This Factory Rebound Isn't Built To Last

Manufacturers wore down their pencils in July. The Commerce Dept. says that producers of durable goods, such as computers, cars, and appliances, wrote up new orders at the fastest clip in 20 years. The financial markets reacted as if the factory sector--and the recovery--were off to the races. Cyclical stocks rallied, bonds sold off on inflation fears, and anticipation of an imminent easing of monetary policy by the Federal Reserve began to fade.

Is a manufacturing boom in the making? Hardly. First of all, such ebullience in new orders is at odds with other reports. A July survey of 1,000 manufacturers by Dun & Bradstreet Corp. says that business conditions remained at recession levels and that expectations deteriorated.

In addition, prices of industrial materials in mid-August fell to their lowest level in more than four years, a sign that demand is still soft. Exports dropped in both May and June. And most factories are still laying off workers instead of adding new ones. Against that backdrop, the July report on orders is much less impressive.

The booming aircraft industry accounted for much of the July jump in orders. Bookings rose by 10.7% (chart), the largest increase since December, 1970. Excluding planes, cars, and other transportation equipment, orders still rose a handsome 6%. In August, however, bookings are likely to retrace much of their July rise. Aircraft orders will fall back, as they always do after a big rise. Combining July and August data will give a truer reading of demand.

To be sure, factory output is rebounding from its recession lows. Through July, industrial production has risen for four consecutive months, fueled by postwar pickup in demand for homes, autos, and other consumer goods. The July surge in orders assures further output gains in the months immediately ahead, but it does not guarantee that manufacturing is home free.


As in all recoveries, factories are benefiting from a positive swing in the inventory cycle. Supplies were low before the recession, and they were liquidated during the downturn. When demand picked up after the war, businesses found that stock levels were too low relative to sales. Presto: Orders and output are now rising.

The trick may not be so easy this time around, though. Demand sets the inventory cycle in motion, but it must remain strong for inventory rebuilding to keep the recovery going. That's the problem. So far, the growth of consumer spending has been subdued compared with past recoveries. And there are increasing signs that consumers do not have the will or the way to sustain these inventory-led gains in output.

Some of the latest indications of that: In July, real retail sales were barely above their March level, and purchases of existing homes fell sharply, adding to fears that the housing recovery is faltering. In August, car sales toppled back to recession levels, darkening the outlook for fourth-quarter car output. And consumers continued to lose confidence--just the opposite of what typically occurs three or four months into a recovery.


The current swing in inventories will have its greatest impact on real gross national product in the third quarter, but that lift will not carry into the fourth quarter without more help from consumers. The government's latest revision to GNP shows a 0.1% drop in the second quarter, compared with the 0.4% gain originally reported. Consumer spending was not as strong as first reported, and inventory liquidation was much larger.

The revision makes three consecutive quarterly declines in real GNP, but the economy will undoubtedly post a gain in the third quarter. Inventories have now been cut deeply for three consecutive quarters (chart). The production gains already in progress will reverse this liquidation and give GNP a big boost this quarter.

Rising auto production will lead the way. Detroit is making cars at a 6.5 million annual rate this quarter. That's a big acceleration from only 5.3 million in the second quarter, when it was struggling to reduce its inventories of unsold cars.

However, fourth-quarter auto production could be a different story. Car sales in the first 20 days of August fell to an annual rate of 6.1 million from 6.8 million in July. If buyers are losing interest, Detroit may cut next quarter's output. It is already scheduled to drop to about 6 million.

Concern about consumer demand extends well beyond cars, however. Consumers still face an uncertain job market, given the restructuring in many service industries, which employ three-fourths of all workers. Many businesses are cutting back on their labor costs as profits continue to get squeezed.

Operating profits, adjusted for inventories and depreciation allowances, edged up by $1.7 billion last quarter, to an annual rate of $287 billion (chart). However, that's 6.1% below a year ago, and margins are still under pressure. That increases the likelihood of more layoffs, the main reason why consumers are on edge.


Consumers grew more pessimistic in August, according to the Conference Board. Its index of consumer confidence fell to 76.3 from 77.7 in July and 81.1 in March, immediately following the victory in the Persian Gulf (chart). The report did say that most of the responses came before the Soviet turmoil, and optimism may have rebounded a bit after the coup failed.

But not necessarily. That's because consumers are more worried about their jobs and incomes than they are about who's running the Soviet Union. The Conference Board says that 38.6% of households feel that jobs are hard to get. That's up from 37.6% in July and 22.1% in July, 1990, when the recession began, and it is the highest percentage in seven years.

In addition, the Conference Board says that 80% of consumers expect their incomes to hold steady or decline within the next six months. Sluggish income growth is a big reason why this recovery remains tenuous. Consumers have increased their spending at the expense of savings. A smaller paycheck would only worsen the average household's financial position.

So it's not surprising that households are cutting back on their buying plans. The recent rebound in home sales has caused some pickup in plans to purchase major appliances. But other big-ticket items, such as cars, houses, and vacations, are being crossed off many shopping lists, says the Conference Board.

Certainly, consumer pessimism about the future is a big threat to the housing recovery. Mortgage rates may be falling, but consumers are unlikely to buy a house if they are worried about their jobs. Indeed, the latest reports from the housing industry illustrate that the rebound so far has been pretty lackluster.

Sales of existing homes fell by a steep 6.7% in July, to an annual rate of 3.35 million, says the National Association of Realtors. And members of the National Association of Home Builders say that sales of new homes slowed as the summer progressed. According to the association, 42% of builders reported that sales were poor in August. That's a sharp increase from 35% in July and 32% who reported weak sales in May and June. Consumer pessimism seems destined to keep the housing recovery in low gear.

In addition, unless consumers start showing more enthusiasm about spending, businesses will have little reason to boost their orders further in an effort to restock their inventories. The ratio of inventories to sales for manufacturers, wholesalers, and retailers jumped during the recession, indicating that stock levels were higher than desired. But going into the third quarter, the ratio was back to where it was prior to the recession.

That's a sign that inventories are about where businesses would like them to be. From here on out, gains in factory production will depend on the pace of demand. But without consumers, manufacturers can expect to give their order pencils a rest in coming months.

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