The Purchasing Managers’ Index (PMI) is a monthly report that provides a snapshot of how the manufacturing and services sectors are performing. Traders and investors closely watch the PMI to track economic health and anticipate market moves.
In this article, we share what PMI is, how it works and how it’s calculated, and how traders use it to inform their strategies.
Understanding what PMI stands for
Definition of PMI in economics
The Purchasing Managers’ Index (PMI) is a closely watched economic indicator that measures the health of the manufacturing and services sectors. It’s expressed as a number between 0 and 100. Scores above 50 indicate economic expansion or growth, while those below 50 indicate contraction or decline.
The purpose of PMI
The PMI tracks business conditions like new orders, production or output, employment levels, supplier delivery times, and inventory levels. It essentially acts as an early signal of economic trends, giving policymakers, businesses, and investors insight into how the economy is performing and where it might be headed next. For example:
- Businesses use the PMI to guide decisions on production, hiring, and inventory management based on where the economy is headed.
- Investors look at PMI readings to evaluate the condition of the economy and guide investment decisions. Rising PMIs can lead to increased stock prices, and vice versa.
- Policymakers use the PMI to inform monetary or fiscal policy decisions. For example, central banks might reduce interest rates to boost economic activity in response to a decreasing PMI.
How the PMI works
Understanding what the PMI includes
The PMI is made up of five core components that provide a snapshot of current business conditions. The five main parts of the manufacturing PMI are:
- New orders: Measures the volume of new purchase orders, providing an indication of demand and future production activity
- Production/output: Measures current production levels, with higher levels suggesting stronger demand
- Employment levels: Measures the level of employment, with increasing levels suggesting growth
- Supplier delivery times: Tracks how quickly suppliers are delivering goods, with longer times suggesting high demand or supply chain issues
- Inventory levels: Measures the amount of unsold goods, with excess inventory suggesting lower demand.
These components might be weighted by importance or given equal weightings depending on the industry.
How the PMI is calculated
The PMI is calculated from monthly surveys sent to purchasing managers across different industries. For each of the above components, managers are asked if conditions have improved, worsened, or stayed the same compared to the previous month.
The responses are then turned into a diffusion index using the following formula:
PMI = (% of ‘improved’ responses) + 0.5 x (% of ‘no change’ responses)
The result is a number between 0 and 100, where readings above 50 = expansion, below 50 = contraction, and exactly 50 = no change.
For example, if 60% report improvement, 30% report no change, and 10% report worsened conditions, the PMI calculation would be:
60 + (0.5 x 30) = 75. This would be considered a strong signal of economic expansion.
The PMI surveys are usually conducted in the second half of the month, with manufacturing PMIs typically released on the first working day of the following month.
Different types of PMI
Different types of PMI include:
- Manufacturing PMI: Focuses on factory activity and production
- Services PMI: Covers non-manufacturing sectors like finance, hospitality, and retail
- Composite PMI: Combines manufacturing and services to give a more holistic view of the economy
- Flash PMI: A preliminary reading released before the final PMI.
The role of PMI in financial markets
Why the PMI matters to traders
The PMI is one of the first economic indicators to be published each month, so it gives traders and investors a snapshot of whether an economy is potentially expanding or contracting before other major data releases, like GDP or employment reports.
Traders use PMI data to guide their strategies and investment decisions. When the PMI is rising, it suggests stronger business activity and improving demand, which might lead to higher company earnings and an increase in stock prices. When the PMI is falling, it might signal slowing growth or even economic contraction, prompting a switch to safer assets like bonds or gold.
PMI releases can also trigger sharp market moves, especially when the figures beat or miss expectations by a long way. For example:
- Significant PMI beats (well above forecasts) can boost market sentiment and investor trust, driving up stock prices and strengthening the domestic currency as traders price in stronger economic growth or potential rate hikes.
- Significant PMI misses (well below forecasts) can rattle the markets and lead to stock sell-offs and a flocking to safe-haven assets.
Using the PMI to inform trading strategies
Many traders use the PMI to anticipate market moves, adjust their portfolios, and identify potential turning points in the economic cycle before they appear in other indicators.
For example, a PMI reading above 50 suggests that businesses are seeing stronger demand, increasing production, and hiring more workers – all signs of economic expansion. In this kind of environment, cyclical sectors like technology, industrials, and consumer discretionary all tend to perform well. Traders might respond to these readings by increasing exposure to these areas, going long on equities or exchange-traded funds (ETFs) tied to economic growth.
On the other hand, a PMI reading below 50 suggests economic contraction. In these cases, traders might shift towards defensive sectors like healthcare, utilities, or consumer staples, which are known to weather downturns more smoothly.
PMI releases can also create potential opportunities for short-term trading, especially when data significantly beats or misses expectations. As mentioned earlier, a stronger-than-expected PMI reading might trigger rallies in stock indices or local currencies, offering bullish trade setups. A lower-than-expected PMI might lead to sell-offs, opening up potential opportunities for short selling or hedging. Traders should be aware that trading during news releases can significantly increase market volatility and increase risk, and may not be suitable for all investors.
In the forex market, traders use PMI readings to shape expectations for central bank actions. For example, persistently strong PMI readings might lead to inflation and rising interest rates. In response, investors might purchase the local currency to earn the now-higher interest rates, driving up its value.
Comparing PMI with other economic indicators
Differentiating PMI from GDP and CPI
PMI is considered a leading indicator, which means it gives early signals about the direction of the economy. This makes it different to lagging indicators, like gross domestic (GDP) and the consumer price index (CPI), which reflect economic changes after they’ve already materialized.
For example, GDP figures are usually published on a quarterly basis and CPI focuses on price changes that have already occurred. PMI, however, is released monthly and based on current business surveys, giving a near real-time view of economic conditions.
International PMI comparisons
PMI reports are published by several major economies, including the US (ISM PMI), Eurozone (HCOB PMI), UK (S&P Global/CIPS PMI), China (Caixin PMI), and Japan (Jibun Bank PMI), amongst others.
These international releases can be useful for forex traders, allowing them to gauge the relative strength of different economies. If US PMI data outperforms European or Chinese PMI figures, for example, it might fuel demand for the US dollar against the euro or yuan.
PMI-related terminology and misconceptions
What PMI means in other contexts
The term PMI can be confusing because it means different things depending on the context. In real estate, PMI refers to Private Mortgage Insurance, a type of insurance you pay when you take out a mortgage with less than 20% down payment. This is different to the Purchasing Managers’ Index referred to in the world of financial markets.
Myths about PMI interpretation
There can be some myths and misconceptions when it comes to interpreting PMI data. For example, some people assume that a strong PMI reading always translates directly into higher GDP growth, but that’s not necessarily true. Even though PMI can give some early clues about the economy, it doesn’t measure the full scope of economic output.
Another misconception is that a high or rising PMI will automatically trigger stock market rallies or currency appreciation. In reality, markets often move on expectations, and if a strong PMI was already anticipated then traders might not react much when the data comes out.
It’s also worth remembering that PMI data comes from surveys and reflects the perceptions of purchasing managers, as opposed to hard data like sales or production figures. This means PMI readings might sometimes reflect short-term events, like temporary supply chain issues or seasonal slowdowns, which might not always reflect lasting trends.
