Explainer: why markets care what businesses are buying

How we track our economy influences everything from government spending and taxes to home lending and business investment. In our series The Way We Measure, we’re taking a close look at economic indicators to better understand what’s going on.

After all the geopolitical turmoil that gripped financial markets in 2016, some bright news started to emerge as we approached the end of the year.

In economies from Australia to China, Germany to the United States, and even in perennial strugglers like Italy and Japan, the Purchasing Managers’ Index (PMI) is signalling an improvement in the economic outlook.

Historically, PMI has correlated closely with economic output. For example, the graph below shows that US PMI, produced by the Institute for Supply Management (ISM), closely aligns with US GDP growth, going all the way back to 1948.

But the real reason so many pay attention to PMI is that it is forward-looking – giving a good indication of where an economy is heading.

What is the PMI?

PMI is pieced together from a monthly survey of purchasing managers in several industries. Purchasing managers play an important role within a firm because they place advance orders for the raw materials that will drive output and corporate performance. As such, they have access to privileged information and are typically among the first to know when trading conditions are changing.

As a result, the PMI is a good indicator of the economic health of particular sectors in the economy. The manufacturing survey attracts most attention (and has the greatest link with economic output), but PMI is typically also available for the service and construction industries.

Several organisations produce PMI measures around the world. Although Markit tracks PMI across a number of countries, the Australian Industry Group (AiG) PMI is most relevant for Australia. The most keenly watched and longest-standing international measure is provided by the American ISM.

Calculating PMI

The exact method of compiling the PMI differs slightly among institutions and across countries but is broadly similar.

Each month, a number of purchasing managers (e.g. 200 for AiG and 300 for the ISM) from a rotating sample of firms are surveyed. They are asked whether business activity has increased, decreased, or remained unchanged from the prior month. The survey also asks about specific business activities, like new orders, production, employment, supplier deliveries, and inventories.

The survey data is then used to create an index (in economic parlance this is called a diffusion index). If all respondents claimed an improvement in business activity, then the index would be 100. If everyone said there has been a decline, then the index would be 0. Generally what we see is an index hovering around the 50 mark.

The common interpretation of this index, then, is that a number greater than 50 indicates an improvement in business activity, while a number less than 50 suggests a decline. Although the headline number is a composite of the various business activities, a more nuanced view of the business environment can be gained by looking at the sub-categories – the answers to the individual questions.

The merits of the PMI

The main difficulties with PMI are the same as those faced by any survey-based measure. The index relies on appropriate survey questions and truthfulness from respondents. Even then, it is possible that external events prevent intended activity from coming to fruition.

The key advantages of PMIs are that they are forward-looking in nature and timely – this owes much to the survey format. Published on a monthly cycle, the PMI gives a prompt indication of the direction of economic activity. It is available well in advance of the quarterly cycle of GDP figures (which are often subject to lags and large revisions) and provides details on new orders and inventory (in the sub-indexes). It can therefore be extremely useful in corporate decision-making.

As it is a survey of private firms, PMI is also not open to the possible manipulation encountered in official government statistics.

Other macroeconomic data may also indicate some of the things found in a PMI report. For instance, industrial production and the employment report may provide similar information to that contained in the PMI sub-indexes.

However, such measures typically take time to collate data and so are produced at a lag to PMI. They also generally reflect current (or past) information and so are not forward-looking. Further, the composite PMI provides a single number that is relatively straightforward for non-economists to understand.

In summary, measures of PMI are useful economic indicators that seem to track well with overall economic activity and are not comprehensively measured elsewhere. Given current PMI readings, even if risks remain, it appears that the global economy is on track to have a bright start to 2017.