The Battle of the May PMIs
You could not wish for a better illustration of how hard it is to read the economic signals these days than the dueling services sector purchasing managers’ indexes released on Monday.
The purchasing managers’ index (PMI) from the Institute for Supply Management (ISM) was a glum affair. The headline index for May dropped to 50.3 percent, barely holding above the threshold dividing growth from contraction, from 51.9 percent. Economists had forecast the index would tick up to 52. The message was that while the economy grew for the fifth straight month, growth was slowing down to a trickle.
“There has been a pullback in the rate of growth for the services sector. This is due mostly to the decrease in employment and continued improvements in delivery times (resulting in a decrease in the Supplier Deliveries Index) and capacity, which are in many ways a product of sluggish demand. The majority of respondents indicate that business conditions are currently stable; however, there are concerns relative to the slowing economy,” ISM’s Anthony Nieves said in the report.
New orders dropped by a steep 3.2 percentage points to 52.9 percent. Employment flipped from growing to contracting. The barometer of business activity fell half a percentage point to 51.5, edging closer to contraction territory.
The PMI from S&P Global told the opposite tale. It saw business activity across the U.S. service sector grew at a sharper pace in May. Output rose at the fastest rate for just over a year, supported by a strong expansion in new business.
From S&P Global:
The upturn in new orders was driven by improved demand conditions in both domestic and export markets. At the same time, firms stepped up their hiring activity again, with employment increasing at a solid pace. Sufficient capacity to process incoming new business allowed companies to reduce backlogs of work for the first time in four months.
Chris Williamson, the chief business economist at S&P Global Market Intelligence, said that travel, tourism, recreation, and leisure are “enjoying a mini post-pandemic boom.” If you have tried to book a flight to a vacation destination or tickets to a concert lately, that will sound all too accurate.
Williamson says that survey data correspond to an annual GDP growth rate of two percent. Expectations in the S&P survey improved, pointing to robust growth as we head into the summer months.
Inflation, however, remains a problem. Williamson notes:
However, just as demand has moved from goods to services, so have inflationary pressures. While goods price inflation has fallen dramatically in May to register only a marginal increase, prices charged for services continue to rise sharply. Although down considerably on last year’s peaks, service sector inflation remains higher than any time in the survey’s 10-year history prior to the pandemic, bolstered by a combination of surging demand and a lack of operating capacity, the latter in part driven by labor shortages.
Is the Employment Figure a Tell?
So, who to believe? One approach that a lot of analysts employ is simply to average the two conflicting reports. This would suggest that growth in the services sector mildly picked up in May.
There is reason, however, to put more weight on the S&P Global PMI. That comes from the other labor market reports. The ISM report’s claim that employment contracted in May is contradicted by the U.S. Labor Department’s nonfarm payrolls report and ADP’s private sector payrolls report. According to the Labor Department, services-providing employers in the private sector added 257,000 jobs in May. ADP said the services sector added 168,000 jobs.
The better-than-expected May jobs numbers would be hard to square with slowing growth in the services sector. This tilts the evidence in favor of S&P Global’s view that services are experiencing a resurgence rather than ISM’s view of the sector turning sluggish.
Wall Street Capitulates on Rate Cuts
One of our most contrarian views on the economy is in the process of becoming conventional wisdom. We have been pointing out for months that there was very little in the economic data or the statements of Fed officials to support the notion that the Federal Reserve would cut rates significantly this year. Yet bond and derivative prices—and the views of many analysts—insisted that a series of cuts were coming down the pipeline.
“Derivatives markets show investors now expect the Fed’s target rate to sit at 5 percent at year-end, according to Tradeweb, up from just above 4 percent last month,” the Wall Street Journal reported on Monday.
The odds implied by the fed funds futures market now imply just a 45 percent chance of a rate cut by the end of the year and very small odds of multiple cuts. There’s around a 36 percent chance that rates will be where they are now and an 18 percent chance that they will be higher.
We think the odds will continue to move in the direction of further rate increases. While the Fed may still opt to “skip” a rate hike at next week’s meeting, barring an unforeseen negative macroeconomic event, the Fed will likely resume hiking this summer.