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.

Some economists are trying to estimate the cost of the current mortgage crises, unfortunately, most of them are blind to the real costs of the crises. IMF recently estimated the cost to $945b. This estimate has misled even some distinguished economist in believing that the mortgage crisis isn’t that serious. The political economist, Anthony de Jasay is one example. In his latest article “A trillion dollar “catastrophe”?” the Anglo-Hungarian economist, argues that the sub prime crises isn’t really a crises, but for the most part a zero-sum-game. In his words:

The current “crisis”, as every opinion-maker persists in calling it, is primarily […], one of loss of confidence.

and

[m]ost if not all of the trillion dollars is only a loss to one side in a zero-sum game; it is a gain to the other side. If the mortgagee lends too much on a house to the mortgagor, the latter gains what the former loses; the house itself suffers no material damage. If the mortgagee escapes the loss by having the mortgage “packaged” with many others in a “collateralised debt obligation,” that is passed on to some institutional or private buyer, it is the buyer who takes the loss if some of the mortgages in the CDO turn out to be worth less than their face value. There may be a whole chain of buyers sharing in the loss. Some in the chain may even gain.

Jasay reaches his conclusion by looking at the nature of derivatives. Since derivatives to a large extent, actually are zero-sum games, where someone’s loss is another one’s gain, he believes the effect of the crisis is limited, mostly to some redistribution effects. But as I argue, the loss from bad derivative transactions are not the only cost that needs to be considered in gauging the effect of the crises. The real costs are the opportunity costs from misallocated investments and capital.

When interest rates where held artificially low in the past, entrepreneurs got the impression that real savings in the economy had increased, fueling capital spending and investments to unsustainable levels. What we now are beginning to see is that entrepreneurs are starting to realize that they don’t have enough funds in order to finish and maintain the new productive structure, causing distress for many businesses.

According to the Austrian business cycle theory, firms far away from consumption, is hit the hardest, as their amount of malinvestments tend to be higher. Therefore, we need to watch the manufacturing sector in order to gauge the real cost from the credit crises fallout.

According to the Institute for Supply Management, the manufacturing sector has now been falling for the third consecutive month. In the April report, increasing price presure and growing inventories show clear signs of troubles down the road as profit margins for manufacturers shrink, leading to slower economic activity, and finally to higher unemployment.

In addition to ISM, the Employment situation show that, non farm employment have now been falling for the fourth consecutive month. While the headline number in the Establishment survey is -20 000, looking at the broader measure for unemployment in the House hold survey, where we include officially unemployed, the number of marginally attached workers, and the number of working part-time for economic reasons, total unemployment surged to 9.2% in April from 8.2% since last year.

A trillion dollar “loss” in derivative related assets may not be Judgement day. But the fact that the manufacturing sector is slowing and unemployment are on the rise, should result in deep concerns, also for people like Jasay.

According to economic theory, illustrated by economic data, the current credit crisis is not only a crisis, but a severe crisis. The real cost for the economy is not primarily related to derivatives, but are found in the malinvested capital. What we are now seeing in the ISM report and in the Employment situation report is a reflection of the process where capital is being liquidated. Some invested capital will be reallocated to better use. But a large part of the capital stock is fixed capital, and cannot be transformed to any other productive use. These investments will be a total waste of resources, and constitute the real unseen cost of the credit crisis.

In retrospect of the latest manufacturing report, I found an interesting chart, worthy of mentioning here. As it is the largest part of the economy, the goods producing sector play an important role in determination of the overall economic health for a country. Although the ISM index is a good indicatior for the manufacturing sector, I also like to look at total sales and inventories for manufactured goods to get a complimentary view.

By taking the ratio of total inventories over total new orders – excluding defense – from the Census Maufacturing report, we get an interesting chart.

We use new orders as an indication for sales, and non defense manufacturing to get a more accurate reading of business demand for manufactured goods. What we are primarily interested in, is a buildup in inventories relative to sales, which would result in a higher reading in the chart above. What this would tell us, is that there is a back log of goods, that has not yet been sold. By looking back, prior to the tech-boom recession, we can clearly se signs of this happening, as inventory in the manufacturing sector had started to increase in late 1999, signaling trouble.

The reason for this buildup in inventories, can be found in the earlier stages of the business cycle, as credit expansion from the federal reserve system created incentives for entrepreneurs to engage in excessive investing. With artificial cheap funding that did not come from real savings, there was no sufficient future demand for the newly produced goods. This was because the perceived profit opportunity moved capital to sectors most benefited from the earlier credit expansion. This created an increase in supply of capital goods, and finally resulted in shrinking profits, and falling prices together with a liquidation of malinvestments.

According to Ludwig von Mises(p.560),

“[t]he crisis [recession] is precisely characterized by the fact that these [capital] goods are offered in such quantities as to make their prices drop sharply.”

In our case, this results in an inventory buildup and initially, an increase in the inventories/sales ratio, that we can see today. Looking at the chart we can observe that we are presently in a up trend, that started in late 2005. This was at the same time the Greenspan housing bubble started to burst. We can expect to see further increases in inventories/sales. As long as liquidity are getting pumped into the system at an accelerating pace, companies will likely add to their growing stocks, putting aditional pressure on companies balance sheets.

Looking at the current money supply growth, and the latest surge in prices faced by business (+8% according to ISM report), we can se that stagflation is present, causing additional pain as input prices are increasing. This is at the same time business already are experiencing the negative effects of earlier credit expansion.

Finally, I would like to comment on the long term downward trend in the chart. The fact that the inventories/sales ratio has decreased the last 18 years is most likely the result from more efficient inventory planning, making it possible for entrepreneurs to hold a smaller stock of inventories.