Devil in the Manufacturing Data: Inventory

By MARK GONGLOFF The manufacturing sector, like the rest of the economy, seems poised to end a long slump. But it still isn't guaranteed a robust recovery. On Wednesday, the Institute for Supply Management is due to release its manufacturing index for June. This index is widely considered one of the most important economic indicators, after the monthly jobs report. Economists think it rose to 45, which would be the highest reading since the Lehman Brothers meltdown last September. Any number below 50 indicates factory output is still shrinking, but the index has recovered sharply from its 28-year low in December. The ISM's new-orders index in May jumped above 50 for the first time since November 2007. Manufacturing collapsed soon after the credit market froze and demand shrunk. Inventories piled up even as production declined, and businesses have been aggressively shedding them ever since. This combination of rebounding orders and declining inventories has typically led to an increase in production, which is crucial to an economic recovery. To divine this trend, economists typically look at the relationship between the ISM new-orders index and its inventories index. The bigger the gap, the bigger the expected jump in production. The gap between the two soared in May to 18.2, the highest since April 2004. That spike in 2004 came just before the headline ISM index jumped to its highest level since 1983. Orders, of course, can be canceled, notes Deutsche Bank economist Carl Riccadonna. The real measure of production is how much stuff gets shipped out, and if you compare shipments to inventories, the picture isn't so pretty. Inventories of durable goods in May rose to nearly 1.9 times the number of shipments of such goods -- the highest so far in this recession. Back in the spring of 2004, the ratio was 1.3, meaning inventories were much lower compared to the amount of goods shipped. That suggests inventories still need to decline relative to production. For there to be a meaningful economic recovery in the second half, real demand must be strong enough to work off inventories, and force a jump in production.