• Since late summer last year US, and global manufacturing activity has entered a severe contraction due to a combined shock from the credit crunch and a collapse in demand growth. Most business indicators - including the US ISM index - are on levels only seen in the deepest post-WWII recessions.
• However, much of the adjustment in the US manufacturing industry has already taken place. First, prior to the recession the US manufacturing industry ran very lean inventories. Second, the liquidity squeeze from the credit crisis has led to an unusually fast alignment of production to demand fundamentals. Consequently, the pace of production is now undershooting the slowdown in demand. Hence, it will merely take stabilisation in demand growth to spark an industrial recovery.
• If credit spreads do not resume widening we believe that the US ISM index will see imminent stabilisation and a subsequent recovery over the coming three to six months. We expect the index to reach 42- 44 by June, which would be consistent with zero GDP growth. If monetary and fiscal policy gets traction further recovery is on the cards for H2.
• A recovery in the ISM index will be the first sign of improvement in several other indicators. Aside from the obvious correlation with manufacturing production, the ISM usually correlates closely with leading indicators, trade, jobless claims and capital goods orders. Hence, we expect that improvement in these indicators over the coming quarters will support a general improvement in sentiment.
• In financial markets this will be a very important event. A recovery in the ISM index usually adds upward pressure to long US bond yields and to the steepness of the money market curve. Moreover, a pick-up in the ISM index will be a signal of a future stabilisation in corporate earnings.
