Manufacturing sector slows

The June ISM survey of the manufacturing sector came in substantially below expectations (49.7 vs. 52). This is the first time it's been below 50 (the point at which, according to the PMI people, the manufacturing sector begins to contract instead of expand) since Dec. '07, which was just before the last recession began. As my chart above suggests, however, it takes a reading below 46 before the entire economy is likely to be contracting. Today it is saying that with the manufacturing sector having weakened—with most of the impact related to Eurozone problems—the economy is likely growing at a 2% pace or perhaps a bit less. That happens to be where the current consensus of opinion is, I believe, so in that sense today's ISM report is not new news.

I note that the correlation between the manufacturing sector and real GDP has not been as strong in recent years as it has been during other business cycles, with manufacturing being much stronger in general than the overall economy. Perhaps that pattern is changing (i.e., manufacturing now tending to move more in line with the rest of the economy), but even so today's news is not a clear-cut recession indicator. It mostly confirms what we already know: the U.S. economy is growing at a very slow rate, and the troubles in Europe are one big source of anxiety.

The export sector is the main source of weakness in the manufacturing sector.

Weak commodity prices are the main source of the decline in the prices paid index.

The employment index continues to be a bright spot in the manufacturing sector. Why would this be so strong if the overall manufacturing sector is supposedly on the verge of contraction? One guess is that the weakness that is surfacing in the PMI indices is being exaggerated by the very visible problems in Europe. Everyone knows that the Eurozone is experiencing tremendous difficulties, and that a good part of the region (the southern region) has been in recession for awhile now. Yet the Eurozone accounts for only 12% of U.S. exports, with Spain, Italy, Portugal and Greece accounting for only a small fraction. Even if those economies were in total collapse the impact on the U.S. economy would be minor. But right now the specter of a Eurozone collapse has had a debilitating impact on everyone's confidence—thus the weak PMI reports, which are at times influenced by psychology. The employment index may be less influenced by psychology and instead more driven by facts; after all, manufacturing payrolls have been steadily increasing so far this year, rising at a 3% annualized pace.

This last chart compares the ISM indices for the U.S. and the Eurozone economies. Is the Eurozone tail finally beginning to wag the U.S. dog? That has been and remains a key question. I'm not terribly worried, and I note that Eurozone swap spreads have improved substantially so far this year, suggesting there has been meaningful improvement in the Eurozone fundamentals.