Conclusion: The Prices Paid component of the ISM Manufacturing Survey suggests that margin compression cometh, as this component accelerated from a December reading of 72.5 to a January reading of 81.5 and is likely heading higher.
The Institute of Supply Managers came out with their Purchasing Managers Index (PMI) Tuesday and it came in at a solid reading of 60.8 for January 2011. This was a sequential increase from the December 2010 reading of 58.5. Further, this was the highest reading since May 2004. There is no doubt that at face value this report was a bullish indicator for economic activity in the U.S. manufacturing sector.
As a refresher, this survey is given to more than 400 purchasing managers around the country, who are chosen based on industry and geographic diversification. The supply managers answer questions based on five subsectors: production level, new orders, supplier deliveries, inventories, and employment levels. The supply managers are asked to answer “better,” “same,” or “worse” for each category, which the ISM then diffuses into an overall reading. A reading over 50 typically implies an economic expansion.
In conjunction with the reporting the PMI, the ISM reports a number of other surveys in its index with a key one being Prices Paid. While Keith highlighted this immediately after the report, we wanted to take a deeper dive into this number.
We show this below, but Prices Paid accelerated from 72.5 in December 2010 to 81.5 in January 2011. This is up 353% since December 2008 and back to levels last seen in the summer of 2008 when oil was testing $150 per barrel. While we won’t debate that the headline PMI number is, on the margin, positive as an indicator of economic activity, the Prices Paid component is worrying as it pertains to future corporate margins.
Interestingly, the ISM also included five comments in their report from various survey respondents. We’ve You Tubed these comments below as they are very indicative and supportive of what we are seeing in the economy. The comments are quoted below:
- "Continued weakness in the dollar is having a negative effect on the components we purchase overseas and increasing our material costs." (Transportation Equipment)
- "Lead times are increasing significantly, and commodity pricing is starting to increase." (Chemical Products)
- "January/February sales will be decent, and we see a strong March. We're cautiously optimistic but reluctant to hire." (Fabricated Metal Products)
- "Business is still slow with no pick-up in sight." (Furniture & Related Products)
- "We continue to see unexpected strength in many non-U.S. markets." (Fabricated Metal Products)
While this is anecdotal, these were the only five comments in the release and they are quite telling – “negative impacts from the U.S. dollar” . . . “commodity prices increasing” . . . “reluctance to hire” . . . “business is slow.” It seems the headline number may not accurately reflect the underlying business conditions.
The key issue with supply managers reporting higher prices paid is the potential impact on future corporate margins. Historically, studies have shown a four quarter lag in margin compression after the Prices Paid component of PMI accelerates to current levels. In the second chart below, we’ve outlined broad corporate margins in the U.S. currently. The takeaway is that they are currently near all-time high levels.
With an acceleration in commodity costs that is now being reflected in the Prices Paid component of the Purchasing Managers Index, it seems unlikely that near-peak corporate margins can be sustained. A corollary to this point is, of course, that the forecasted 15% growth in 2011 for SP500 earnings is also increasingly unlikely as margins come in.
Perhaps the CEO of Whirlpool said it most succinctly yesterday on his firm’s earnings call: “And finally, we expect raw material inflation to drive higher costs and therefore have an unfavorable impact on operating results.”
Daryl G. Jones