The Handoff – Manufacuturing to Housing

As you may have heard, the latest reading on the ISM Manufacturing index declined in June to a level of 49.7. The index is designed such that values of over 50 indicate expansion while values below 50 indicate contraction. This marked the first time since July 2009 that the index registered in contraction territory, although there is some discussion whether or not the manufacturing sector is shrinking or slowing. It is obviously slowing, at the least, however the one aspect that is generally not discussed is that this was largely expected to happen because the manufacturing cycle always wanes or rather it ebbs and flows. So far the ISM Manufacturing index has been at expansion levels for 34 out of the 36 months of the U.S. economic expansion. 3 years for a continued manufacturing cycle is pretty good from a historical perspective – see the borrowed Calculated Risk graph below. A multi-year, not a decade-long manufacturing cycle is the norm.

Now, does that mean the economy is doomed? Not neccessarily. Even after a slowdown in manufacturing, the industry can and likely will continue to grow in the coming years, just that the growth is and was not expected to remain consistently strong. Second and more importantly, one item our office – Mark – was sure to highlight in the forecast and in discussion with the Governor’s Council is the transition from manufacturing to housing as a major economic driver. There is this handoff that occurs from the manufacturing cycle, which has so far helped to drive the initial phase of the recovery, to housing, which will propel the economy in the near future. The initial part of this handoff has already occurred as evidenced by the two graphs below. Residential Investment (new home construction) is now growing nearly 10% year-over-year while the manufacturing cycle is slowing. This initial part of the handoff occurred in fall 2011. Europe’s woes were front page news while domesticaly, mortgage rates continued to hit lows, multifamily rents were increasing and the payroll tax cuts were extended.

Note that in both graphs the monthly ISM index has been converted to a quarterly frequency.

The only difference in the graphs is above the ISM index is calculated on a growth rate basis, while below it is in level terms on the right axis.

While housing is now growing strongly, it is not a leading contributor to overall economic growth. In the recovery so far, beyond personal consumer expenditures, exports and investment – largely the manufacturing cycle – have been significant contributors, while the housing downturn continued to languish. Now, housing growth has returned but the industry is not yet doing the heavy lifting. The much stronger growth in housing is not expected until 2013 and 2014 in our forecast, and most others as well.

Summary: During most recoveries housing has led the economic growth out of recession, however given the causes and consequences of the Great Recession, housing was in no shape to do so in recent years. Which meant that consumer spending, exports and investment were expected to lead growth, however the manufacturing cycle is now waning. It is certainly slowing and possibly contracting, although this change is largely driven by the external sector. Most forecasts have generally followed the pattern that growth would continue at a lackluster pace until housing regained its footing, when the handoff of major economic driver would transition from the manufacturing cycle to the housing cycle. Right now, the U.S. economy is in the initial phases of this handoff. Should everything else go according to plan (I know!), this transition will continue to occur in the coming year or so.