What Is Not Seen

In a couple of my earlier posts, I have argued that the manufacturing sector make up the largest part of the modern industrialized economy, especially the U.S economy. While the press keeps nagging about the fact that consumption constitute 70 % of GDP, manufacturing constitute totally 62 % of the whole economy! To quote from one of my earlier posts:

By looking at the broader statistic provided by the Bureau of Economic Analysis, Gross-Output, total spending in the US economy is approximately $24 trillion. With GDP of $13 trillion, industrial spending including spending on manufacturing can be estimated roughly to $14,9 trillion. This would infer that consumer spending constitute only 38 % of total economic spending not 70 % according to the GDP. The other 62% can be subscribed to spending in earlier stages of the production process, in particular manufacturing.

Now, according to the latest numbers, the manufacturing sector gained momentum during May. Looking at the ISM survey (Institute for Supply Management), released yesterday, we saw that PMI growth in manufacturing increased to 49.6 % in May, up from 48.6 %, in April (A number below 50 signifies a slowing manufacturing sector). The biggest positive change was found in production, new orders and prices, where production increased 3.2 % to 49.7 % and new orders 2.1 % to 51.2 %, sending an apparently bullish signal.

Also, today’s Census report on Manufacturers’ shipments, inventories and orders agree with the ISM survey, showing an increase in manufacturing with 1.1 % for new manufacturing orders in April.

Looking back on 2007, we see that manufacturing peaking in July. So, what then does these numbers tell us. Is the April readings possibly a through for manufacturing?

Not likely! While ISM new orders increased, we saw a sharp 5.5 % decline in order backlogs. Backlogs can be viewed as total value of sales orders waiting to be fulfilled. Thus, by merely looking at new orders compared to backlogs, we see that the gain in new orders is smaller than the decline in backlog. Keeping in mind that ISM is only a survey, the net effect indicates a slower overall demand for manufacturing goods.

Another important fact regarding new orders can be seen in the Census report. According to the headline number, new orders in manufacturing increase by 1.1 % in April. However, non-seasonally adjusted change during the month for new orders declined with -2.7 %. That is a positive adjustment of totally 3.8 %.

The case with ISM production, on the other hand, is not as obvious as with new orders. Looking at the downward trend since July 2007, when manufacturing peaked, the May production reading is likely nothing more than a short-term divergence from the long term-trend. According to economic theory, manufacturing in this stage of the business cycle should experience severe problems.

But what about the FED cutting interest rates? Since September 2007 the FED has cut interest rates by 3.25 %. While the rate cuts often have a direct impact on the stock market, they have a lagging effect on the economy.

First, a lower interest rate means lower financing costs for companies, as they now can borrow money more cheaply. This low rate environment creates an artificial boost to accounting profits as capital is allocated to the manufacturing sector.

Second, an artificially low interest rate creates monetary inflation. Eventually, this inflation results in higher prices. The recent surge in commodity prices, such as energy, metals and agricultural goods, is partially a consequence of prior rate cuts.

Looking at the ISM report, prices reached 87 % during May, the highest reading for the index since it registered 88 percent in April 2004. A surge I input prices directly affects capital intense businesses, such as manufacturing, resulting in lower profit margins.

At this point, it is too early to call for a new “bubble” in manufacturing. Although, the rate cuts still have a distorting effect, keeping malinvested capital from being liquidation. Surging input prices have put a cap on growth in manufacturing. As long as prices on energy and other input goods keeps on piling up, manufacturing will suffer. Hence, we should expect further weakness going forward.

Finally, to answer the initial question: What’s up with manufacturing? let us once again turn to the ISM survey to see what respondents are saying:

“Higher prices, tighter supply, longer lead times, shrinking inventory (same as last month).” (Transportation Equipment)

“Just two months ago we were cautiously optimistic, but now sales inquiries are coming in at a snail’s pace.” (Machinery)

“Ethanol-driven agricultural commodity increases continue to pose major hurdles.” (Food, Beverage & Tobacco Products)

“Pricing is skyrocketing for chemicals.” (Chemical Products)

“Current forecast flat for Q2 through Q4 after dip in Q1.” (Computer & Electronic Products.

Paul Kasriel, from Norther Trust, has written a great article about How Housing has Affected the Economic “Ecology”, where he provide lots of important data worth digesting. He writes that

In sum, the economic “ecology” has been disturbed first by the recent boom in housing and now by the current bust in housing. As a result, the current recession is likely to be more severe than the last one because it will be concentrated in the household sector, which accounts for about 75% of real GDP.

Thus, the economic recovery, which is likely to emerge late in 2008, will be muted due to the lack of credit creation from financial institutions. So, don’t expect a V-shaped recovery, but rather a U-shaped or even L-shaped one.

Because financial institutions will experience large losses across a wide spectrum of credit classes and because there is the likelihood of increased regulation, the financial system will be capital “impaired,” probably through 2009. Even though the Federal Reserve is and will continue to offer “cheap” credit to the financial system throughout 2008 and into early 2009, financial institutions will have diminished demand for the Fed’s offer because they will not have the capital to support lending to the private sector.