The ISM Manufacturing Index improved slightly in February

The ISM Manufacturing Index remained in contractionary mode last month but showed signs of potentially stabilizing. The February index reading of 47.7 was slightly better than January’s reading of 47.4, while still signaling weakness for the nation’s goods manufacturers. It was the index’s fourth consecutive month below the 50.0 mark.

Underlying the data was a mixed story. New orders, perhaps the most important forward-looking component of the index, rose sharply to 47.0 from 42.5 in January — consistent with continued shrinkage in new customer orders but at a pace that may be moderating.

Unsurprisingly, six consecutive months of declining demand took a toll on production volume and employment needs. Manufacturers trimmed production activity for the third consecutive month. Even with those cutbacks, inventories modestly increased again in February — the 19th consecutive month of inventory growth. Given the supply chain disruptions that interrupted the flow of raw materials in recent years, manufacturers had focused on rebuilding their stock. A combination of supply chain normalization and falling demand have helped to provide some needed cushion. Further erosion in demand could quickly turn the tide from insufficient stockpiles to an excess of unsold goods, something that will merit watching in the coming months.

Reduced demand also resulted in some curtailing of production schedules, which also rippled through to the demand for factory workers. In response, manufacturers trimmed their payrolls modestly, partially offsetting net hiring in the preceding two months. Manufacturing employment has bounced around 50.0 over the past year, as the sector adjusted to reduced demand for consumer goods.

Without question, the marked improvement in new orders provides the most meaningful glimmer of hope for those looking for signs of stabilization in the sector. The January surge in retail sales certainly suggests that consumers aren’t ready to surrender despite the headwinds of higher prices, a shift in marginal spending toward services, and growing recession clouds on the horizon.

But there was a more ominous component to the February report as well, as raw materials prices increased for the first time in five months in February across a range of industries. The reopening of China’s economy likely played a role in increased global demand for commodities, which lifted prices. Improved global demand might bode well for near-term economic growth but raises additional concerns about the near-term path for inflation.

In recent months, consumers had become more optimistic, as various inflation measures pulled back. That optimism fueled a resurgence in stocks and other risk-oriented investments on the belief that the Fed might be close to the end of its tightening cycle or could even begin to trim rates sometime later this year.

The surprising strength of labor conditions and consumer demand since the beginning of the year have pushed back against near-term recession risk, but there are growing indications that elevated inflation could prove to be stickier than hoped. With raw material prices now edging higher again and few signs of relief in services prices, the risk of higher-for-longer inflation is rising.

The result? Expectations have shifted quickly toward further interest rate hikes and a longer path ahead for inflation to return to — or at least meaningfully toward — the Fed’s 2% target.

Additionally, already soft demand for goods could be further impaired in the months ahead if producers have to pass along additional price increases to customers. If they aren’t able to do so, further erosion in profit margins should be expected.

The bottom line? Manufacturers are still feeling pressure from demand slippage, but evidence of some potential stabilization in new orders is a welcome development. Higher raw material prices will merit a cautionary stance though, signaling that there are still challenges ahead.