Under the Economy's Hood

Cars and truck sales are goosing recent factory strength.
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Looking at the headline of the Institute of Supply Management's manufacturing survey, you could judge that the factory sector is back on track after nearing a contraction in the spring.

And indeed, the report does help build the case that the

Federal Reserve

will continue raising short-term interest rates to at least 4% by year-end, as most economists now expect. Yet, the sustainability of the "recovery," which mostly reflected the incentive-happy auto industry, is questionable.

Confirming a series of bullish economic reports, manufacturing activity continued to rebound strongly in July, according to the survey. The ISM said its index rose to 56.6 in July, compared with 53.8 in June, well above economists' expectations for 54.5.

The report is the second in as many months wherein conditions in the manufacturing sector were improving, reversing a previous period of declines that had led the ISM down toward 50. A reading below 50 indicates contraction in manufacturing activity.

"Not so long ago, all the talk was how the ISM was heading in a straight line down below 50, where the Fed has never raised rates," says Ian Shepherdson, chief U.S. economist at High Frequency Economics, in a research note. "Some revision to this view is now required; one good month is easy to dismiss but two is a bit trickier."

That was also the view of the bond market. The benchmark 10-year Treasury bond continued its downward trend of the past several weeks, losing 15/32 while its yield rose to 4.34%.

Reacting also to a spike in oil prices, major stock proxies were mixed, with the

Dow Jones Industrial Average

recently down 12.10 points, or 0.11%, to 10,628.81, while the

S&P 500

was up 1.96 points, or 0.16%, at 1236.14. The

Nasdaq Composite

was adding 8.72 points, or 0.4%, to 2193.55.

The ISM's prices paid index fell to 48.5% in July from 50.5% in June, which supports the currently low-inflation environment. The employment index rose to 53.2% from 49.9% in June, portending possible price pressures.

Moreover, "given that manufacturing employment was down in recent months, the gain in the

ISM's employment component imparts upside risk to the employment gain on Friday," says Wachovia chief economist John Silvia in a research note. His pre-ISM expectations are for the economy to have added 180,000 jobs in July, in line with the consensus forecast of economists polled by Reuters.

Together with recent economic data -- durable goods orders, consumer confidence and the second-quarter GDP -- the ISM reading supports Fed Chairman Alan Greenspan's position that the economy is still growing at a pace strong enough to remove the Fed's accommodative stance on monetary policy. In other words, the Fed will continue raising short-term interest rates in the near future.

In a speech Friday, San Francisco Fed president Janet Yellen said that "it makes sense to continue the process of removing

monetary accommodation."

But for next year, the interest rate outlook becomes more questionable. Yellen said that a neutral range for the key fed funds rate was between 3.5%-5.5%, adding that she sees Fed policy "becoming increasingly data-dependent as we get closer to bands of estimates of neutral."

The sustainability of a rebound in manufacturing later this year therefore becomes key. And beyond the headline economic readings, one key aspect of the rebound so far hasn't received much press: It is auto-based.

Transportation and equipment figured prominently in all of the improving areas of the ISM survey, and that's without counting autos' direct impact on other sectors of the economy, such as the primary and fabricated metals sectors. Nor does it account its fallout on other sectors.

"I do have reservations about the nature of this reading," says Asha Bangalore, economist at Northern Trust, who has been bearish on the economy since early this year. "It's related to the auto industry."

One of the key factors behind the economic "soft patch" experienced in the spring was the impact of surging oil prices on the auto industry.

As consumers shunned gas-guzzling SUVs, the inability of

GM

(GM) - Get Report

and

Ford

(F) - Get Report

to deal with lower sales of their most profitable vehicles partly led to their credit ratings being cut to junk. The automakers cut production drastically.

But that was then.

After using cutthroat sales incentives ahead of the summer driving season, the automakers have started to draw down their inventories while sales have picked up nicely. That contributed to the $6.4 billion of inventories liquidated in the second quarter (as seen in Friday's second-quarter GDP report); most economists have therefore upwardly revised their growth forecasts for the second half of the year.

It also heavily contributed to the improvement in Friday's Chicago purchasing managers index and, to a lesser extent, Monday's national ISM survey.

"What we really need to see is stronger consumer spending excluding autos, because once all those attractive incentives have expired, what will replace them?" says Northern Trust's Bangalore.

GM's strategy, it seems, is to take the price war directly to the "sticker" of its 2006 model-year vehicles, as the automaker announced on Monday.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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