Mark Vitner

Manufacturing activity improved slightly in April, with the ISM manufacturing survey rising 0.8 points to 47.1. The ISM survey is a diffusion index and provides insight into the breadth of strength or weakness within the factory sector. A reading above 50 means more manufacturers see conditions in their business improving than deteriorating.

April marks the sixth consecutive month the index has been below the key 50 break-even level, signaling a contraction in the manufacturing sector. Furthermore, the Institute for Supply Management notes any reading below 48.7 is generally consistent with a decline in overall economic activity, and the index has been below that level for the past five months.

Manufacturing has been unusually volatile in the wake of the Pandemic. Supply shortages had greatly extended delivery times, which helped pull the index to extraordinary heights as the economy reopened. Supply chains have normalized across many industries and the decline in the delivery times has tended to exaggerate the slide in the index to the downside.

Producers are actively working down their backlogs and reducing inventories to generate cash.

While manufacturing is showing a great deal of resilience, producers are actively working down their order backlogs and reducing inventories to generate cash. The shift may reflect some caution on the part of manufacturers in lieu of the troubles in the banking sector. There was no mention of credit conditions in the ISM report, however, and the reduction in backlogs might simply reflect normalizing supply chains.

Order backlogs surged following the pandemic, as demand recovered much faster than production. The order backlog index peaked about a year ago and has tumbled more than 20 points since. The latest data show the backlog index at just 43.1, a level that has typically been associated with manufacturing job loss.

Manufacturing activity is still being impacted by echoes from the pandemic, however. One of the reasons backlogs have slowed so rapidly is that deliveries of key raw materials and inputs are now much timelier and there are fewer shortages. One thing that remains in short supply, however, is labor and manufacturers appear to be in no hurry to reduce staff that has been so hard to hire and retain.

Backlogs are likely to continue to contract this year. While the advance first quarter GDP data noted a decline in inventories, all that drop occurred at manufacturers and wholesalers.  Retailers saw inventories increase in the first quarter. That inventory build may be carrying over in the spring. Customers’ inventories rose 2.4 points in April to 51.3, which means more manufacturers report their customer inventories were too high than were too low, likely presaging a further pullback in orders.

On the plus side, export demand may be reviving. The export order index rose 2.2 points in April to 49.8. China’s reopening might possibly be boosting exports.

The 4-point rise in the prices paid component is one of the more notable swings in the April ISM report. The prices paid series had trended down sharply over the past year, as supply chains normalized and there were fewer bottlenecks and shortages. April’s reversal marks a break with this trend and might signal there is less price relief remaining in the pipeline. The Institute for Supply Management noted price increases for foundational purchased materials like steel, copper, plastics, and diesel fuel continue to put upward pressure on material costs.

The 4-point rise in the Prices Paid series signals there is less price relief left in the pipeline.

The ISM survey is one of the last pieces of data the Fed will see before they make their decision on interest rates this week. The FOMC is likely to take note of April’s 4-point rise in the prices paid component, as well as the resilience of manufacturing payrolls. We expect the Federal Reserve to hike the federal funds rate another quarter percentage point and look for the language in the policy statement and Chair’s press conference to suggest the interest rate decision at the June meeting remains an open question.

The advance report on first quarter real GDP came in on the softish side.  Real GDP grew at just a 1.1% annual rate, as continued strength in consumer spending was largely offset by a big drawdown in inventories.

The underlying details of first quarter GDP were generally more positive. The large drawdown in inventories sliced 2.3 percentage points off overall growth. Inventories have been unusually volatile since the pandemic began. Much of the reduction in Q1 occurred at wholesalers and manufacturers. Real final sales to private domestic purchasers, which is our preferred measure of final demand, rose at a 2.9% annual rate in Q1 and is now up just 1.4% year-to-year.

While there is undoubtedly still more work to be done to bring inventories back in line with demand, particularly at retailers, a significant portion of this correction now appears to be behind us. The drawdown in inventories has weighed on industrial production in recent months.

The Fed has achieved a soft landing but needs to maintain it to pull inflation back to target.

Economic growth now appears to have slowed to a pace consistent with a soft landing. Getting there, however, was the easy part. With the core PCE deflator still up 4.9% over the past year, the Fed will likely need to hold growth at its current pace or less for at least a year to bring inflation down close enough to its 2% target that they can begin to ease.

Real personal consumption grew at a 3.7% annual rate, marking the strongest quarterly gain for consumer spending since the second quarter of 2021, when the last round of stimulus checks sent spending into overdrive. Transfer payments also helped support Q1 spending, as a big rise in social security payments fueled a surge in leisure and travel at the start of the year. Light vehicle sales were another bright spot. Spending on big-ticket items surged at a 16.9% annual rate, the strongest rise since the first quarter of 2021. Spending on nondurables rose at a 0.9% pace.

The spending spree lost momentum in February and March, however, and personal consumption will likely rise only marginally in Q2 as consumers have increasingly been tapping credit cards to support spending. Technical factors will also make it harder for spending to add to GDP growth in Q2. Unseasonably mild weather likely pulled some spending forward into Q1, which will weigh on spending this spring.

Consumer spending appears to be losing momentum, as consumers have increasingly been tapping credit cards to support spending.

The slide in inventories subtracted 2.3 percentage points off first quarter GDP growth. Wholesalers and manufacturers accounted for most of the drop, with a jump in shipments of commercial aircraft helping clear out inventories at aircraft manufacturers.

Sustaining a soft landing is difficult, as once economic growth slows that deceleration tends to become self-reinforcing. We are already seeing considerable knock-on effects as a growing number of businesses announce spending cuts and layoffs. Business fixed investment slowed to a 0.7% pace in Q1, with equipment purchases declining at a 7.3% pace. That drop was offset by another large gain in nonresidential structures, much of which appears to be fueled by the Inflation Reduction Act and CHIPs act.

Sustaining a soft landing is difficult, as the deceleration tends to become self-reinforcing.

Government outlays rose strongly in Q1, with federal outlays rising at a 7.8% clip. Defense spending rose at a 5.9% pace, while nondefense outlays surged 10.3%, marking their second consecutive double-digit gain. The surge in federal outlays is at the center of the current battle over the debt ceiling. We suspect some agreement will be reached, restraining nondefense outlays later this year and into 2024. Constraints on federal spending might make the soft landing a little softer but also make the Fed’s job a little easier, possibly even pulling interest rate cuts up a quarter or two.