Slack in the Industrials System

No Green Shoots in Industrial Production

The Fed’s report on Industrial Production (IP) and Capacity Utilization (CU) was downright dismal. CU is a particularly important thing to look at since as the chart below shows (from http://www.calculatedriskblog.com/) it almost always turns up right at the point that the NBER eventually decides is the end of a recession. Furthermore, it does not tend to provide a lot of false signals.

Total capacity utilization fell to yet another record low (records go back to 1967) of 68.3%. Before this downturn, the worst the country had ever seen was 70.9% in December 1982. This was down from 60.0% in April and 69.4% in March, so the rate of decline actually accelerated in May. Thus, one cannot even make a second derivative argument that things are getting better (or worse at a slower pace). The average utilization between 1972 and 2008 has been 80.9%. In general, a reading of 85% represents a boom, and around 80% is normal.

A year ago, CU was 78.9%. We tend to get down to 75% in a pretty bad recession. Below 70%? Well, that is just plain ugly.

CU is measured for three areas, Manufacturing, Mining and Utilities. Of the three, Manufacturing is by far the most important, and the most significant. Mining is a small part of the overall economy and the Utility numbers can be affected by the weather as much as by economic activity. Manufacturing CU fell to 65.0% from 65.6% in April and 65.9% in March, and 76.7% a year ago. The long-term average for Manufacturing CU is 79.6%. Mining CU is much higher at 80.8%, but it to fell sharply in May from 85.5% in both April and March, a year ago it was at 90.8% and its long-term average is 87.6%. Utility CU fell to 79.3% from 80.6% and 83.7% a year ago.

If one digs deeper and looks at CU by stage of production, it fell at all three levels. There is the least slack in the system at the Crude level at 77.7%, but it was down from 78.5% in April and 79.5% in March; a year ago it was at 88.6%. The intermediate stage of production has the most slack at 65.6%, down from 66.7% in April and 67.0% in March and 78.8% a year ago. Finished goods CU was 67.4% vs. 67.6% in April and 68.1% in March. A year ago it was at 75.0%.

Factories, of course, represent extremely large fixed costs to companies, and if they are sitting idle it is not a good thing for profitability. This level of slack in the system means that industrial companies are seeing the bad side of operational leverage, regardless of the financial leverage they have.

In particular, though, this data is very bad news for suppliers of industrial goods like Illinois Tool Works (ITW) and some of the divisions of firms like Honeywell (HON) and Ingersoll Rand (IR). If you have lots of equipment sitting idle, just what is the incentive for businesses to order more?



On the IP side of the report, things do not look much brighter. Overall, industrial output fell 1.1% in May, and is now down 13.4% below a year ago. Further, the output decline in April was revised down to a 0.7% slide from 0.5%, and March was revised down to 1.8% decline from 1.7%.

Manufacturing output fell 1.0% following a 0.6% decline in April (revised from a 0.3% decline). It is down 15.3% year over year.  Utility output was 1.4% lower more than reversing a 0.7% rise in April. It’s year-over-year decline, though, is a relatively moderate 3.4% -- but then again, remember that Utilities are very weather-sensitive.

Mine output plunged 2.1% in May following declines of 3.2% and 1.9% in April and May, respectively. In part, this may be the lagged effect of the earlier declines in commodity prices. If so, the recent rebound in commodities could mean that mine output will pick up again in the coming months.

The manufacturing decline was very broad-based, with all major areas down. Not surprisingly, output of building supplies is off the most on a year-over-year basis at 21.5%. It was down 1.0% for the month. Business equipment output is down 16.5% year over year and fell 1.4% in the month. Output of Consumer goods fell 0.8%, the smallest of any of the major categories. The decline is also the smallest on a year-over-year basis at 7.1%.

I consider this report to be a significant piece of evidence for the anti-"green shoots" case. Historically, we have never seen a recession end while capacity utilization and industrial production are still falling. This recession is already the longest in post-war history, and the evidence suggests that it still has a ways to go.

Granted, Manufacturing is not as important to the overall economy as it once was, but it is still the major swing-factor between a healthy growing economy and a contracting one. Reports like this one are herbicide to green shoots, not fertilizer.

Read the full analyst report on ITW

Read the full analyst report on HON

Read the full analyst report on IR