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Sep 19, 2019

Written by: Keith Prather, Armada Corporation Intelligence

Depending on which media source one prefers to listen to, it seems that we are being pitched two extreme economic conditions. But when we peel back the onion, there is an interesting story at the core of our current economic condition. The U.S. (and the global economy for that matter) is currently in a “tale of two economies.”

The Institute for Supply Management’s August ‘Report on Business’ was a perfect illustration of this dichotomy between two economies. The services sector report, which accounts for 65-70% of the U.S. economy, grew in August with a strong reading of 56.4. This was well above the critical midpoint of 50 (the dividing line between expansion and contraction) and 2.7 points higher than July’s 53.7. Even more importantly, new orders were sharply higher at 61.5, up 8.4 points over 53.1 in the prior month. Services sector demand is strong, and consumers are spending.

However, the manufacturing side of the house is telling a different story. The manufacturing sector experienced contraction for the first time since 2016 in August. The ISM’s PMI reading came in at 49.1, down from 51.2 in the prior month. What is perhaps worse is that the New Orders component was down sharply at 47.2. U.S. manufacturing is seemingly struggling.

Misery loves company. When we look at the largest U.S. trading partners, we see a lot of weakness in their manufacturing sectors. In the latest global manufacturing reports from each country, only 6 of the 18 top trading partners with the U.S. had expanding manufacturing sectors. Of the 12 countries that were contracting in August, at least five were in deep contraction with PMI’s under 48 points (Germany, UK, Taiwan, Switzerland, and Hong Kong).

Why is the manufacturing sector struggling if the services side of the economy is still consuming at a fast rate? As a major importer and driver of growth around the world, wouldn’t U.S. consumption create reciprocal demand for manufactured goods from all over the world? How can the U.S. and global manufacturing sectors be in contraction at the same time if the services side of the equation is so strong?

The answer could be in the management of inventory. Two events continue to rattle global businesses and push companies to get out in front of risk, and it has affected manufacturing demand in this part of the cycle. Companies attempted to “get out in front” of Brexit and U.S./China trade war deadlines throughout 2019. Both issues have created a significant number of “deadlines” that have come and gone, and in most instances the “can was kicked down the road”. But, each deadline forced companies to make decisions to avoid risk.

Businesses don’t standstill. Executives loaded up on inventories to get ahead of Brexit and tariff risk ahead of each of those deadlines. Inventories in the wholesale sector surged 7.1% higher year-over-year through July. That might not sound significant, but in a world where supply chain sophistication has allowed companies to operate in “lean” environments where four weeks of inventory is “normal,” sitting on 6-8 weeks of inventory is a significant change in strategy. It nearly doubles the length of time between new orders. And it creates risk. It ties up capital and increases the risk of obsolescence and perishability (which leads to margin erosion as companies are forced into deep discounting to move products that are overstocked).

As products are consumed and new orders flow in, manufacturers and wholesalers are fulfilling those orders with existing inventories. This reduces the need to fire up assembly lines, procure new raw materials, hire workers, order products from abroad, etc. It creates a manufacturing “stall,” which is what we see in the data.

The U.S. consumer is still doing well. Employment fundamentals continue to show low unemployment, ample job openings, and slowly strengthening wage growth (which is now outpacing inflation). This environment supports increases in consumer spending and consumption, the fuel that propels about 70% of U.S. GDP.

Inventories are dropping and look to be falling into a more balanced state. Products are being consumed, and companies will begin to reset their supply chains and start the reorder cycle once again. That could happen before the end of the year, and global PMI’s will start to pick up momentum. At that stage, the economic outlook narrative might change, and there could be some renewed optimism going into 2020 despite the usual dark cloud overhang from a contentious Presidential election.

If there is a favorable Brexit solution by Halloween and progress in U.S./China trade talks, supply chains will revert back to more “normal” cycles, and the services and manufacturing sectors will fall back into alignment.

Keith Prather is a Managing Director of Armada Corporate Intelligence. If you want information on a weekly basis like the article above, Armada publishes the Black Owl Report, an executive intelligence briefing that focuses on corporate risk. The Black Owl Report is just $7 a month and more information can be found here:

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