U.S. manufacturers reported business activity declined for the 11th month running in September, but the cycle appeared to be close to its trough and poised to return to growth in the next few months.
Renewed manufacturing growth will boost industrial energy consumption, especially for diesel, but with inventories still low, prices are set to escalate rapidly, rekindling concerns about inflation.
The Institute for Supply Management’s manufacturing purchasing managers index rose to 49.0 (24th percentile for all months since 1980) in September up from 47.6 (17th percentile) in August.
The index remains below the 50-point threshold dividing expanding activity from a contraction but has increased for three months running from a recent low of 46.0 (11th percentile) in June.
Sustained improvement is consistent with the sector nearing the bottom of the cycle and likely to start expanding again within the next few months.
The new orders component of the index remained negative 49.2 (20th percentile) in September, but has risen significantly from the recent lows of 42.6 in May and 42.5 in January (both in the 6th percentile).
The production component climbed to 52.6 (31st percentile) and has now been at or above the 50-point threshold for two months running.
The percentage of manufacturers in the survey saying their own production was higher increased to almost 22% in September, from 15% in June.
In the short term, labour unrest and strike action within the automotive sector is likely to dampen manufacturing activity.
In the medium term, however, manufacturers’ new orders are stabilising and output has started to increase from a low base.
The recent downturn has been long but shallow, sharing some of the characteristics of both a mid-cycle slowdown and a cycle-ending recession.
Since 1948, most mid-cycle slowdowns have lasted eight months or fewer whilst recessions have tended to last for 11 months or more.
The current downturn has already been longer than any mid-cycle slowdown, except perhaps the one between May 1989 and March 1990.
That mid-cycle slowdown turned into the much longer cycle-ending recession of 1990/91 after Iraq’s invasion of Kuwait cause a spike in oil prices.
The mid-cycle slowdown or “soft landing” of 1989/90 and the cycle-ending “hard landing” of 1990/91 are usually considered as one episode.
But economist Alan Blinder has convincingly argued they should be considered somewhat separate (“Landings, Soft and Hard: The Federal Reserve, 1965-2022, Blinder, 2023).
Blinder has argued the Federal Reserve would have achieved a soft landing if oil prices had not spiked for unrelated reasons.
“History does not offer us redos, but I have long believed that the tightening cycle of 1988–1989 might have produced a perfect soft landing were it not for Saddam Hussein’s invasion of Kuwait.”
“While the landing after this monetary tightening was on the hard side, the fault lies with Saddam Hussein, not Alan Greenspan.”
It could be argued the current manufacturing cycle and soft landing most closely resembles the events of 1989/90, but without a spike in oil prices, so far.
The problem is that inventories of diesel and other distillate fuel oils did not accumulate much during the downturn and remain at very low levels.
Distillate consumption is closely correlated with the industrial cycle and any acceleration in manufacturing activity and freight movements will lead to further inventory depletion.
The volume of distillate supplied to the domestic market (a proxy for consumption) was down by almost 1% in the three months from May to July compared with the same period a year earlier.
The fall in consumption was actually slightly less than might have been expected given the low readings on the ISM index – which would be consistent with a prolonged but very shallow manufacturing downturn.
One consequence, however, is that there has been only a limited chance to rebuild inventories in preparation for a new expansion.
U.S. distillate inventories amounted to 119 million barrels at the end of September 2023 up from 111 million barrels from a year earlier.
But inventories were still 19 million barrels (-14% or -1.12 standard deviations) below the prior ten-year average at the end of September 2023.
For the month of September as a whole, inventories averaged just 120 million barrels, up from 114 million in 2022, but otherwise the lowest for the time of year for 23 years.
Given the low level of inventories, upward pressure on distillate prices is likely to emerge early and aggressively in any new cyclical upturn.
If shortages of diesel and other raw materials re-emerge quickly, the central bank’s ability to engineer a soft landing and sustain it could be tested quickly.
If energy shortages are combined with continued strength in the labour market and persistent wage growth the effect on inflation would be significant.
Interest rate traders now doubt the central bank will have much scope to reduce interest rates in the course of 2024.
Interest rate futures show traders expect rates to end 2024 at 4.50%-4.75%, down by just three quarter-points from the current level of 5.25-5.50%.
End-2024 rates were expected to be as low as 4.25-4.50% (four quarter-point reductions) at the end of August 2023 and 4.00-4.25% (five quarter-point reductions) at the end of June.
If the central bank’s scope to reduce rates is limited by persistent inflationary pressures, the current soft landing might turn into a harder one in 2024, just as it did in 1991.
The best prospect for a sustained soft landing in the United States might be a recession in Europe and China, relieving some pressure on diesel supplies and inflation, and allowing the Federal Reserve to cut interest rates faster.
John Kemp is a Reuters market analyst. The views expressed are his own
(Editing by Alexander Smith)