A new manufacturing index from RSM has been declining on trend for 14 months since peaking in June 2018, and has been negative since December of last year. The performance of the new measure, the RSM US Manufacturing Outlook Index, suggests the potential for negative growth in manufacturing sales in the months ahead.
The composite index is based on surveys of business sentiment conducted by six regional Federal Reserve banks. The index can be considered representative of the general direction of national manufacturing activity.
The RSM MOI is reported as a Z-score (the number of standard deviations that manufacturing sentiment is above or below normal conditions). A Z-score value of zero indicates normal levels of sentiment, while a Z-score of greater than 2.0 or less than negative 2.0 represents periods that are significantly different than normal levels of sentiment and indicative of bubbles or burst bubbles, both of which are cause for concern.
The chart above shows the RSM MOI was significantly below normal levels of sentiment in the periods immediately preceding the recent recessions of 2001 and 2007-2009, and during the commodity price crash of 2014-2015. In the current cycle, the index turned negative in December of last year, which points to a U.S. economy potentially nearing the end of the decade-long recovery from the Great Recession.
The ISM benchmark
The Institute for Supply Management’s Purchasing Managers Index (PMI) is the benchmark business conditions index for the financial world. It often leads changes in the direction of the business cycle. Consequently, knowing the pivot points of the economy should lend insight into the direction of monetary and fiscal policy and the potential returns on asset prices.
MIDDLE MARKET INSIGHT: The monthly RSM US Manufacturing Outlook Index (MOI) and Institute for Supply Management’s Purchasing Managers Index (PMI) should be viewed as essential guides for middle market decisionmakers, helping to gauge future supply and demand requirements.
In its June 2019 Report on Business, the ISM reported that while the manufacturing sector continues to grow, June was the third month in a row of “slowing expansion,” a trend that began in September 2018.
The ISM index is based on a monthly national survey, with the ISM diffusion index reported on the first business day of the following month. Respondents are asked to evaluate business conditions, answering if those in the current period are better, worse or about the same than in the prior month. The percentages for those three choices are determined, and the diffusion index is calculated such that a value of 50 represents no change from the prior month, with the distance above or below 50 representative of the direction and rate of change.
Building a better mousetrap
With the ISM entrenched as a benchmark manufacturing sentiment gauge, the question is: “Can we come up with a better mousetrap?” We’ve calculated RSM MOI by combining business condition surveys maintained by six regional Federal Reserve banks. The RSM MOI has a correlation of 0.90 with the ISM index (see chart below).
More important, the RSM MOI has higher rates of correlation than the ISM index with respect to the growth of real (0.73) and nominal (0.68) manufacturing sales and the growth of real GDP (0.65) (see chart below).
Cross-country outlook for manufacturing
Because of geographic differences and the dominance of local industry, it is expected that there would be variance in sentiment levels by region and industry composition. For example, business sentiment in Texas and western New York is probably more dependent on energy prices than other regions, while sentiment in the Kansas City region is more dependent on the outlook for commodity markets. As would be expected, the inclusion of additional regions into our RSM MOI increases its correlation with national manufacturing sales and overall economic growth.
A couple points to note: (1) the outlook for manufacturing in each of the six sectors is substantially lower than the post-crisis peaks in sentiment; and (2) the outlook for manufacturing in each of the regions has been declining on trend since the summer of 2018.
Appendix: Calculating the RSM Manufacturing Outlook Index
The RSM MOI is a composite of diffusion indices from monthly surveys conducted by six regional Federal Reserve Banks:
- Philadelphia Fed: Manufacturing Business Outlook Survey
- New York Fed: Empire State Manufacturing Survey
- Richmond Fed: Fifth District Survey of Manufacturing Activity
- Chicago Fed: Midwest Manufacturing Activity Index
- Dallas Fed: Texas Manufacturing Outlook Survey: General Business Conditions Index
- Kansas City Fed: Manufacturing Survey: 10th District Manufacturing Activity
The survey results are normalized relative to a base period of pre-Financial Crisis behavior (January 1994 to June 2008) and then averaged. The normalized values of the survey average are reported, representing the number of standard deviations that business conditions are perceived to be above(+) or below(-) normal levels.
[Note: the normalized values are referred to as Z-scores, with values above 1.96 or below -1.96 are considered to be significantly different than the average level, with zero defined as normal.]