in today's report are less alarming. New orders did slow but not very much and remain respectable and solid at 8.3. And unfilled orders are building nicely so far this month, at 10.2 for a more than 8 point gain which is very strong for this reading. Shipments continue to move out the door at 16.6 and hiring remains solid at 9.4."

In  conclusion, the manufacturing data is indicating a slowdown, but it is not at recessionary levels. Globally, PMI's have improved with the Eurozone PMI trending higher for most of this year. Also, the emerging market and China PMIs have improved to above 50 after dipping below 50 earlier this year. So PMIs in the low 40's would be more of a concern versus brief periods falling below 50.