ISM manufacturing gauge is a noisy indicator of recessions

| September 6, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The ISM factory survey in August slipped below the breakeven 50 mark, suggesting manufacturing is officially in contraction. But a sub-50 mark on this gauge does not necessarily provide a reliable harbinger of broader recession. Manufacturing currently represents only 8.5% of employment and a little over a quarter of economic activity. But history shows manufacturing can contract without dragging the rest of the economy with it.

When manufacturing meant the economy

Decades ago, the manufacturing sector represented the largest and most important segment of the economy.  Business cycles usually turned on inventories.  Softening demand would lead to a buildup in inventories, factories would have to curtail production to pare down the excess stocks leading to extensive layoffs, and the economy would turn down.

It has been decades since that dynamic was the dominant driver of economic growth. Even so, reflecting days of yore, it seems that there is a nearly infinite supply of economic indicators measuring factory activity, which keeps the sector in the focus of financial market participants. Perhaps the most prominent of all manufacturing indicators is the storied ISM factory survey, which has about a 70-year history and has traditionally been viewed as a key indicator for the economy.  But the indicator has been noisy.

Episodes of sub-50 ISM manufacturing readings in the distant past

Going back to the glory days of the manufacturing sector, the decades after World War II, the ISM Manufacturing composite index slid below 50 before or during every official recession.  However, it also dipped below 50 several other times when the overall economy did not contract.  In most of the instances of false positives, it is obvious in retrospect that the economy might not have contracted. Several episodes below 50 were brief, and the gauge bottomed out at higher levels than in episodes when a recession actually followed.  However, in real time, this is a luxury.  All we know today is that the ISM gauge has slipped modestly below 50 for a single month.  Historically, even when the manufacturing sector was the dominant force in the economy, a month below 50 was not always a signal of recession.

The US has seen at least three instances of an honest-to-goodness downturn in the factory sector in the distant past that did not lead to an official recession.  In 1951-1952, the ISM composite gauge spent more than a year below 50 and dropped as low as 36.7 without a subsequent official recession.  Likewise, in 1967, the ISM index was below 50 for seven straight months, reaching a low of 42.8, without triggering a recession.  Finally, in 1985, the ISM index inched below 50 for eight straight months, though the measure bottomed out at 47.1, only modestly below the breakeven point.

Modern times

 The ISM manufacturing gauge fell well below 50 for an extended period in each of the last three recessions: 1990-1991, 2001 and 2007-2009.  However, there have been several other false positives over the past 30 years as well.  Interestingly, both of the 1990s mini-easing cycles that Fed officials have cited as potential models for the current period included a dive below 50 for the ISM factory index.  There was also a stretch of sub-50 readings in early 2003, a period when the Fed eased once because it was worried about a double-dip recession that ultimately did not materialize and below-target inflation.  Most recently, the manufacturing sector went through a mini-contraction in 2015-16 after the dollar strengthened sharply, but consumer spending sustained the economy at roughly a 2% growth clip.  Exhibit 1 shows all of the episodes over the past 30 years when the ISM manufacturing gauge dropped below 50.

Exhibit 1: ISM manufacturing gauge contractions

Source: ISM, NBER

Over the past 30 years, there have been five false positives not including instances where the ISM dipped below 50 for one or two months (Exhibit 1).  It is reasonably easy to see in retrospect that the three instances where the economy did suffer through a recession had longer stretches of sub-50 ISM readings and also had lower troughs.  However, the question at hand is whether the ISM factory gauge dropping below 50 is an accurate leading or even coincident indicator of a recession, and the historical record includes numerous false signals.

To be fair, in several of the instances cited above, the factory sector could be accurately described as enduring a contraction, even as the overall economy continued to grow.  In 1985 and again in 2015-2016, a steep appreciation in the dollar hit the factory sector hard but was not sufficient to plunge the overall economy into a downturn, a scenario that appears to be occurring again currently.

The bottom line is that while the 49.1 reading for the ISM Manufacturing gauge in August is disturbing, it is too soon to say whether it is signaling a recession in the near future.

ISM non-manufacturing gauge is more dependable

The ISM Non-Manufacturing index does not have the same lengthy historical record, as it only goes back to 1997, but over the past 22 years, it has done a much better job of signaling recessions.  In fact, over the history of the ISM Non-Manufacturing survey, the composite gauge has only fallen below 50 in periods when the economy did suffer a recession (see Exhibit 2).

Exhibit 2: ISM non-manufacturing gauge contractions

Source: ISM, NBER

In fact, there was only a single sub-50 reading of this measure that occurred at a time not accompanied by a recession: March 2003, the month of the second Iraq War (and even that was a marginal 49.1).  Thus, sub-50 readings for the ISM non-manufacturing index are a surer indication of recession.  However, the ISM non-manufacturing measure is apparently not a leading indicator, as in each of the two recessions cataloged above, the ISM index initially dropped below 50 a month after the official start date of the recession.


Economists and financial market participants are on heightened alerts for signs of an economic downturn, especially given the inversion of the yield curve, which has historically been a reasonably accurate indicator of a recession.  A sub-50 ISM Manufacturing index reading in August is potentially another warning signal, but the historical record indicates that this measure has given off plenty of false positives over the years, and the current episode appears to have more in common with many of those periods (e.g. 1998, 2015-16), at least so far, than with the recession periods.

john.killian@santander.us 1 (646) 776-7714

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