Back to work, time to taper?

US manufacturing is at its strongest in years and with improved construction and employment data, conditions may soon be right for the Fed to move.

Positive news raises the possibility of a December taper, but if it happens expect it to be small. The data overnight points to improving conditions in the manufacturing and construction sectors. All eyes will be focused on the US payroll data, released on Saturday morning, to provide some insight on the Fed’s next move.

Good news overnight for United States manufacturing, with the US ISM manufacturing index rising in November to be at its highest level since April 2011. Given that period reflected a rebound following the onset of the global financial crisis, the last few months possibly represent the strongest sustainable expansion in manufacturing since late 2005.

The index, shown in the graph below, can be interpreted as follows: historically an index score above 42.5 indicates an expansion of manufacturing activity in that month; the higher the index number goes above 50 the faster the expansion. By extension, a score below 42.5 indicates a contraction in activity.

Graph for Back to work, time to taper?

But arguably the more important information is contained in the subindices. For example, the employment index rose by 3.3 percentage points and is now at its highest level since mid-2012. The data points to a further pickup in manufacturing payrolls and on Saturday morning we will find out whether this survey reflects reality.

The timing of the Fed’s taper of its asset purchasing program is tied to improving conditions in the labour market, so this manufacturing index provides just another example that conditions are improving albeit slowly. 

However, the recent improvement in the ISM manufacturing index has yet to be reflected in other data. Orders for durable goods, for example, which includes capital equipment such as machinery and computers declined by around 2 per cent in October. So it is important not to get too carried away with today’s data but historically these survey measures have provided a reasonable gauge on economic activity.

Construction data was also released overnight and indicated that construction expenditure rose moderately in October. Private residential construction spending declined by 0.6 per cent in October but is still 18 per cent higher over the year.

Despite the pickup during 2013, residential construction remains weak by historical standards. Obviously residential investment fell sharply following the onset of global financial crisis, but the overhang of property supply has been wound back and there is now some potential upside for the US economy. The property overhang, while large, was not large enough to justify such a sustained period of low residential investment and there is the potential for investment to rebound rapidly once the recovery gains some footing.

Graph for Back to work, time to taper?

The main concern about the residential investment outlook is that house prices may already be near their peak, with pending sales declining over the past five months. I expect prices to either stabilise or even decline a little bit over the next six months and that may dampen the enthusiasm for residential investment. On balance though, I’d still expect residential investment to be a solid contributor to growth in 2014 and beyond.

Non-residential investment continues to muddle along; although leading measures of investment such as the Architecture Billing Index indicate that the sector may pick up soon. I’m not too concerned about non-residential investment at this stage, mainly because it is a lagging indicator of the economy. It’ll recover once other measures of the economy pick up (such as residential investment and the labour market) and also once the taper begins and businesses start looking at expansion as a source of growth.

The fiscal drag from public sector construction also looks to have ended, having increased by 7.2 per cent since May 2013. Public sector construction had slowly declined since peaking in early 2009 and was until recently at its lowest level since 2006.  

On balance, this was a fairly positive construction report. There are perhaps some concerns regarding the outlook for residential investment but these could easily be overblown. Non-residential investment is set to improve, while the public sector is at last not working to slow the economy.

Certainly none of the news overnight does any harm to the prospect of the Fed tapering at its 17-18 December meeting. I still consider it a long shot but the recent data has been mostly positive and a strong labour market report on Saturday has the potential to tip their hand. If the taper does come, expect it to be small, with the program wound down slowly over a long period of time to ensure there isn’t a rout of financial markets.

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