May Manufacturing: Pause or Peak

Morris Segall      consumer spending, Economic Growth, economic recovery, economy, manufacturing, slowdown, stock market, trends

The ISM national manufacturing survey for May fell precipitously from April levels, confirming the trend seen in regional manufacturing surveys released over the past two weeks. For a number of reasons, the economy, including manufacturing, is slowing as we proceed into the second quarter. This looks very much like the pattern in economic activity we experienced last year as economic growth peaked last March-April and receded over the summer before reviving in the fall and winter. The reasons for the slowdown this year are primarily related to the surge in inflation since last summer, led by huge jumps in food and energy prices. This has been a restraining factor on consumer discretionary spending and has put pressure on corporate profit margins. It appears the rising level of prices is causing businesses to reduce spending to a greater extent than consumers as the experience of the recent recession has taught businesses to move quickly to cut spending to protect profitability.

Another factor hurting manufacturing currently is the dislocation of orders and shipments from and to Japan as a result of the earthquake and tsunami that has devastated that nation and created havoc with its industrial production and shipments.

In addition, the contraction in economic growth in Europe and ongoing sovereign debt issues are suppressing exports to the weaker economies in the Euro zone.

The unrest in the Middle East and North Africa has dislocated business orders and shipments from that region.

Lastly, the huge decline in shipments reported in the regional and national manufacturing surveys in May, reinforce our belief that a significant factor in May’s manufacturing weakness is due to the severe storms experienced in April and May in the Eastern U.S. and particularly the Midwest. In all of the manufacturing surveys production measures experience some of the biggest declines in the month of May.

It is noteworthy that the category of “No Change” increased significantly in many of the regional and national surveys in May. The increase in this category in May raised the absolute readings in this category to levels that far overshadowed the levels of weakening responses in the surveys. We interpret this that more of the weakness in these manufacturing diffusion indices is due to a “flattening” in the key metrics rather than massive deterioration. In addition, employment in virtually all of the manufacturing surveys remained positive. We acknowledge that employment is a lagging indicator and further weakening in orders, shipments and backlogs will result in weakening trends in employment going forward. Surprisingly, in many of the manufacturing surveys, including the national, respondents were generally positive regarding the future and expected key trends in orders and shipments to improve from May levels. If we are correct in our assessment of the impact of weather on the May surveys, we would concur. Finally, it should be noted that in the national survey, 14 of 18 industries reported growth in May with only 3 industries reporting contraction and those three industries were not major capital goods sectors.

It remains to be seen if the manufacturing growth trends rebound in June and beyond. If so, the capital investment cycle that has led the economic recovery will remain intact. If not, and the May surveys are signaling a weakening trend, then we will have to face the possibility this cycle may have peaked.

We are not optimistic that if such is the case, the federal government will resuscitate it with further stimulus as it did last year. The absence of further strong growth in manufacturing will lead to reduced overall economic growth this year and into next. Because of the flagging growth in manufacturing and net exports so far this quarter, we will be re-evaluating our economic growth projections for the second quarter and the rest of this year. We will evaluate the May employment report before we make our revisions.

The weakness in the May manufacturing report along with a forecast of weak employment growth by the independent payroll processing firm, ADP, caused a major sell-off in the U.S. equity markets on Wednesday that is being replicated by Asian markets Thursday morning and likely will spread to Europe. The world capital markets are nervous about the outlook for world economic growth and financial stability and have become very volatile. Those outlooks will dim further if the U.S. economic recovery stalls out. This is why we have emphasized private equity and the investment themes of merger and acquisition, infrastructure investment and business growth financing in our capital market strategy for the intermediate and longer term (See our website article of January 6, 2011 and our website Economic and Capital Market Presentation of February 2, 2011). Recent events overseas and the fragility of our own economic recovery plus our long term financial difficulties, reinforce this strategy.

Morris R. Segall