Recommendation: Read between the lines of the latest PMI
Purchasing Managers’ Index
The Purchasing Managers’ Index, PMI, is based on a monthly survey of selected companies that provides an advanced indication of what’s really happening in the private sector economy. A reading above 50 indicates that the private manufacturing sector has expanded, while a reading below 50 indicates that private sector manufacturing output has contracted.
January’s PMI declined sharply, by 5.2 points, from December’s 56.5 level. The most significant decreases were observed in new orders (down 13.2 points to reach to 51.2) and production (down 6.9 points to reach to 61.7).
Both bellwether numbers indicate that consumption and private investment in the U.S. economy are off to a slow start in 2014. Part of the slowdown in manufacturing activity has been attributed to the colder weather experienced in January.
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However, signals from the PMI report were mixed. At the industry level, 11 out of the 18 industries covered reporting expansion and the remaining seven contracted.
A decrease in the PMI implies that manufacturing is contracting, which generally anticipates a decrease in consumption. If sustained, the lower consumption may lead manufacturers to reduce private investment, which reduces the needs for credit and results in lower interest rates—meaning higher bond prices. However, most industries remain in expansion mode. The sharp drop was partially driven by the weather, so the effect should be temporary as long as the weather improves in February. The February PMI will give a better picture of the economy’s direction.
Another potential argument that could have a longer-term implication would be a drop in overseas demand due to the knockoff effects that the Fed’s tapering has had in markets around the world. The stronger dollar and flight of capital into the U.S. may reduce demand across several industries that rely on exports. This is slightly reflected in the drop of the export component of the PMI, which reduced to 54.5 in January from 55 in December.
The bottom line is that if PMI does fall below 50 next month, investors are likely to fly to safety and buy bonds as they take money out of equity markets. This will inflate bond prices and cause interest rates to fall.
To read about another indicator that’s good news for the economy but that will lower bond prices, continue to Part 6 of this series.