Are V-shaped PMIs misleading?
Economic conditions look to be the best in a while for the US and most European countries, at least according to recent readings of the popular Purchasing Manager’s Index (PMI). Ever since the global recession started to unravel in March, economists and market analysists alike have been on the hunt for any data to confirm the frequently hypothesized but rather elusive “V-shaped recovery”. PMIs for the US and Euro Area countries from June onward certainly seemed to offer optimism in that respect, but upon further scrutiny of the PMI data there are good reasons to believe that this optimism might be a fallacy.
The PMI is an index based on surveys of purchasing managers in various corporations, compiled for different sectors in each country to be used as an early indication of economic conditions. In the past, it has predicted correctly what indicators such as real GDP growth and industrial production growth would later confirm, making it an increasingly popular headline indicator which many now take for granted in its accuracy.
The contrast between PMIs and broader economic indicators
It should come as no surprise then that releases of US manufacturing PMI data over the past few months have indeed come with little scrutiny and much optimism. After hitting a low in April, the index compiled by information company IHS Markit bounced back in remarkable fashion, rising to indicate expansion for the fourth month running in October. While data from the US Bureau of Economic Research leading up to September show a similar bounce in total US manufacturing production, output has remained in contraction with the latest figure showing annualised growth at -6%.
The contrast for Germany is perhaps even more stark, where the manufacturing PMI rose to a 31-month high in October to indicate one of the best months of expansion on record, while data from the Federal Statistics Office showed that total manufacturing output for Germany was still contracting by an annualised -8.7% in September. The discrepancies between PMIs and broader indices observed for manufacturing activity are even more extreme when it comes to services, which already alludes to the possible explanation for the observed divergences.
The problem of relying on a limited survey
While it may still be the case that the PMIs will be proven correct in the coming months by newly released data on broader economic indicators―as indeed was the case in 2009―, there are good reasons to believe this may not happen this time around. Simply put, PMIs do not cover the thousands of restaurants who have been forced to close down due to COVID-related measures, or the hundreds of retail shops who are being abandoned in favour of online shopping. This is because the surveys used in PMIs typically only cover a limited number of large companies in order to approximate conditions for the sectors those companies operate in.
For instance, the US services PMI covers just around 400 of the largest companies in selected services sectors, while the broader services index of “real consumption expenditures on services” covers around two-thirds of total spending in the US on services. The differences between the two indices, as shown in the chart above, have been extreme, with the former giving the impression that the economy is in a much better state than it really is. The services PMI crucially fails to capture the carnage in services that was unlike any seen during previous recessions.
PMIs are hinting at structural changes
That is not to say that PMIs should be disregarded. What the out-performances of PMIs could be alluding to is the structural changes taking place in the US and other advanced economies. Much like Amazon has devoured the brick-and-mortar retail competition during the pandemic, many of the other larger corporations have managed to increase their market shares dramatically with changing consumer behaviour, and fiscal and monetary policies that have benefited them disproportionately.
If not for an indication of broad economic conditions, PMIs are still worth looking at for activity among the corporations covered by the surveys. But those celebrating recent PMI readings as proof of a V-shaped recovery for the overall economy might be better off searching for some confirmation, before declaring that the global economy has bounced back from one of its deepest contractions on record.
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