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Graph of the week

Graph of the week

13-10-2017 | Insight

Growth spurt?

  • Jeroen Blokland
    Portfolio Manager, Robeco Global Allocation team

The US ISM Manufacturing Index is currently at its highest level in more than 13 years, while the ISM Non-Manufacturing Index is the highest it's been since August 2005. The sky's the limit! But just what do these indices mean again and what is their significance to investors?

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ISM indices

In the ‘Manufacturing ISM® Report On Business®’, the Institute for Supply Management (ISM) publishes the ISM Manufacturing Index, which is definitely the more important of the two indices. It is based on the results of a survey among manufacturers which are members of the ISM Business Survey Committee, in which they are asked to rate the current month's level of business activity as ‘better’, ‘the same’ or 'worse’. The result, also often referred to as the PMI, is the figure that receives so much attention every month.

It is what is known as a diffusion index, i.e. an index which illustrates a change relative to the month before. The calculation is based on the percentage of manufacturers responding with ‘better’, plus half the percentage of those who indicated that business activity was the ‘the same’. For instance, if the percentages of respondents who said business activity was ‘better’, ‘the same’ and ‘worse’ were 20%, 70% and 10%, respectively, then the PMI would be 55% (20% + 0.5 x 70%). If all the respondents had said ‘the same’, the index would come out to 50%. That's precisely why the figures are routinely compared to 50: because any value above that means business activity has improved, while anything below that level indicates a decline.

The methodology used for the ISM Non-Manufacturing Index is exactly the same, but the respondents are businesses in the service sector. Even though they account for 80% of the US economy, this index is still the less important of the two. That's because the manufacturing industry is by nature much more cyclical than the service sector. In other words, changes in economic activity are generally more clearly reflected in the ISM Manufacturing PMI.

Growth predictor

This concludes our ISM refresher course. The graph below shows that the ISM Manufacturing PMI correlates closely with the US GDP growth rate. In fact, it actually changes ahead of the growth figure and therefore has predictive power. Based on the historical relationship, the most recent figure of 60.8, which indicates that a relatively large number of businesses have seen improvement, points to growth of over 6%. Incidentally, we won't reach that level. That's because growth in the service sector, which represents the remaining 80% of the US economy, doesn't fluctuate anywhere near as much.

Impact on the financial markets

The intrinsic predictive power of the ISM Manufacturing Index is what makes it and the statistics in the monthly jobs report the country's most important economic figures. But that's not all it can do. It is important for the financial markets, too. The graph below shows the ISM Manufacturing Index relative to year-on-year changes in the S&P 500 Index. It seems clear that generally speaking − though certainly not always − a higher score signifies a big change in the S&P 500 Index. So a reading of 60.8 would suggest that US stocks could still rise further. An increase in activity usually points to growth in earnings, which is generally good for stock prices. So the ISM Manufacturing Index also provides new and relevant information for stock markets.

It even gives us critical information about bond yields. The graph below illustrates a simple model based on three factors − the Manufacturing PMI, inflation and short-term interest rates − which, up until the era of quantitative easing, offered a pretty good explanation for bond yield levels . As I discussed in detail in one of my earlier columns, that relationship has since been disrupted, but assuming things ever go back to normal, then, based on the latest Manufacturing PMI figure, US 10-year bond yields should now be 4.26%, as compared to 2.32% at the time of writing that article.


So far, I've disregarded one very important detail. That's the hurricanes in Texas and Florida. As paradoxical as it seems, these natural disasters have had a positive effect on the ISM figures. After all, all the damage done to roads, buildings, electricity grids, etc., has to somehow be repaired. That probably means, too, that the ISM Manufacturing Index will drop back down over the coming month or months. The predicted growth spurt, a 40% increase in the S&P 500 Index and a 10-year yield of over 4%, is therefore not totally realistic. However, the underlying ISM data shows that a clear improvement is underway in the US states unaffected by the hurricanes or those only affected to a limited extent. In other words, for the time being, the US economy is doing fine.

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