Wall Street returned from the New Year holiday to some unwelcome news from the U.S. manufacturing sector in the form of a sharp decline in a widely followed survey of factory activity in December. The Institute for Supply Management (ISM) manufacturing index for December displayed weakness that was surprising relative to other factory sentiment measures.
In light of the weak December ISM reading, the market is quite clear on how it expects Federal Reserve policymakers to respond. Prices of Fed funds futures, which reflect market players' expectations for interest rates in coming months, showed that traders expect a 100% probability of a quarter-point cut in the Fed funds rate to 4% by the end of January and a 20% chance for a more aggressive 50-basis-point cut.
But another economic report released Jan. 2 helped ease the sting a little. The construction spending report for November was modestly stronger than expected overall, offsetting some of the downside ISM surprise for the markets. But the construction report carried a sobering reminder of the weakness in housing, showing a remarkably large gap—mostly through revisions to data for previous months—between plummeting residential activity and surging growth elsewhere.
Just as residential construction is now poised for a decline of historic size in the fourth quarter, the commercial and public sectors of the economy are posting similarly impressive surprises to the high side, alongside steady growth in home improvement.
Here is Action Economics' rundown of the Jan. 2 releases:
ISM Manufacturing Index
The headline December ISM index dropped to 47.7 vs. economists' median forecast of 50.5, from 50.8 in November. (A reading below 50 is considered a signal of contracting activity in the sector.) The surprisingly large drop on the month leaves the index at the lowest reading since April, 2003. Weakness was led by big declines in both new orders and shipments.
This leaves the index showing the weakest trajectory of the various U.S. factory surveys, as it compares to an ISM-adjusted reading of 54.1 for the Empire State index, 53.8 for the Philadelphia Fed survey, and 52.8 for the Chicago purchasing managers' index.
The mix of results from these various surveys leaves an average ISM-adjusted reading in December of 52, compared to a 53 average in both October and November. While such a reading would be below September's 54 and the 55 readings in July and August, it remains at a level that is consistent with expansion in the manufacturing sector.
The ISM has lowered our forecast for the ISM non-manufacturing activity figure for December to 54.5 (previously 55.0).
The various sentiment indicators surged with gross domestic product in the second quarter and have dropped back since, following the pattern of the GDP growth zig-zag of 4.9% in the third quarter and a projected 1.5% in the fourth. The December ISM manufacturing reading mitigates some of the outperformance in these factory measures earlier in the fourth quarter.
Construction spending rebounded 0.1% in November from an upwardly revised -0.4% in October (-0.8% previously). Residential construction plunged another 2.4% after a 2.3% decline in October (revised from -2.0%). Nonresidential construction rose 2.1% after a 1.1% gain in October (revised from 0.1%). Private construction spending was down 0.7% in November while public spending was up 2.5%.
Though our fourth-quarter GDP estimate will remain at 1.5%, we now expect a hefty 29% rate of contraction in residential construction. That would mark the largest drop since the 35% rate of decline in the fourth quarter of 1981, when the Fed funds rate averaged 13.6%, Consumer Price Index inflation was near 10%, and GDP contracted at a 4.9% rate.
Yet despite earlier signs of slowing in nonresidential construction that have now been revised away, we expect a 21% growth rate for this GDP component in the fourth quarter, marking an acceleration from the 16% rate of the third quarter. Public construction is growing at a similarly impressive 17% pace in the fourth quarter, and this bodes well for growth in government spending during the quarter.
Robust growth in nonresidential and public construction, alongside solid growth in home improvement activity, continues to mostly fill the void left by the weak single-family housing sector. The rate of contraction in single-family housing has kicked into a higher gear than seen over the past five quarters, as credit market turmoil is clearly having an outsize impact on buyer psychology in the real estate market as well as on the activity levels of new-home builders.