PMI Indices for EMU Bounce – Dead Cat or Live One?

Hooray! The MFG and Services PMIs for Europe in January have bounced. It’s too soon to call it a bottom but since they are bouncing off historic- or near-historic lows, maybe we have seen the worst of decay. Even if that is true it is a far cry from saying we are about to embark on recovery.

What it means - At a reading of 34 for MFG, the sector is telling us that about 34% of the industries are expanding… (That is strictly speaking an improper interpretation since the PMI reading is all the ‘up’ readings plus ‘half the unchanged responses’ and there are myriad ways to get that result. A given PMI reading does not tell you how many, or which proportion, of industries are expanding. But the reading of 34 is ‘as if’ 34% were rising and the rest falling although fewer may be rising and twice the residual might be unchanged. I will use this short hand of treating the PMI as if it were an ‘up only’ index for simplicity but the reader should understand that the truth is a bit more complex- I think nothing is lost by this expositional device.). For services the reading of +42 is coming off that (shorter) series’ all-time low.

Lots of weakness ahead - In any event it is clear that these two measures can rise for some time and still not get back to neutral (a reading of 50 is neutral- half the sectors expanding, half contracting).

‘Neutral’ is not ‘normal’ - And of course ‘neutral’ is not the same as ‘normal’. When you put your car in ‘neutral’ is neither in ‘drive’ nor ‘reverse’. If we were to average what gear your car were in most of the time the average would not be close to neutral. Similarly, since July 1998 when the services measure was launched it has averaged 54.2. Over the same span the MFG index has averaged 52. On balance more sectors are expanding than contracting in normal times. So the current readings are a very great distance away from being ‘normal’ and it should take a good deal of time to get back to normal.

Diffusion increases do not necessarily mean that output increases - When these diffusion indices rise, until they surpass a reading of 50, they are indicating contraction at a slower pace but still contraction and not expansion.. For now the PMIs are saying that the worst – most severe phase of the contraction - is behind us, not that recession is ending. And that is the message only if the December bottoms stay in place and are not replaced by new weaker readings.

More weakness ahead - Rest ‘assured’ that more declines lies ahead for conventional economic variables even if the diffusion indices continue to rise from their lows.

Diffusing as Mr Sensitivity - Diffusion readings are very valuable because they are so timely and because they are sensitive. Formally the PMI indices are measures are gauges of the BREADTH not of its strength. But everyone treats theses measure of breadth as if they are of strength. Financial experts are well aware that is not so. For stock markets analysts (for example) always looked at big ‘up’ or ‘down’ days in the stock indices to see if the breadth reinforced the trend or not. Breadth in fact is not the same as strength – but they are highly correlated. So again be careful how use diffusion data. They often are the first whiff of slowdown or of bottoming. But they are indicators and are not real economic variables so be careful how you interpret them.