U.S.: Now Tech Adds to the Drag on Manufacturing

Excess capacity and inventories will curb factory output for months

Act II of the recession in manufacturing is well under way, and it's just as depressing as Act I. The story began with production cutbacks in autos and related industries late last year in an effort to liquidate excess inventories as demand fell off. The scene has now shifted to the tech sector, where equipment makers are struggling with the same problem. Will this story have a happy ending, or will it end in tragedy as the conflict spreads to other economic sectors?

So far, stalwart consumers, a solid housing sector, and stimulative government policies give reasons for optimism. In particular, consumers, like a Greek chorus, continue to be the voice of reason during these troubled times. True, their spending has slowed from the sizzling pace of a year ago. But shoppers' finances will get a boost from lower interest rates and tax cuts beginning in the third quarter. Meanwhile, labor markets still have not loosened enough to prevent wages from growing faster than inflation. That means consumer spending should pick up steam in the second half.

Keep in mind, however, that consumers spend the bulk of their money on services and imports. Their purchases of U.S.-manufactured goods have shrunk steadily over the years. So while a consumer rebound means that the worst may be over for the economy as a whole, the same cannot be said for manufacturing.

PROBLEM NO. 1 for manufacturing is that the drag from the tech sector is intensifying (table) as businesses of all stripes slash their capital budgets amid lowered expectations for demand and profits.

Booming demand for tech equipment had powered industrial production over the past few years. In the first half of 2000 alone, tech output grew at a peak annual rate of more than 70%. And by the fourth quarter of last year, the growth rate of tech-production capacity hit a peak of 50%.

But in 2001, demand for computers, telecom equipment, and the like collapsed. Shipments of tech equipment, not adjusted for falling prices, plunged at an annual rate of 26% in the first quarter, and the April level is down 32% from the first-quarter average. The result is a glut of tech goods and production capacity that will take a long time to absorb.

At the same time, U.S. manufacturers won't get much help from foreign demand. Growth in the 12-nation euro zone was at an annual rate of 2.2% in the first quarter, down from 3.4% for all of 2000, and growth in the second quarter appears to have fallen well below 2%. Meanwhile, Japan appears to have entered yet another recession. That means the rest of Asia, which is already struggling, is sure to slow some more. U.S. exports fell in both the fourth quarter of 2000 and the first quarter of 2001. Another drop seems likely in the second quarter.

Adding insult to injury, U.S. factories are suffering from the surprisingly strong dollar, which makes exports more expensive in foreign markets. The broad trade-weighted dollar, adjusted for overseas inflation rates, has risen nearly 11% since early 2000 despite the 67% crash in tech-stock prices, the Fed cuts in interest rates, and the threat of a U.S. recession. Most of the gains have been vs. the euro and the yen.

BECAUSE OF ALL THIS, PRODUCTION in factories, utilities, and mines fell in May for the eighth consecutive month. Output dropped 0.8% last month, and declines were widespread. Production in manufacturing alone fell 0.7%, with all but four of the 19 major industry sectors posting declines. In recent months, the weakness has stretched from consumer goods, down 0.8% in May, to business equipment, off 0.8%, to a wide range of intermediate materials, down 0.9%.

Construction supplies is another factory sector where output is declining--but this weakness is surprising because it runs counter to the solid pace of homebuilding (chart). It may reflect the caution felt by builders at the end of last year, when the economy turned sour. Orders fell off, and manufacturers of construction supplies saw their inventories pile up.

Housing, however, has held up well in 2001. Starts jumped 2.3% in April and fell a mere 0.4% in May, to an annual rate of 1.62 million. That rate isn't far below the record annual pace of 1.65 million set in 1999. And the National Association of Home Builders' Housing Market Index, which measures builders' assessments of current and expected sales plus buyer traffic, climbed in June, thanks to loftier expectations and stronger buyer activity. But with materials inventories still high, output of building supplies will likely remain soft this summer.

MOTOR-VEHICLE PRODUCTION was one of the few categories to post a gain in May. So far this quarter, it is growing at a 29.2% annual rate, compared with declines of 23.6% in the fourth quarter and 27.2% in the first. But at the same time, output of computers, peripherals, communications equipment, and semiconductors is dropping at an annual rate of 14%, more than twice as fast as the 5.7% slide in the first quarter.

Why the contrast? Auto makers have put their inventory overhang behind them, but tech producers are still wrestling with theirs. Indeed, the ratio of inventories to sales for motor vehicles and parts dealers has turned down substantially in recent months, following a steep rise. The ratio for computers and electronic products, however, was rising sharply in April.

The net effect of these two trends will play a big role in gross domestic product's second-quarter growth. In the first quarter, nonfarm businesses liquidated some $25 billion in inventories, at an annual rate. But in April, overall inventories of manufacturers, wholesalers, and retailers began the second quarter unchanged from their level at the end of the first quarter. Based on GDP math, if inventories were to remain steady for all of the second quarter, nonfarm inventories would contribute a full percentage point to the quarter's GDP growth rate.

The tech sector's problem may carry over into the third quarter. In May, tech equipment makers were using only 70.3% of their production capacity. That's the lowest rate in 25 years, and a steep drop from 90% in July, 2000 (chart). Trouble is, through May, tech production capacity was still growing, though at a slower rate than last year. Most economists believe that capacity must ultimately decline in order to realign tech output with demand.

The news from that sector sounds alarming, but keep in mind that tech plays only a supporting role in this drama. Manufacturing is about 16% of GDP, and tech equipment is just 10% of manufacturing output. Consumers, whose spending totals some two-thirds of GDP, still command the limelight. So while tech looks like a formidable antagonist, don't be surprised if, in the second half, the consumer turns out to be our hero.

By James C. Cooper & Kathleen Madigan

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