It Ain't A Recovery Till The Factories Humby
Manufacturing has always been the heart of the U.S. economy. And despite its ever-shrinking contribution to output, the factory sector still provides some of the best gauges of the twists and turns in the business cycle. Throughout this recovery, manufacturing's beat has been slow and erratic. And it's going to stay that way until consumers are financially able to provide a much-needed shot of adrenaline.
As consumers struggle with heavy debts and light wallets, manufacturers contend with a trickle of new orders, a shrinking backlog of unfilled orders, and uncertainty over the future. As a result, factories have little incentive to step up production and hiring. They have every reason to keep inventories as lean as possible. And under these conditions, they are in no rush to shell out for new equipment and buildings.
The slowdown in exports only makes matters worse. Exports surged in June, helping to narrow the trade deficit to $6.6 billion from $7.1 billion in May. However, exports had dropped in five of the previous six months.
Since 1986, the increasing contribution of foreign demand to manufacturing growth has pushed exports of goods as a share of industrial output steadily higher. That share hit a record in the first quarter, but it fell sharply last quarter, suggesting that exports' contribution to factory output is waning.
THE BOND MARKET RALLY IS A PLUS
As for domestic demand, stubbornly high long-term interest rates have been particularly punishing for durable-goods manufacturers. On that front, the two-month rally in the bond market is good news. With long rates falling, mortgages are cheaper, and the demand for housing-related items and other high-cost, credit-sensitive durable goods should firm up in the second half, just as it did during the first-quarter surge in housing.
So far, the rate drop has not yet shown up in the housing data because of reporting lags. Housing starts in July fell 2.8%, to an annual rate of 1.12 million. The key single-family sector posted a 4.1% drop (chart). Overall, building permits jumped in July, but that says little about the future. All the rise in permits occurred in the multifamily sector, which is beset by past overbuilding. Single-family authorizations were about unchanged.
August numbers on sales and starts should look better. Mortgage applications for home purchase dipped in early August, but they had jumped sharply in July. And the average for 30-year, fixed-mortgage rates fell to 8.01% on Aug. 14, down from 8.15% the week before. But still, housing demand is going to be constrained by job worries, weak income growth, and burdensome debts.
Moreover, the Presidential election could be a stumbling block for lower long-term rates. Despite the ever-brighter inflation outlook, long rates rose amid the bond market's renewed edginess over the fear that some new deficit-widening plan to cut taxes would emerge from the Republican convention. A Democratic victory in November would hold even more uncertainty.
THINGS ARE QUIET ON THE SHOP FLOOR
Manufacturing just cannot seem to generate any momentum. After gains earlier this year, factory production was flat in July, after falling 0.2% in June (chart). Overall industrial production rose 0.4%, but that reflected a weather-related surge in electric-utility output and a rebound in mining output at the end of the rail strike.
Because of tepid production gains, a lot of factory capacity stands idle. The factory operating rate fell from 77.8% in June to 77.6% in July. Before the recession in 1990, the rate was about 83%. The current low level of capacity use hardly justifies an increase in capital spending. It also implies that price pressures among goods producers are virtually nil--and likely to remain so.
Gyrations in auto production are partly responsible for the zigzag pattern of factory output, and Detroit will be a plus in the third quarter. After gains in April and May, auto production fell back in both June and July--with attendant impacts on suppliers. Domestic car assemblies slipped to an annual rate of 5.7 million in July, from a 6.1 million pace in June, but Detroit's August and September schedules call for a jump to about 6.3 million in both months.
A potential problem for holding that faster production pace: Car sales in early August ran at an annual rate of only 5.7 million, down from 6.5 million for all of July.
The factory sector does have two fundamentals going for it. First, the combination of cost-cutting and productivity gains has completely stymied the growth in unit labor costs. That means better profitability even in a weak economy. Second, factory inventories in relation to sales are the lowest on record. That means production can respond very quickly to any pickup in demand.
STILL THERE'S LITTLE DEMAND
That's fine, but where's the demand? The poky pace of jobs and incomes has spooked U.S. consumers and derailed their buying plans. Capital spending looks iffy. Defense cuts keep coming. And slower growth abroad means less demand for American exports.
The trend in consumer spending is particularly ominous for manufacturers. Retail buying posted big gains in January and February, but it has stayed in a holding pattern since then. Until sales show a solid upward trend, retailers have no reason to boost their ordering.
Despite lean factory inventories, retail stocks were not in the best of shape in June. Inventories jumped 0.8%, as sales fell by 0.3%. During the past year, retailers have seen their stockpiles grow by more than 6% (chart), while sales are up less than 3%. This suggests that retailers are heading into the fall buying season with heavier-than-normal inventories--and questionable prospects for consumer spending.
Retail sales managed a 0.5% gain in July, but the Commerce Dept. revised away the originally reported June gain of 0.5% to show a decline. That was the third time in the past four months that Commerce has revised the sales data lower than first reported.
Most retailers showed sales gains in July, but for the most part, the increases just offset the June declines. Only furniture and clothing stores have been able to break out of the horizontal pattern plaguing retailers. Worse, initial reports for August suggest another so-so performance for total sales this month.
In addition to sagging car sales, early August department-store receipts look weak. The Johnson Redbook Service, published by Lynch, Jones & Ryan Inc., reports that store sales, which soared 2.3% in July, have fallen back this month. For the first two weeks of August, Johnson Redbook says sales are down 0.4% from July.
In addition, the University of Michigan's index of consumer sentiment in early August reportedly dropped to 75.3%, from 76.6% in July. Consumers worried about the economy are unlikely to go out on a shopping spree.
Of course, economic problems are not endemic to the U.S. Stagnation in other countries is hurting exports, while America's appetite for imports remains strong. These trends suggest that foreign trade will make little, if any, contribution to economic growth in the second half. In June, both imports and exports hit record levels. Imports rose 4.7% to $44.9 billion, while exports jumped 7.2% to $38.3 billion.
Despite the June gain, export growth has slowed. In the year ended last quarter, exports were up only 5%--the slowest pace in five years (chart). Stagnant demand from Japan, Europe, and Canada has offset growth in exports to Latin America. And that trend will not change until the industrialized economies start to expand again.
Making sure that U.S. consumers are up and running again is the first concern for most American manufacturers, however. Right now, households need two things: faster job growth and stronger balance sheets. The recovery's sluggish pace is saying that both of these may take a while. Until then, manufacturing will continue to beat in fits and starts--and so will the recovery.