U.S.: The Old Economy Might Show the New One a Thing or Two
Don't look now, but the worst may be over for U.S. manufacturers. And if so, you can thank the Old Economy.
Make no mistake--as of March, manufacturing was still drowning in its own recession, even as the overall economy managed to stay afloat. Factories started slashing output and payrolls late last summer and early fall, as orders for everything from cars to computers began to sag. And they continue to suffer disproportionately. For example, weighing in at only 16% of gross domestic product, manufacturing accounted for 60% of the drop in fourth-quarter corporate profits.
The nation's factory sector has been the bellwether of this economic slowdown. It gave out the first and clearest signs that something was amiss, and recession worries will not go away until manufacturing takes a turn for the better. That turn may be beginning, according to the March report from the nation's purchasing managers. A key reason: Helped by stalwart consumer demand in the first quarter, old-line manufacturers are making progress in realigning their inventories, especially auto makers (charts).
At the same time, the upstart tech sector is a big drag. That's a key 10% of manufacturing where orders and shipments are declining, and where production, while still growing, has slowed sharply. The weakness here seems likely to extend into the summer, even as the rest of the factory sector gets its act together. That's because producers of high-tech gear got a later start on wrestling their inventory excesses into shape. Plus, the tech sector depends more on business demand than consumer spending, and right now businesses are cutting their tech outlays deeply.
WHAT'S SHAPING UP for manufacturing--and the economy--may well be a tug-of-war between the consumer-driven, interest-rate-sensitive Old Economy and the investment-led, less-rate-sensitive New Economy. So far, lower interest rates are buoying homebuilding, car sales, and demand for other consumer goods. They are also cutting the cost of capital for Old Economy businesses. That, plus continued strength in consumer demand, will make investment in machinery and equipment, including high-tech gear, more attractive.
However, the high-tech New Economy is beset not only by weaker business demand but also by an ongoing explosion of production capacity that is far in excess of current demand--or even near-term future demand. That's a harder problem for the Federal Reserve to deal with, because even a sharply lower cost of capital will not help: There is no payback for new facilities when tech companies are already swamped with capacity. The necessary adjustment in coming months is substantial, but keep in mind that tech is only 10% of manufacturing capacity.
Moreover, tech companies may only now be experiencing the worst of their inventory adjustment. From September through February, stockpiles among tech manufacturers rose 8.3%, even as their shipments fell 7.5%. As a result, the inventory-sales ratio for high-tech goods jumped from a record low of 1.03 in September to 1.21 in February. Tech's failure to address the overhang more quickly has dragged the economy's inventory correction into the second quarter, probably at a substantial cost to economic growth, as was the case in the first quarter.
IN CONTRAST, the auto industry already has its inventory excesses under control. By the end of March, cars on dealers' lots were back down to more normal levels, thanks to a combination of production cuts and strong demand. Car sales in March posted a solid annual rate of 17.1 million, after a 17.4 million pace in February and 17.1 million in January. First-quarter sales were up from their fourth-quarter level.
After dropping more than 20% from September through January, output of motor vehicles and parts stabilized in February. And based on data from Ward's Automotive Reports, auto production rose in March, and second-quarter production plans suggest that auto output could contribute as much as 1.5 percentage points to the quarter's growth in real GDP. Auto output subtracted nearly a percentage point from GDP growth in both the fourth and first quarters.
Steadier footing in Detroit is partly responsible for the mildly encouraging news from the nation's purchasing managers. The trade group's index of industrial activity--a composite of orders, production, employment, inventories, and speed of deliveries--rose for the second month in a row in March, to 43.1%, from 41.9% in February and 41.2% in January, which was the lowest level since the 1990-91 recession.
The purchasers' report also showed some progress on inventories. In March, only 19% of the purchasing executives surveyed described stockpiles as "too high," down for the second consecutive month from a peak of 26% in January. There's still some work to do, though. A year ago, only 10% of the purchasers reported that inventories were excessive.
CONSUMERS ARE A KEY REASON why there is hope for manufacturers. Not only is their spending helping to stabilize old-line manufacturing, but as those businesses see demand growing, they will be more inclined to increase their investment in high-tech gear. Consumer spending, adjusted for inflation, rose 0.1% in February, following a 0.6% advance in January. Even if March outlays did not grow at all, real consumer spending for the quarter probably rose at an annual rate of 3.1%. Taken alone, that's enough to add two percentage points to first-quarter GDP growth.
The low-tech construction industry is also set to contribute handsomely to first-quarter growth. Real outlays for private building projects increased 1.8% in January and 0.9% in February, after a declining trend stretching back to April, 2000 (chart). Not surprisingly, given unyielding strength in home demand and starts so far this year, residential construction is leading the gain.
Strength from the economy's veterans will help to lessen the drain coming from the new kid on the block. When the Commerce Dept. reports first-quarter GDP on Apr. 27, expect to see a big drag on growth from investment in high-tech equipment, especially outlays by information-technology and Internet companies. IT industries' January shipments fell 2.8% from December, and they plunged an additional 3.1% in February. Even if March shipments hold steady, the total for the first quarter will fall at a record annual rate of 19%.
But even against that enormous drop, first-quarter GDP growth still appears to have kept its head above water--if only barely. The point here is that, in the first quarter, Old Economy strength is offsetting much of the New Economy weakness. In the end, consumers will determine which force prevails, and the answer may not be known until well into the summer.
By James C. Cooper & Kathleen Madigan