ISM Purchasing Managers' Index (PMI)

In short: PMIs are leading indicators of growth and inflation in the economy. They measure the aggregate response of a large sample of companies to questions like “How is new business going?” and “Are costs rising?”

PMIs are monthly surveys compiled by the Institute for Supply Management that ask manufacturing and service companies “How is business going compared to last month, better or worse?” via a questionnaire made of several questions - how is business, are you hiring, are prices rising, etc….The acronym means “Purchasing Manager Index”.

The survey consists of a diffusion index that summarises whether market conditions are expanding, staying the same, or contracting, as viewed by purchasing managers. The PMI is based on a monthly survey of supply chain managers across 400 companies in 19 different industries. The PMI is based on five major areas: new orders, inventory levels, production, supplier deliveries and employment. All five factors are equally weighted.

PMI = (P1 * 1) + (P2 * 0.5) + (P3 * 0)

Where P1 - percentage of answers reporting an improvement P2 - percentage of answers reporting no change P3 - percentage of answering reporting a deterioration

The value derived from the above formula is a number between 0 to 100. A PMI greater than 50 represents an expansion compared to the previous month, a PMI less than 50 represents a relative contraction, and a reading of 50 implies no change. Therefore, the further away the PMI value is from 50, the greater the level of change relative to the previous month.

Responses to the PMIs survey are used as critical decision making tools for managers in different roles and industries. Taking a computer manufacturer, for example: they make production decisions based on the expected demand in the coming months. Based on that, management will decide whether to buy more component parts and raw material. Existing inventory balances will be taken into account to determine the amount of manufacturing needed to completely fill the new orders and keep some as reserve.

On the supply side, suppliers use the PMI to estimate the amount of future demand for its products. The survey also helps suppliers understand how much inventory customers have on hand, which affects the demand for more inventory. Lastly, by understanding the interaction of supply and demand, suppliers can decide what prices to charge. Essentially, a company can use the PMI to plan its financial budget, resource management and future forecasts.

Similar to TOGGLE’s leading indicator, investors can use the PMI as a leading indicator for incoming economic changes such as GDP, industrial production and employment. Understanding movements in the PMI can yield profitable insight into developing economic trends.

New Orders PMIs

New Orders PMIs in particular are the index built around the question “Is new business coming in better or worse than last month?” and are oftentimes leading the rest of the PMI complex.

New Order PMIs are the fastest gauge of trend for an industry or a whole economy. Since they are released at the beginning of the month for the previous month, they provide a much timelier alternative to GDP.

Generally high New Orders mean an economy that is doing well and low new orders mean an economy that is doing poorly.

Inventory Levels

This measure looks at the supply and demand for a product, relative to previous periods. Increasing inventories may signal aggregate demand is slowing down and thus firms could cut back on production. Decreasing inventories, on the other hand, indicate rising demand for products as sales are greater than forecasted. Understanding the change in inventories of a firm allows you to understand the aggregate demand for the product and hence, the changes needed in supply to meet the equilibrium.

A classic combined indicator is to look at New Orders minus Inventories. High orders with Low inventories is bullish (and marginally inflationary) whereas the opposite is bearish.

Production

This measure looks at the 4 factors of production: land, labour, capital and entrepreneurship. Land refers to physical land, such as the acres used for a farm or the city block on which a building is constructed. Labor refers to all wage-earning activities, such as the work of professionals, retail workers, and so on. Entrepreneurship refers to the initiatives taken by entrepreneurs, who typically begin as the first workers in their firms and then gradually employ other factors of production to grow their businesses. Finally, capital refers to the cash, equipment, and other assets needed to start or grow a business.

Input Prices

“Input Prices” PMIs measure the trend in the cost of inputs for companies. An increase in the price of inputs leads to contracting margins or higher costs. Input Prices are one of the leading indicators you can observe to gauge trends in inflation for consumers. .

Supplier Deliveries

*note: the suppliers’ delivery times question is only asked in the manufacturing and construction sector PMI surveys

Supplier delivery times gauges the overall supply delays, capacity constraints and price pressures in the economy. The index looks at the relationship between the current demand/supply versus a buyers/sellers market - providing information on inflation trends.

Companies are asked “are your suppliers’ delivery times slower, faster or unchanged on average than 1 month ago?” Slower delivery times have historically led to rising prices, especially post periods of faster global manufacturing production. Furthermore, suppliers struggle to meet the demand for inputs. As a result, suppliers get greater pricing power, which causes manufacturers’ input prices to rise.

Take the example of the economic boom observed post the COVID-19 pandemic - accelerated global economic growth, coupled with supply chain hiccups due to COVID, led to demand which could not be met and thus, rising prices.

On the other hand, at times of falling demand and production, manufacturer's cut back on their input purchases, which leaves suppliers with excess unsold stock. This results in suppliers offering discounts to manufacturers, which drives the price of inputs lower.

Employment

Employment versus output helps understand productivity: employment directly correlates with changes in output (or business activity in the service industry). Over time, output will tend to grow faster than employment as industries become more capital intensive and reduce hours worked per unit of output. However, if employment grows at a faster pace than output, that means productivity has decreased.