What is the PMI, and why is it important for traders?
A purchasing managers’ index (PMI) can be a valuable and accurate economic indicator. Learn more about what it is, how it’s derived and how you can use it when trading.
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What is the PMI?
In the UK, a purchasing managers’ index (PMI) produced by a company like IHS Markit is an economic indicator representing the rate of expansion or contraction of a specific sector – such as manufacturing, services or construction. Published monthly, PMIs are derived from surveys completed by managers from a range of differently sized companies within a chosen sector.
A headline PMI quoted by the media is often the UK IHS Markit/CIPS manufacturing PMI.
Ideally, PMIs aim at quickly identifying market trends and turning points. Economists, analysts and managers look to PMIs as near-real time measures of the state of an industry. Moreover, given the importance of the manufacturing, service and construction sectors, economists and managers also use it to gauge the performance of the economy as a whole.
In this regard, the advantage that the PMI enjoys over gross domestic product (GDP) data is that whereas official, government-published data may lag behind the economy by three months, the PMI can be used to anticipate these later statistics and to make timely and essential decisions about planned business expenditure. The indices may even inform monetary policy – specifically, interest rates – set by the Bank of England (BoE).
The selection of survey respondents is designed to model the economic sector as closely as possible to produce accurate, truly representative results. A primary benefit of a PMI is that each month’s results are published within the first working week of the following month – putting PMIs amongst the first reliable indicators of prevailing market conditions.
How does the PMI work?
PMI datasets are gathered from a panel of purchasing executives (or a suitable alternative) from several hundred companies within a sector. Questionnaires are completed in the second half of each month, and the results are published as close to the beginning of the next month as possible.
As an example, the UK IHS Markit/CIPS indices are released on the first, third and fourth working days of the month – for manufacturing, services and construction, respectively.
The surveys identify key variables available to purchasing managers, and ask participants to indicate whether they have changed since the previous month. Before exploring these variables and the index calculation in greater detail, however, it’s important to note that a PMI is a diffusion index.
This means that, by evaluating and combining the direction of movement of its multiple components, the index establishes a general trend. Like many diffusion indices, the PMI uses 50 as a base value. The degree to which the PMI is above 50 reflects how fast the sector it focuses on is expanding; conversely, the degree to which it is below 50 reflects how rapidly it is contracting.
At a value of exactly 50, expansion and contraction are in balance, so the sector, on average, is at a constant level of output. More on this further down.
Any index value above 50 indicates an expansion. Major contractions in the PMI – and the UK economy – can be found around the 2009 financial market collapse and in the early stages of the pandemic in 2020.
What does the PMI include?
The variables included in the PMI depend on what type of purchasing managers’ index is in question. As the index is meant to be a representative model of an entire sector – or economy – its components are selected on whether they are indicative of the overall demand for the relevant goods or services. The variables are also weighted according to their relative importance.
As the manufacturing PMI is one of the most significant indices, we can use it as an example. The IHS Markit/CIPS manufacturing
PMI uses the following sub-indices and weightings:
- New orders (30%)
- Output (25%)
- Employment (20%)
- Suppliers’ delivery times (15%)
- Stocks of purchases/inventories (10%)
New orders, output and employment levels account for three-quarters of the weightings, mirroring their importance as indicators for determining the health of the manufacturing sector. For a services sector PMI, suppliers’ times and inventories are omitted, and output levels become the key variable.
How to calculate the PMI
The PMI calculation is a summation of the responses to the survey. Because the PMI is a diffusion index, the magnitude of the change in the variables is left out of the equation. Instead, the survey aims to establish the direction of the trend and how widespread it is.
With this in mind, survey respondents are only given three choices when asked about the performance of each variable when compared to its performance during the previous month. That is, participants can say that the variable has increased, decreased or remained unchanged.
Based on these responses, the value of the PMI is calculated using the below formula:
- P1 = percentage of survey participants reporting an improvement in conditions
- P2 = percentage of survey participants reporting a constant condition
- P3 = percentage of survey participants reporting a deterioration in conditions
The resulting figure will be a value between 0 and 100. At the upper bound, if 100% of the respondents indicated an improvement, the PMI would equal 100 (100% x 1). At the lower bound, if 100% of respondents reported a deterioration, the PMI would equal 0 (100% x 0). Exactly between the two, if 100% of respondents indicated that conditions had remained constant, the rate of change would be zero and the PMI would be 50 (100% x 0.5).
At 50, a sector is neither expanding nor contracting – however, the further away from this baseline the PMI moves, the more rapidly the sector is improving or deteriorating
Why is the PMI important for traders?
The PMI is a valuable source of information for several reasons. A primary advantage it brings to the table is its timeliness – meaning that, in essence, the PMI conveys information about how markets are performing at the time of publishing. In this way, it can be used to make immediate decisions about short-term sector growth, the likely direction of commodity prices and current business expenditures.
In the longer run, accumulated PMI figures can be looked to when anticipating the results of other influential statistics like GDP growth, the inflation rate, employment levels and interest rates. The latter indicators are important considerations when making investment and speculative decisions. A high inflation rate, for example, could induce investors to transfer wealth from cash and fixed-income assets to inflation-resistant assets like property and gold.
How can traders use the PMI in their trading strategies?
It’s important to bear in mind that spread bets and CFDs are leveraged derivatives. While leverage can lower the cost of opening a position, it will also amplify both potential profits and losses. When trading with leverage, it’s vital to manage your risk properly.
When you invest in shares or exchange traded funds (ETFs), you take ownership of the security instead of speculating exclusively on price movements. This means that you’re able to hold your shares for the long term and earn dividends (if offered by the company or fund).
Here are a few things to keep in mind when using a PMI for speculation or investment:
- Stocks: the share prices of firms operating within the sector could move in tandem with PMI figures. If this happened, traders could either buy shares they expect to perform well or go short on stocks they expect to fall in value. You can learn more about how to short-sell stocks here. But, please note, short selling is a high risk trading method – you should fully understand its risks before using it
- ETFs: exchange traded funds are pooled-fund investment vehicles that passively track items like an index, sector or commodity. They often purchase a wide range of stocks to achieve a mirroring of the index or sector they track. The value of an ETF is highly dependent on the value of its constituent stocks – if these rise, the ETF share price will rise, too. And vice-versa. Traders can use the PMI as an input into their decision making on whether to buy or short ETF shares
- Commodities: an improving manufacturing PMI could induce business managers to further expand output. This increase in demand for input commodities, in turn, could drive up commodity prices. The reverse is also true
- Inflation rates: consistently strong PMIs suggest that inflation is on the horizon. Traders could anticipate market reactions to inflation – like the previous example of a flight of cash to gold and property. This could mean an appreciation in real estate investment trust (REIT) prices as well as the prices of gold-based ETFs and exchange traded commodities (ETCs)
- Forex: as noted above, widespread economic growth often leads to inflation. To curb inflation, central banks like the BoE may raise interest rates to dampen spending. When this happens, the local currency may appreciate as investors buy the currency in order to earn the now-higher rate of interest on offer
- PMIs are survey-based, and attempt to measure the performance of the manufacturing, services and construction sectors in near-real time
- A headline PMI often quoted by the media is the UK IHS Markit/CIPS manufacturing PMI
- PMIs are diffusion indices – the value of the index indicates the direction of a trend and how widespread it is. While a value of 50 is neutral, figures above this show an expansion in a sector and figures below show a contraction
- Given the importance of the manufacturing, service and construction sectors, economists and managers also use PMIs to gauge the performance of the economy as a whole
- Traders can use the PMI for both short-term and long-term decision making. In the short term, a PMI could provide valuable info about sector trends; in the longer run, PMI figures could anticipate other influential statistics like GDP growth, inflation, employment and interest rates
- Traders may look to PMIs when speculating on company share prices, the performance of ETFs, the likely appreciation or depreciation of commodity prices, and movements in exchange rates
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