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ISM Manufacturing Index Drops in May, Shows Contraction

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The ISM Manufacturing Index was released Monday morning and it showed that the manufacturing sector contracted in May. The Index came in at 49.00, less than April's 50.7 and below the consensus forecast of a reading of 51.0.

Comments from the ISM were also negative, especially those looking-forwards. "Several comments from the panel indicate a flattening or softening in demand due to a sluggish economy, both domestically and globally," the ISM said in its press conference after the release. One CEO called the economy "sluggish and pensive" with managers not purchasing more than what they need to meet current demand.

Breakdown

In the report, most of the internals showed weakness in May. The broad Manufacturing Index is a composite index of 10 sub-indexes which look at items such as employment, inventories, new orders, and the backlog of orders. Some indexes are more forward looking while others are more sensitive to the past.

In May, eight of the 10 sub-indexes posted lower figures than they did in April, showing broad-based weakness. Further, the only two sub-indexes to post gains had to do with inventories, gains which generally point to slower production in the future as companies produce less in order to sell out of inventory.

New Orders

The New Orders sub-index, the forward-looking index in the report, dropped to 48.8 in May from 52.3 in April as companies see the rate of orders from customers slowing month over month. Generally, a drop in the New Orders sub-index foreshadows a weaker report in the next month as production slows to meet the lack of order growth.

In terms of production, current production also dropped in May from April as the Production sub-index declined to 48.6 from 53.5 as companies produced less in May. For both the New Orders and Production sub-indexes, both point to continued contraction in manufacturing output both in the past and the next month. However, it is still to be seen if these effects are seasonal as many factories shut down for the summer.

Employment

The Employment sub-index of the ISM report did show expansion in May, but only marginally so. The index dropped from 50.2 in April to 50.1 in May, a sign that manufacturing payrolls were near flat in the month. This should spill over slightly into Friday's Non-Farm Payrolls release to show that manufacturing jobs were flat in the month.

Looking forward to Friday's report, the market expects that the economy added 170 thousand jobs in May, more than April's 165 thousand jobs. The unemployment rate is expected to remain flat at 7.5 percent.

Inventories

Notably, inventories were the only part of the report to post gains, a further negative in the report. The Inventories sub-index rose to 49.0 from 46.5, still showing contraction for the third consecutive month but also showing a much smaller rate of contraction than in April. Declining inventories usually point to higher production in the next few months but slowing rates of contraction imply that the inventory cycle has already corrected.

Further, customer inventories rose in the month, meaning that end demand for manufactured goods could also slow in the following month. Although these inventories contracted for the eighteenth consecutive month, the rate of contraction also slowed meaning that inventories are catching up with demand and should no longer provide a boost to output.

Conflicting Reports

An earlier report on U.S. manufacturing, the Markit PMI, showed that manufacturing in the U.S. actually expanded in May and at a faster pace than in April as the PMI rose to 52.3 from 52.00 on expectations of a flat reading. This Markit report contradicts the ISM's assessment of domestic manufacturing and raises questions as to the true health of the U.S. manufacturing sector.

The ISM report also contradicts global reports from early Monday and from over the previous weekend which showed that other countries saw strength in manufacturing in May. Reports from China to Italy to the U.K. all showed strength in May.

Market Reaction

U.S. shares sold off on the news but quickly erased those gains following the news release. The S&P 500 Index rose 0.05 percent to 1,631.48 and the Dow Jones Industrial Average added 0.69 percent to 15,219.86. Notable gainers in the Dow included Merck (NYSE: MRK) and chip-maker Intel (NASDAQ: INTC), with each company gaining more than 4 percent.

The real action was in currencies as the dollar sold off strongly on the news. The EUR/USD climbed to 1.3021 after selling off as low as 1.2960 and the USD/JPY fell below 100 for the first time since early May. Overall, the Dollar Index dropped 0.45 percent after trading near flat before the news release.

U.S. Treasury yields tightened after the release following the month of May where bonds were routed and yields rose across the curve. The yield on the benchmark 10-year Treasury tightened 3 basis points while 2-year note yields tightened 1 basis point ahead of the weekly 3- and 6-month auctions later Monday.

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