Manufacturing Contraction Signals
In September 2019, the Institute for Supply Management (ISM) Purchasing Managers Index (PMI) fell to 47.8%, the lowest since June 2009.1 A reading below 50% generally indicates that manufacturing activity is contracting. The August reading of 49.1% had already suggested contraction, and September’s drop indicated the slowdown was accelerating. The PMI rose slightly to 48.3% in October, marking the third consecutive month of contraction.2
Nearly two-thirds of economists surveyed by the Wall Street Journal in early October said the manufacturing sector was already in recession, defined as two or more quarters of negative growth.3
PMI as a Leading Economic Indicator
The PMI tracks production, new orders, employment, supplier deliveries, and inventories. Because of this, it often predicts the broader economy’s future direction. Historically, manufacturing contractions have preceded recessions. However, services now carry more weight in the U.S. economy than manufacturing.4
During the “industrial recession” of 2015-2016, services offset manufacturing weakness and helped the economy grow. Current signals are mixed. In September, the ISM Non-Manufacturing Index (NMI) dropped to 52.6%, the lowest in three years. It rebounded to 54.7% in October, marking the 117th consecutive month of service sector expansion, but still below the November 2018 peak of 60.4%.5
Global weakness and trade tensions
The slump in U.S. manufacturing stems from several factors: a weakening global economy, a strong dollar, and escalating tariffs on U.S. and imported goods.
In October 2019, the International Monetary Fund (IMF) lowered its forecast for global growth in 2019 to 3.0%, the lowest since 2008–09. The IMF cited trade tensions and slower global manufacturing as key reasons. Simply put, a weaker world economy reduces the global market for U.S. manufacturers.
The strong dollar makes U.S. goods more expensive overseas. It reflects the relative strength of the U.S. financial system and is unlikely to change soon. Tariffs, on the other hand, are a more immediate and volatile issue.
Originally, tariffs aimed to protect U.S. manufacturers. They succeeded in some sectors, but their overall effect has been negative. Tariffs have raised raw material costs and triggered retaliatory tariffs on U.S. exports. For instance, tariffs on foreign steel, first imposed in March 2018, allowed U.S. steel producers to charge higher prices. However, this also increased costs for U.S. manufacturers using steel in their products. Retaliatory tariffs from Canada and Mexico contributed to a $650 million drop in U.S. steel exports in 2018 and a $1 billion increase in the steel trade deficit.9 In May 2019, the U.S. removed steel tariffs on Canada and Mexico, and retaliatory tariffs were lifted in return.10
U.S. manufacturers in every industry may pay higher prices for imported materials used to produce their products. An average of 22% of “intermediate inputs” (raw materials, semi-finished products, etc., used in the manufacturing process) come from abroad.11 Tariffs paid by U.S. manufacturers on these inputs must be absorbed — cutting into profits and/or passed on to the consumer, which may reduce consumer demand.
The uncertainty factor
Along with specific effects of the tariffs, manufacturers and other global businesses have been hamstrung by trade policy uncertainty, which makes it difficult to adapt to changing conditions and commit to investment. A recent Federal Reserve study estimated that trade policy uncertainty will lead to a cumulative 1% reduction in global economic output through 2020.12
On October 11, 2019, President Trump announced that he would delay further tariff hikes on China — including an increased tariff on intermediate goods scheduled for October 15 — while the two sides attempt to negotiate a limited deal. Although a deal would be welcomed by most interested parties, past potential deals have collapsed, and it’s uncertain how any agreement might affect the $400 billion in tariffs on Chinese goods already in place, or the tariffs on goods from other countries.13
Will the slowdown spread?
Manufacturing accounts for only 11% of U.S. gross domestic product (GDP) and 8.5% of non-farm employment, a big change from 50 years ago when it accounted for about 25% of both categories.14-15 However, the manufacturing sector’s economic influence extends beyond the production of goods to the transportation, warehousing, and retail networks that move products from the factory to U.S. consumers. The final output of U.S.-made goods accounts for about 30% of GDP.16
Even so, a continued slowdown in manufacturing is unlikely to throw the U.S. economy into recession as long as unemployment remains low and consumer spending remains high. The key to both of these may depend on the continued strength of the services sector, which employs the vast majority of U.S. workers. It remains to be seen whether the service economy will stay strong in the face of the global headwinds that are holding back manufacturing.
1-2, 5) Institute for Supply Management, 2019
3) The Wall Street Journal, October 10, 2019
4) The New York Times, July 28, 2019
6) International Monetary Fund, 2019
7) National Review, August 22, 2019
8) Bloomberg, March 24, 2019
9) The Wall Street Journal, March 18, 2019
10) Bloomberg, May 17, 2019
11) Federal Reserve Bank of St. Louis, 2018
12) Federal Reserve, 2019
13) USA Today, October 11, 2019
14) U.S. Bureau of Economic Analysis, 2019
15-16) The Wall Street Journal, October 1, 2019
