Manufacturing index signaling 'fiscal cliff' impact?

INDICATOR: March Supply Managers' Manufacturing Index

KEY DATA: ISM (Manufacturing): 51.3 (down 2.9 points); New Orders: down 6.4 points: Production: down 5.4 points: Employment: up

IN A NUTSHELL: "With the tax increases and sequestration-driven spending reductions starting to kick in, some of the projected negative impacts may be starting to show up."

WHAT IT MEANS: The February data were better than expected but we are now into the March numbers when the sequestration government spending slowdown was starting and the cumulative impacts of tax increases eating to disposable income were expected to moderate spending. That just might be the happening. Manufacturing activity, while still growing, did so a lot less robustly in March than the previous month. Of concern was the sharp deceleration in order growth and output. In addition, backlogs grew more slowly, which is not good news for future production levels. Despite all that, firms actually hired more rapidly. That is an indication that maybe there is some technical issues going on here.

MARKETS AND FED POLICY IMPLICATIONS: Why would firms hire more people in the face of falling demand? There is an answer and while it is a bit technical, it makes sense. The January and February data may have been skewed by the uncertainties caused by the fiscal cliff. Orders and production rose solidly those two months but the reason may have been a temporary slowdown to the previous months to guard again potentially going off the cliff. Once we passed that crisis, firms had to make up for lost time and did so the first two months of the year and by March, they had reached more sustainable levels. That would mean the March numbers are more "real" but not necessarily a sign of weakness. We will not know if the March decline was just an adjustment issue or an evolving trend until we see the April report. My view is that it is a little of both. We are beginning to see where the government spending cuts will reduce demand and in those sectors and parts of the country that will feel the wrath of sequestration, adjustments are being made. But it is early in the process so we should not be seeing a whole lot yet from sequestration. Also, lower and middle-income households who are hurt the most by the tax increases can sustain spending levels only for so long. Ultimately, they will have to cut back but once again, that is a slow process. Thus, some of the slowdown may be due to moderating spending, but it should not have created such a large drop in the new orders index. The remainder of the fall off should be ascribed to the adjustment from the fiscal cliff crisis. Regardless, investors have to looking for signs that this great rally may finally face a correction. This report is a warning but with the employment report coming on Friday, I don't think it will have a large impact on the markets.