Posted by Jeffrey J. Roach, PhD, Chief Economist
Tuesday, April 4, 2023
Overview
- Manufacturing activity last month fell to its lowest since May 2020, as recession fears loom in front of businesses and consumers alike.
- Employment shrunk for the second month as firms cut workers in response to weaker demand. The decline in jobs is a harbinger of a weaker job market in the months ahead.
- Prices paid by factories declined in March and align with the latest reading from the Federal Reserve’s (Fed) preferred inflation gauge released last week.
- Bottom Line: The main takeaway from this report is the job market is slowing so investors should prepare for a weaker job market, higher unemployment, and cooling wage growth in the months ahead. A cooler job market should release some of the inflationary pressure the Fed is working hard to conquer.
All Components Below 50—A First Since 2009
The manufacturing business report reveals the weakness within the manufacturing sector as the economy reacts to high inflation, tighter financial conditions, and uncertainty within the banking sector. For the first time since 2009, all components of the ISM Manufacturing Index were below 50 (levels below 50 signify contraction.) The headline index was the lowest since May 2020, as recession fears loom large in front of businesses and consumers alike. Looking into the details of this report, we can build expectations for Friday’s employment report and those expectations are not great. Factory employment activity shrunk in March as firms cut workers as demand slows. Of course, our modern economy is a services-oriented economy and the manufacturing industry does not impact us as much as it did in earlier periods. However, the deterioration in factory activity is likely a harbinger of broader weakness ahead. In this period of recalibration, the consumer seems to be adjusting the composition of spending and showing persistent demand for services. We could call this the “demand for experiences” and so the ISM Services Index will likely hold up better than the ISM Manufacturing Index.
Manufacturing activity is negatively correlated to the real trade-weighted dollar index. As shown in the chart below, in most years after the Great Financial Crisis, U.S. manufacturing activity declined when the dollar appreciated. Part of the story is the dollar is a safe haven asset, so when the economy slows and domestic manufacturing declines, investors increase appetite for the dollar. Another factor is a stronger dollar allows firms to shift away from domestic manufacturing and use the leverage of a stronger dollar to increase demand for foreign labor and capital.
Indexes are unmanaged and cannot be invested into directly. All performance referenced is historical and is no guarantee of future results.
Inflation Outlook Will Likely Improve
The inflation outlook will likely improve from a weaker job market, higher unemployment, and cooling wage growth in the months ahead. Already, other metrics show inflation has eased. In the inflation dashboard below, the pipeline is clearing as import prices and producer prices are off their peak from last year. March prices paid in the manufacturing sector fell below 50, signaling an outright decline in prices and align with the latest reading from the Fed’s preferred inflation gauge released last week.
What Does It Mean for You?
The main takeaway from this report is the job market is slowing so investors should prepare for a weaker job market, higher unemployment, and cooling wage growth in the months ahead. A cooler job market should release some of the inflationary pressure the Fed is working hard to conquer. The inflation fight is not without its challenges in the near term. Recent news out of OPEC+ producers incited a jump in crude oil prices. The interest for lower oil production is in response to an anticipated global slowdown in demand from tighter financial conditions and weaker consumers. The surprised cut in output makes sense if you believe financial risks are high and a recession is coming soon. In the more immediate term, high oil prices create a conundrum for central bankers on the fight with inflation. However, the modern domestic economy is less reliant on crude and the pass-through effects from higher energy prices are not as pronounced today as they were in previous decades. Obviously, the transportation sector is most sensitive to changes in energy prices in today’s economy, but investors should remember that, in general, a modern services-oriented economy will be less affected by oil price volatility than the historic manufacturing-oriented economy.
We do believe recession risks are elevated and as Chair Powell hinted previously, the economy may endure some pain (of a recession) before inflation is fully conquered.
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