MORE REASONS FOR PessimISM

The ISM manufacturing PMI for September dropped to 54.4 from 56.3 in August, the lowest reading since November 2009. David Rosenberg noticed that

If not for the surge in the inventory component from 51.4 to 55.6 — the highest level since July 1984 — the headline ISM actually would have gone down even further, to 53.6.

The inventory build-up, which for most of this cycle was intentional, now seems to be involuntary. How do we know? Well, for one, production slipped to 56.5 from 59.9, its lowest level since June 2009 just as the recession was about to end. Normally, this level of production is consistent with a 47.4 inventory index, not 55.6, as was the case last month. And, order books are now being squeezed — down from 53.1 in August to 51.1 in September — also the lowest since June 2009.

What is critical here is the orders-to-inventories ratio, which leads the headline ISM by roughly three months and strongly suggests that we will be sub-50 and as such ‘double dip’ talk will re-emerge before the end of the year.

Look at the chart below. The record shows that at this level in the past, the economy slipped into contraction 75% of the time.

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The FT Lex column wrote on the same theme this am using a different calculation method with the same statistics:

Unfortunately, the Institute of Supply Managers (ISM) survey of US manufacturers suggests that this cycle has turned negative again. As the chart shows, virtually without exception, whenever the ISM’s measure for inventories exceeds its measure for new orders, a recession comes soon after. (…)

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The overall ISM index remained at 54.4 (its spring peak was 60.4; the dividing line between recession and expansion is 50) but mainly because inventories rose from 51.4 to 56.1, the highest level on this survey since 1984. It looks like companies were wrong-footed by a lack of orders. If they now trim inventories, a dip below 50 for the main ISM survey is a real possibility. That would be a harbinger of a new full blown recession. (…)

The spread between the New Orders and Inventories subcomponents, which leads the headline data by 3 months, argues that a sub-50 print is a risk before year’s end. Double dipping risk will rise if that happens.

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So, inventories have been rising in the face of weak final demand. Can demand recover quickly enough to avoid an inventory correction? The ISM New Orders index has been declining steadily from 58.5 in June to 51.1 in September. The number of industries reporting growth in new orders was split equally at 7 with those reporting decreases. This is down from 8 in July and August and 13 in June. The next 3 charts plot from left to right the ISM index for New Orders, Inventories and Backlog. Nothing to cheer in there, is there?

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Take a look at the same charts for Non-Manufacturing where inventories are not as significant but where new orders and backlogs  have been weakening. There were 8 industries reporting growth in new orders in September, down from 9 in August, 12 in July and 10 in June.

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Europe’s PMI is also weakening as per this morning’s Markit release:

New business rose for the thirteenth successive month in September. However, the rate of expansion was the weakest since last November, reflecting slower growth of both domestic and external demand. Rates of increase in total new orders moderated in both the manufacturing and service sectors, and manufacturing new export orders rose at the slowest pace for ten months.

One might hope that Christmas sales will be strong enough to save us from a major inventory overhang. The odds for that are not great if one looks at US chain store sales trends.

US chain store sales declined 0.8% last week. The 4-week moving average has been falling for the 8th consecutive week. While this decline mirrors the April-May 2010 freefall, this one is worse since the poor back-to-school sales generally herald weak Christmas sales.

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In early July, when equity markets were hitting fresh lows for 2010 on rising odds of a double dip, I favored a less damaging muddling through scenario which justified a cautious increase in equity exposures at a times when equity markets were clearly undervalued.

Yesterday, I published US EQUITIES STILL VERY CHEAP BUT… trying to justify taking advantage of cheap equity markets while the economic environment remains very challenging. Today’s economic news (although markets are positively reacting to better than expected US non-manufacturing top-line PMI and the EU’s Service PMI) are certainly not conducive to much optimism. Low valuation is attractive but the economic catalysts are nowhere in sight. As I wrote yesterday:

US equities are currently like a big sailboat in a rough sea, without much engine power, no headsail, a weak jib and a flailing rudder. The boat will likely make it to port but nobody really knows how, when and where. Obviously not everybody’s dream for a cruise.

Be cautiously invested in equities but remain nimble.

 

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