The purchasing managers' index: way more interesting than the Oscars

Last week’s post looked at a measurement of fear in the financial market. This week we’ll turn our attention to a broader measure of future economic prospects, the purchasing managers’ index (PMI).

During its heydays in the 1960s, manufacturing accounted for a quarter of South Africa’s gross domestic product (GDP). The sector has since declined, but still comprises a significant 15 percent of the country’s total economy. Industry remains an important job generator and a key focus of government policy. Put simply, manufacturing matters.

As Andre Coetzee, managing director of the Chartered Institute of Purchasing and Supply (CIPS), points out, “Internationally and over time, recessions and recoveries tend to appear first in the manufacturing sector.” It’s no wonder then that economists, investors and policymakers worry about manufacturers’ health.

A key indicator of the direction in which manufacturing is headed is the Kagiso purchasing managers’ index (PMI), which Coetzee says is “the earliest indicator within the sector”. Modelled after a similar survey conducted by the Institute for Supply Management (ISM) in America, South Africa’s PMI is produced monthly by the Bureau for Economic Research in collaboration with CIPS.

How does this indicator work?

The PMI survey is mailed to a panel of purchasing managers throughout the country. These are the men and women, across a wide range of manufacturing sub-sectors, responsible for purchasing the raw materials companies need to make the things you and I buy. They live and breathe manufacturing conditions day in and day out, so their opinions are about as well-informed as any you’ll find.

Respondents are asked to answer nine questions about the monthly changes (i.e. increased, decreased or stayed the same) they’ve experienced in each of the following indicators.

Business activity (overall output).
New sales orders (orders received during the month in question).
Backlog of sales orders (orders received but not yet filled).
Employment (including temporary and contract workers).
Purchasing inventories (stock levels of raw materials).
Purchasing commitments (irrevocable purchasing orders with suppliers).
Purchasing supplier deliveries (speed of delivery and availability of goods and services).
Purchasing prices (approximate rise or fall of average input prices).
Purchasing conditions (satisfaction or dissatisfaction with current conditions).

All of the responses received are then used to construct an index, ranging from 0 to 100, for each of these nine indicators. Zero means that all respondents reported a decline while 100 indicates that all respondents experienced an increase.

The index value for each indicator is equal to the sum of the percentage of respondents that indicated an increase plus one-half of the percentage of respondents that indicated no change. For example, if 50 percent of those surveyed in July said that new sales orders increased and 20 percent said that new sales orders remained unchanged, then the new sales orders index would equal 60 (i.e., 50 +10). That can be confusing, I know. So feel free to read that bit again. The bottom line is that any value over 50 indicates increased activity.

Once index values are calculated for each of these nine measures, researchers determine the overall PMI. This headline index is the weighted average of five of the nine sub-indices. These five indicators and their weightings are as follows.

Business activity = 25 percent of PMI
New sales orders = 30 percent of PMI
Employment = 20 percent of PMI
Supplier deliveries = 25 percent of PMI
Inventories = 10 percent of PMI

This headline figure, like each of the nine indicators discussed earlier, also ranges from 0 to 100.

How do I use this indicator?

“The first thing to look for is whether or not the PMI is above 50 or below 50,” explains Abdul Davids, head of research at Kagiso Asset Management. A value above 50 indicates that manufacturing is expanding. A value below 50 indicates that the sector is contracting.

“Next,” says Davids, “look beyond the headline figures to the sub-indices.” New sales orders, he points out, are quite important. This sub-index is heavily weighted, comprising 30 percent of the overall PMI. “If that’s expanding,” he notes, “it’s a very good sign.” Davids points out that the employment sub-index also merits special attention. Unemployment is arguably the biggest economic problem confronting South Africa. If this sub-index’s value tops 50, the sector is likely to add much-needed jobs.

Coetzee suggests giving special attention to a ratio of two measures, new sales orders divided by inventories. “If the ratio is positive,” he says, “new orders are outstripping inventories and production activity will probably rise to meet demand. If the ratio is negative, the reverse holds true.” Production will most likely slow. Historically, he says, even when the overall PMI has been at its lowest, improvement in this ratio has accurately predicted an improvement in conditions.

Most important, says Coetzee, is to “look for trends”. If the headline figure, new sales orders and employment numbers all improve for several months in a row, a manufacturing expansion is likely. This, in and of itself, is important information for those interested in the direction of South Africa’s economy. More narrowly, from an investment perspective, stock prices tend to rise when the outlook for manufacturing is positive. Bond prices, on the other hand, tend to suffer.

When and where do I find this indicator?

The PMI is an important barometer of South Africa’s economic future. As a result, monthly headline numbers are widely reported in the press, typically alongside commentary by specialists. Releases are issued on the first business day of every month and cover the previous month’s survey findings.

Those who wish to dig deeper have several options available. Kagiso, the sponsor of the index, publishes monthly results and commentary on their website (www.kagiso.com). Detailed results and analysis can also be found on the Chartered Institute of Purchasing and Supply’s website (www.cips.org) by clicking on the South African flag icon on the site’s uppermost banner. Finally, for those willing to pay an annual subscription fee, the Bureau for Economic Research publishes monthly results and historical data (www.ber.ac.za).