The ISM numbers today again support our view that slowing demand is likely to cut significantly into second half earnings and in many cases drive some significant surprises or revisions. Given that this coincides with a period of very high relative valuation for many of our sectors, we remain firmly of the view that the relative risk is stacked heavily to the downside for the balance of the year.
The ISM production index is down (again) – generally industry is producing less – incremental sales are almost always at high incremental margins and so losing incremental sales results in losing very profitable revenues. Excluding the 2008 recession, the production index is at its lowest level since May of 2003. This is not good.
However, it gets worse; inventories are higher. As you reduce production you would expect inventories to fall, but they are rising – see exhibit. So we are making less and we are still selling less than we are making. It would be less concerning if this was because customers were reducing inventory, but they are not. Customer inventories are flat, but at the elevated level we highlighted in June.
The bottom line – real demand is weakening. If this continues:
- Volumes will disappoint
- Prices will weaken – possibly severely in highly competitive fungible product areas
- Returns on capital will fall
- Companies will miss guidance
- What already look like expensive sectors will look even more expensive
We would be most cautious about Specialty Chemicals, Paper, Electrical Equipment and Express Mail.