Schwab Guide to Economic Indicators: Non-manufacturing ISM Report on Business®

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Schwab Guide to Economic Indicators: Non-manufacturing ISM Report on Business®
by the Schwab Center for Financial Research
November 19, 2007

What is it?
It's an economic-direction summary covering 10 non-manufacturing indicators. Examples of the indicators covered include business activity, employment, inventories, new orders, prices and supplier deliveries. Of those, business activity is considered the headline number. However, it's not a weighted composite of all the indicators. According to the ISM, "[s]everal years of data will need to be developed before that type of non-manufacturing indicator can be developed."

The report is produced by the Institute for Supply Management (ISM) and is based on a survey of "approximately 370 purchasing and supply executives in over 62 different industries."

Note: Many analysts and journalists use the terms "services" or "services-producing" interchangeably with non-manufacturing in an attempt to better describe the type of industries represented by the Non-manufacturing ISM Report on Business®. (Examples of services include finance, education and health care.) However, this description is incomplete. While the services' portion comprises most of the non-manufacturing classification, non-manufacturing includes other segments of the economy:

68% services
5% construction
2% mining
1% agriculture, forestry, fishing and hunting

What is its relative importance?
High. It's widely followed because the report is considered a forward-looking barometer of non-manufacturing activity, which represents approximately 76% of the economy. It's one of several key reports monitored by the Federal Reserve as it sets monetary policy.

What impact does it have on the market?
The degree to which the index meets expectations is typically one of the most influential aspects of the report.

If the trend in the index exceeds forecasts in a way that hints the economy is overheating, bond prices typically fall (yields rise) on the outlook for greater overall economic demand, potentially higher inflation and an increased chance that the Fed will hike interest rates. Stock prices may also fall.

Why?

A rise in bond yields can make bonds more attractive once the fall in bond prices settles down. Compared to where the weights of stocks and bonds were in your portfolio, the typical thing to do in response to this change in valuation would be to sell some stocks and put the proceeds into bonds. Even if corporate profit growth seems supported in this time of strong non-manufacturing activity, the market will likely see it as being short lived given expectations for impending rate hikes and eventually slower economic growth.

Alternatively, if the index exceeds forecasts during slack economic times, this can give a boost to stock prices. That's because the market's expectation of potentially higher profit growth from greater economic demand can initially be the more influential factor in favor of higher stock prices. That is, for a period of time, it can be the more-dominant driver of stock prices, overshadowing the negative impact of rising bond yields (as discussed above).

How is it calculated?
To produce each indicator, the ISM summarizes the responses to three basic questions: In the current month compared to the previous month, did the indicator measured move in a

positive economic direction
negative economic direction
or stay the same

Indicators measured include:

backlog of orders
business activity*
employment*
imports
inventories (approximately one-third of the respondents do not have inventories or do not measure them)
inventory sentiment
new export orders
new orders*
prices*
supplier deliveries

(* seasonally adjusted, "[t]he remaining indexes have not indicated significant seasonality," per the ISM)

The 10 indicators are each transformed into what is known as a diffusion index. It's simply a summary of the answers to the three questions. To calculate the diffusion index, the ISM includes "the percent of positive responses plus one-half of those responding the same."A diffusion index of 50% is generally considered to be the separation point between expansion and contraction. While this varies by indicator, the general rule of thumb is readings above 50% depict expanding conditions, with those below 50% portraying contracting conditions. See the ISM's website for specific details for each indicator.

How is it used?
The trend from month to month in the business activity index can be used to monitor the direction of the non-manufacturing sector. The other indicators or sub-indexes can be used anecdotally. For example, the prices index tends to garner attention because of its perceived direct correlation with inflation.

Another way the report can be used is to intuitively look at a variety of indicators. Suppose the inventories index was contracting at time when backlogs and new orders were expanding, that would suggest that business activity and employment have a good chance of expanding faster the following month.

The report can also be used in conjunction with the ISM's manufacturing report to gauge the direction of the lion's share of the economy—everything outside the government sector. According to the Bureau of Economic Analysis, the following represent the approximate value added by category to gross domestic product based on 2006 year-end data:

76% non-manufacturing
12% manufacturing
12% government

The two ISM reports cover nearly 88% of the economy. Hence, they collectively provide a comprehensive view of U.S. business trends. Given their forward-looking nature, these reports can have a meaningful impact on the perceived strength of the economy, corporate profits and what the Fed might do next with interest rates.

Clarification between regional and national reports
There are a variety of regional reports that appear to be similar to the Non-manufacturing ISM Report on Business® and the Manufacturing ISM Report on Business®. However, the ISM makes it very clear that there is no connection with any of the regional reports when it comes to deriving the national indexes.

Some of the regional reports are produced by the Fed. While the Fed has 12 districts encompassing the United States, only five provide a manufacturing-type of report: Dallas, Kansas City, New York, Philadelphia and Richmond. A services-type report is also produced by the Richmond district. These reports provide views for the current month compared to the previous month, plus views six months into the future. They also calculate the diffusion index differently. This is done by subtracting the percentage of negative responses from the percentage of positive responses. As a result, 0% becomes the separation point between expansion and contraction.

Other regional reports come from the National Association of Purchasing Management (NAPM). Most of the diffusion indexes they produce are derived in a similar fashion used by the ISM. This is where it can become confusing. Some regional NAPMs are affiliates of the ISM—Chicago, for example. Yet the national ISM is adamant that the regional information is not used to produce the official Manufacturing ISM Report on Business® or the Non-manufacturing ISM Report on Business®.

Many of the regional NAPMs combine manufacturing and non-manufacturing industries. Furthermore, most—but not all—cover industries in just their area. NAPM's Chicago PMI is a good example of how the coverage can deviate. According to its website, "[s]ince the report covers the activities of each 'company,' its coverage is global, but focused through membership in the NAPM-Chicago."

Despite these differences and caveats, the regional reports from the Fed and the NAPM can move the financial markets simply because some are released before the Manufacturing ISM Report on Business® and the Non-manufacturing ISM Report on Business®. Some examples of these include the New York Fed (aka the Empire State Manufacturing Survey), the Philadelphia Fed (aka the Philly Fed) and the Chicago NAPM (aka the Chicago Business Barometer or Chicago PMI).

While the regional reports are not necessarily representative of the entire country, the financial markets have a tendency to act as if they are, especially if the weight of the evidence from them is lopsided in one direction or the other, or if a noteworthy sub-index (e.g., prices) moves dramatically.

When is it released?
The Non-manufacturing ISM Report on Business® is released on the third business day of the month and can be found at http://www.ism.ws/.

(2007-5771)

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