Purchasing managers' index: how not to read this leading economic indicator
Economic indicators such as the purchasing managers' index (PMI) plummeted in the first quarter of 2020. PMIs are useful to gauging changes in economic activity, but their readings are often misunderstood.
What is the purchasing managers’ index (PMI)?
The purchasing managers’ index (PMI) is an economic indicator that is published monthly and captures how the managers of companies that are surveyed believe conditions affecting their business changed over the month. PMIs are a useful tool to assess how the overall economy is performing and are more timely than other economic data such as retail sales and industrial production.
PMIs are available for countries all over the world and are usually cover two parts of the economy: manufacturing and services. You can see the latest PMI data using Daily FX’s economic calendar.
The two main PMI providers are Markit Group and the Institute for Supply Management (ISM). Each month, they ask business mangers a series of questions which are answered in the form of 'higher', 'lower' or 'the same' as the previous month. For example:
'Are your company’s new orders higher, lower or the same as one month ago?'
Each answer gets weighted by the following values:
Higher = 1.0
No change = 0.5
Lower = 0.0
The survey answers are then aggregated and a diffusion index is created. The PMI can range from 0.0 to 100.0, with 50.0 as the base value. A reading of 50.0 suggests that overall business activity was unchanged compared to the previous month.
If every manager that is polled answers 'higher', the index would be 100.0 for the month. If half the respondents answered 'higher' and other half reported 'no change', the PMI would be 75.0.
A higher PMI reading does not necessarily mean improving economic conditions
Recent readings of PMIs show steep declines in business activity as a result of enforced lockdowns by governments around the world.
For example, the manufacturing PMI for China sank to 35.7 for February. Since then, China has been started to ease its lockdown restrictions after reported cases and deaths from Covid-19 have fallen from their peak. In March, the PMI index came in at 52.0.
This prompted some market commentators to suggest China was experiencing a v-shaped recovery. But they are wrong!
Figure 1: China manufacturing PMI
A PMI reading of 52.0 implies a very, very small improvement in business activity compared to the prior month. Therefore the jump in the China manufacturing PMI from 35.7 to 52.0 implies that the Chinese economy was in just as bad shape in March than it was in February, and definitely does not point to a v-shaped recovery.
The PMI chart therefore plots the rate of change of business activity. The lowest point on the chart shows the month in which business activity deteriorated at the quickest pace.
Will PMIs show further weakness in Europe and the Americas?
Whilst there are tentative signs of improvement in the number of reported cases of Covid-19 in Europe and the Americas, these regions are about a month behind China and other Asian countries such as South Korea and Japan.
The UK is heavily reliant on its services sector which is estimated to make up around 80% of gross domestic product. For March, the IHS Markit/CIPS UK Services PMI fell to 34.5 – a faster rate of contraction than during the 2008/09 financial crisis.
When PMI data for April is released on 1 April, it will be interesting to see whether to UK economy contracted further, which would be shown by another reading below 50.0, or if the weak conditions remained unchanged with a reading of around 50.0. It is highly unlikely that we will see an improvement in business conditions for April given that lockdown restrictions remained in place for the whole month.
S&P 500 returns after a sharp drop in the US manufacturing PMI
The stock market tends to lead the economy and we have already witnessed an incredible recovery in stock markets even while it is still an unknown as to when the economy will be fully functioning once again. The US stock market, which for this analysis we use the S&P 500 index, has already seen a remarkable +26% recovery after witnessing a 34% drop during the first quarter (Q1) of 2020.
Looking back since the 1980’s shows that when the ISM manufacturing PMI fell below 40.0, which it has done so on four separate occasions, 12 month returns for investors averaged +15.1%.
Figure 2: S&P 500 returns after PMI falls below 40.0
|ISM manufacturing PMI||1-year return||5-year return (annualised)|
Whilst every crisis is different, history points to double digit annual stock market returns for the five year period following a sharp decline in the ISM manufacturing PMI.
While we certainly do not know if we have already seen stock market make their lows during this current crisis, the data suggests that it pays to be bullish on stocks when there is panic in the streets.
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*Survey average for April 2020 ISM Manufacturing PMI
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