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Non-manufacturing index hits 5-month high, good for homebuilders

The Institute of Supply Management non-manufacturing index assesses the state of non-manufacturing business in the United States

The Institute of Supply Management (ISM) Purchasing Manager’s Index (PMI) is similar to the other regional PMI indices, but it covers the entire country. It’s the sister index to the ISM Manufacturing Purchasing Managers Index. The non-manufacturing ISM 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.

ISM non-manfEnlarge Graph

Business activity eased somewhat in April and the outlook became more cloudy

The index of overall activity rebounded in July to hit a five-month high. New orders and business activity drove the increase. Prices paid rose, while employment fell. Backlog and inventory fell. Overall, the report shows the service sector’s growth is accelerating.

Implications for homebuilders

The homebuilding sector is highly sensitive to overall macroeconomic growth—especially job creation. While employment did tick down in the survey, it was still positive, meaning that employment is still growing, just not as fast as it did last month. The overall tone of the report was generally optimistic. Businesses generally feel like the second half of the year will be stronger than the first. This is also the Fed’s forecast.

Overall increases in business activity and consumption are starting to drive more business for homebuilders, like Lennar (LEN), KB Homes (KBH), Toll Brothers (TOL), and NVR. Housing starts have been so low for so long that there’s some real pent-up demand that will unleash 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 homebuilders is optimistic—household formation numbers will be a real wind at their backs.

That said, we have seen from a couple builders—PulteGroup (PHM) and Beazer (BZH)—that the first-time homebuyer may be backing away a little due to higher rates and higher prices. While demographic considerations will almost certainly dominate (even in lousy economies, people still get married, have kids, and move out of their parents’ house), the growth could be taking a bit of a breather.

The survey noted increases in commodity prices and most of the builders have noted a shortage of skilled labor. If this continues, the shortage of skilled workers could negatively affect margins as business expands. While margins are still expanding for the group, it’s worth watching to see if we’re close to a high water mark. If that’s the case, then earnings growth will have to come from the top line.

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