Institute for Supply Management Purchasing Manager’s Index disappoints

ISM PMIEnlarge GraphThe Institute for Supply Management Index assesses the state of manufacturing in the United States.

The Institute of Supply Management Purchasing Manager’s Index is similar to the other regional PMI indices, however, it covers the entire country. The ISM PMI looks at various business indices, like new orders, production, employment, supplier deliveries, inventory, customer inventories, prices, backlog, exports and imports, and capital expenditures. A reading over 50 means that manufacturing is generally expanding. A reading over 42 indicates the economy in general is expanding.

Manufacturing activity eased somewhat in May and the outlook became more cloudy

The index of overall activity fell to 49 in May from 50.7 in April, for the third consecutive month, indicating contraction in the manufacturing sector for the first time since November of 2012. New orders and production drove the decline, possibly due to lowered government spending. Backlog fell while inventories increased. Prices fell as raw material prices decreased. Employment fell slightly to 50.1, the 44th consecutive increase, although the growth rate is moderating.

PMI can be used to predict GDP growth. The current level for May (49) would correspond to a 2.1% increase in GDP. The average from January to May (51.7) would correspond to a GDP growth rate of 3%.

Implications for home builders

Overall, the report shows the economy stuck in neutral. The drop in employment is certainly discouraging, although the report does not mention the sequester, which has been the excuse du jour for weak employment numbers. Any sequestration-related effect is going to be concentrated in Q2 and then dissipate.

Overall increases in business activity and consumption is starting to drive more business for home builders, like Lennar (LEN), KB Homes (KBH), Meritage (MTH) and Ryland (RYL). Housing starts have been so low for so long that there is some real pent-up demand that will become unleashed as the economy improves. This can create a virtuous circle in the economy as increasing demand raises prices, which re-ignites the wealth effect and increases consumption. The secular story for home builders is optimistic – household formation numbers will be a real wind at their backs.

On the other hand, the shortage of skilled workers could negatively affect margins as business expands. That said, the report noted that raw material prices are falling, and home builders generally reported pricing power and margin expansion. An uptick in raw material pricing or labor costs could negatively affect home builders, but so far they have yet to appear.