ISM Data Show Contracting Employment and Accelerating Prices: Mar. 1, 2023

The Federal Reserve’s goal of taming inflation while maintaining a strong labor market hit a setback this morning: Manufacturing ISM data shows the resurgence in price increases is strong while manufacturing employment is contracting.

While still assessing yesterday’s batch of troubling economic data, investors are facing the cold and somewhat contradictory reality of a continuing decline in manufacturing, a big jump in input costs and a loss of jobs. February’s Manufacturing ISM PMI remained in contraction territory despite climbing to 47.7, which fell short of the forecasted 48 headline number but was up from 47.4 in January. The lower than 50 number shows that manufacturing is contracting, which implies that demand destruction is occurring thanks in part to the drastic, quick shift from accommodative to restrictive monetary policy alongside the transition from goods spending to services. In a perplexing development, however, the ISM Manufacturing Prices Paid Index, at 51.3 for February, has made a huge upward leap from January’s 44.5 number. Four consecutive months of declining input prices have now been reversed as buyers acquiesce early in the new year to seller explanations of structurally higher inflation across their supply chains.

As higher prices hit U.S. goods producers, manufacturers are tightening their belt by cutting back on labor, with the ISM Manufacturing Employment Index falling from 50.6 in January to 49.1 in February. Higher financing costs, furthermore, have caused a 0.1% month-over-month decline in construction spending, despite the expectation for an increase.

Markets started today’s trading between modest gains and losses for equities; however, the mood transitioned after the 10 a.m. release of the daunting ISM report. Yields took the spotlight with the 10-year rising 9 basis points (bps) above pivotal resistance at 4% and the 2-year reaching fresh cycle highs of 4.9%. The S&P 500 Index is down 0.5% to 3950, right above the pivotal 200-day moving average at 3940. Interest rate sensitive tech is faring much worse than cyclical industrials with the Nasdaq Index down 0.8% and the Dow down only 0.1%. Crude oil is down 0.1% to $77 a barrel despite sizzling hot economic data from China earlier this morning. China’s strong economic recovery pales in comparison to rising U.S. inventories and buoyant supply as the Kremlin’s oil output recovers to pre-sanctions level, at least for now. The dollar index is down 25 bps against the backdrop of a stronger euro driven by accelerating inflation and significantly higher yields.

Supply Chain Woes Persist

Supply chains continue to be a major hurdle in controlling inflation. Broadly speaking, shipping costs from Asia to the U.S. have receded after climbing dramatically during the COVID-19 pandemic, but transatlantic shipping prices are still high. Other factors are contributing to higher logistics costs.

• Many companies are still subjected to prices imposed by long-term shipping contracts signed in 2021 and 2022, so the recent declines in Asia to U.S. shipping fees have had a muted impact on businesses’ costs, says Jason Miller, an associate professor of supply-chain management at Michigan State University.
• A tight labor market has resulted in first-year truck drivers earning more than the top paid drivers did just four years ago, according to the National Transportation Institute.
• Excess warehouse capacity is also tight, resulting in warehouse rents increasing 10.6% year-over -year (y/y), according to WarehouseQuote. While businesses may begin to work off excess inventory, higher financing costs have reduced new construction, so warehousing capacity is expected to remain tight in the foreseeable future.

Semiconductor and EV Industries Go on Construction Binge

Overall construction is slowing, but the semiconductor and electric vehicle industries are exceptions. Supply chain issues combined with U.S. Chip Act subsidies for semiconductor manufacturers and the Inflation Reduction Act’s subsidies for electric vehicles have ignited a construction boom within those industries. Highlights include the following:

• Micron Technology plans to invest more than $100 billion over 20 years for building a memory chip fabrication plant in upstate New York. Micron is also building a fabrication plant in Idaho.
• Taiwan Semiconductor Manufacturing (TSMC) is also taking the plunge with plans to build a second chip plant in Arizona that will boost the company’s investment in the state from $12 billion to $40 billion.
• Other semiconductor companies that are rushing to build factories include GlobalFoundries, Intel, Samsung and Texas Instruments.
• The Southeast has become the “battery belt” as electric vehicle manufacturers have flocked to the region for new construction projects.
• According to NPR and Atlas Public Policy, the EV industry is pumping at least $73 billion into building factories across the U.S.

A concern I’ve voiced early last year, as valuations can’t sustain themselves due to the market backdrop shifting from low rates and high liquidity to the exact opposite: high rates and low liquidity. “Monthly mortgage payments are too damn high.”

Those developments are bucking a broad decline in the real estate industry. The National Association of Real Estate Investment Trusts, or Nareit, reports that high interest rates and weak valuations resulted in REIT capital raising in the third quarter of 2022 sinking to its lowest level since 2009. Separately, home prices are in a free fall with the S&P Case-Shiller Index having declined for six consecutive months. A concern I’ve voiced early last year, as valuations can’t sustain themselves due to the market backdrop shifting from low rates and high liquidity to the exact opposite: high rates and low liquidity. “Monthly mortgage payments are too damn high.”

Manufacturing Contracts as Consumers Struggle

Brick and mortar retailers are struggling as inflation and higher interest rates cause shoppers to reduce discretionary spending. This morning’s earnings releases from Kohl’s and Lowe’s illustrated this trend.

• Sales during Kohl’s fiscal fourth quarter ending January 28 fell 6.6% y/y, substantially worse than analysts’ estimate of a 3.7% decrease. The company provided steep discounts during the quarter to shore up weakening sales of apparel. Those discounts contributed to Kohl’s reporting a loss of $2.49 a share compared to the 98 cents of profit per share expected by analysts.
• Home improvement retailer Lowe’s is also struggling with weakening sales as consumers have increased spending on traveling and entertainment while cutting back on purchasing goods. The company’s fiscal fourth quarter sales of $22.45 billion was up from $21.34 billion in the same quarter last year but missed the $22.69 billion expected by a Refinitiv survey of analysts. The recent period had one more week then the fourth quarter of 2021. Without the extra week, Lowe’s total revenues would have declined y/y. Additionally, the company’s same-store sales fell 1.5% and same-store sales in the U.S. declined 0.7%. Its adjusted earnings per share of $2.28, however, beat the consensus expectation of $2.21. Lowe’s estimates that same-store sales during its fiscal 2023 year could be flat or maybe decline as much as 2% compared to fiscal year 2022.

Rather than stock up on household goods consumers are traveling and setting out for the high seas. Norwegian Cruise Line (NCL) yesterday reported record-high cruise bookings, but it generated a fourth quarter loss of $1.04 per share, more than analysts’ estimates of 85 cents. NCL attributed much of the loss to inflation substantially increasing its operating costs.

Upscale Brands Continue to Grow

Inflation tends to be less impactful for higher income individuals because they spend a smaller percentage of their income on non-discretionary items. Retailer of upscale clothing Abercombie & Fitch has benefited from this tendency with its fourth quarter net sales climbing 3% on a reported basis and 5% on a constant currency basis. Inflation may not be impacting sales considerably for the company, but rising input costs, including cotton, have contributed to Abercombie & Fitch’s gross profit rate of 55.7% dropping 260 basis points y/y.

Rough Waters Ahead

Today’s ISM report may be providing early signals of a softening labor market. Businesses compelled to deal with contracting margins on the back of slowing sales and structurally higher inflation eventually have to trim costs as demand slows. As monetary policy lags are long and variable, the economy may soon begin to digest the initial 475 basis points of Fed tightening. Investors will have to price in the economic deceleration occurring from past rate hikes while they assess the effects of future rate hikes. In fact, Fed tightening expectations continue to rise, with odds of a July terminal rate of 5.63% rising to a whopping 39%. With Fed Chairman Powell steering the vessel, investors are left to wonder if the captain and his crew decide to pick up the pace and raise by 50 basis points at the next meeting. Happy March! 

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