Why a strong ISM services index caused a bond sell-off

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 the sector in question is generally expanding.

MR-ISM non manufacturingEnlarge Graph

Services activity rebounded in October in tandem with the ISM manufacturing index

The index showed that overall activity in the non-manufacturing sector increased for the 46th consecutive month and that growth is accelerating. The manufacturing sector is outperforming the services sector. The business activity index hit 59.7% and the employment index jumped from 52.7 to 56.2. The best-performing sectors were management, retail, and IT. Arts, entertainment, and recreation performed the worst.

The strong ISM number was one catalyst for the bond sell-off, as the market is becoming nervous about strong economic data ahead of the jobs report on Friday. Note that bonds sold off on the stronger-than-expected ISM report the week before. While no one is expecting a blockbuster jobs report on Friday, a mildly strong one in spite of the shutdown will bring a December tapering back into the picture.

Implications for homebuilders

Altogether, the report shows the economy is beginning to pick up steam, although the employment indicator dropped, which is discouraging. The Fed had been anticipating that growth would accelerate into the second half of the year. Perhaps this is some evidence that it’s playing out the way the Fed anticipates. That said, all bets are off due to the government shutdown and the debt ceiling.

Overall increases in business activity and consumption are starting to drive more business for homebuilders, like Lennar (LEN), KB Home (KBH), Toll Brothers (TOL), Standard Pacific (SPF), and NVR Homes (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 reignites the wealth effect and increases consumption. The secular (long-term) story for homebuilders 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. In fact, the ISM manufacturing noted manufacturers were seeing higher raw material pricing without a corresponding increase in finished good pricing. Homebuilders could be facing rising material and labor costs.