Service Industry Surges but Details Raise Concern for Labor Markets

By Rom Badilla, CFA

October 3, 2012

The service industry continues to strengthen providing more evidence of growth for the U.S. economy. The Institute for Supply Management released its Non-Manufacturing survey index which improved from 53.7 in the prior month to 55.1 in September. This uptick in the index, which surveys more than 375 companies from various service sectors, surprised market participants since the median forecast by economists was at 53.4. In addition, the September print is the highest level since March 2012 and puts the index above the six-month average of 53.5.

Weaker economic growth usually translates into lower stock prices and falling bond yields and vice-versa. Like its manufacturing counterpart, a reading below 50 represents contraction in the service sector while above this threshold suggests growth. A significant downturn in non-manufacturing activity usually rolls up into the broader economy since an index reading in the low 40’s spells a looming recession. Conversely, a number in the high 50’s suggests a robust expansion for the U.S. economy. Obviously, the health of the economy can have a huge impact on both stocks and bonds.

The growth in the headline was mostly driven by improvement in the Business Activity and New Orders component. The Business Activity index jumped 4.3 points to 59.9 in September from the previous month.

According to the Institute of Supply Management, thirteen industries reported increased business activity in comparison to only 3 industries reporting a decline. The Retail Trade, Transportation & Warehousing, and Utilities industries were some of the thirteen to report growth while Mining, Arts Entertainment, & Recreation industries reported decreased business activity.

The New Orders index which is a gauge of future demand, registered 57.7 in September from 53.7 in the previous period. Like the headline number, the September print on New Orders is the highest reading since March 2012 and is above the six-month average of 54.7.

Unfortunately for the U.S. economy, not all components increased in September. The Employment component decreased to 51.1 from 53.8 in August. As we pointed out last month courtesy of Deutsche Bank’s economist, Joseph LaVorgna, this index carries a lot of weight since private service sector jobs represent a little over 80% of employment. As a result, this indicator has been highly correlated with private sector payroll growth from a historical perspective. The drop in September toward the threshold between growth and contraction does not bode well for the labor markets.

Below is a chart of the Employment component of the ISM Non-Manufacturing Index and the Change in Non-Farm Payroll. The former is adjusted by subtracting the aforementioned threshold number of 50 from the actual value to represent expansion and contraction in service sector employment.

All signs point for employment growth to be moderate going forward. However, given the decline in the Employment component of this survey, the risk is for de-acceleration in employment gains. This Friday’s Jobs Report should provide clues as to the current state of the U.S. economy. As of now, the median forecast by economists for Non-Farm Payrolls growth stands at +115,000 workers which follows an addition of 96,000 employees in August.

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