Is Manufacturing Leading a Recovery?

by: Econophile

The requirements usually associated with a recovery stemming from a rise in manufacturing are lacking in the present situation.

The classic analysis of a business cycle says that lower interest rates as a result of increased savings will stimulate borrowing by manufacturers of capital goods to produce goods such as machinery used to produce intermediate or consumer goods, or even housing, thus increasing wages and employment in that industry, and then such spending makes its way through the economy and results in greater economic activity and thus recovery.

The latest data show that manufacturing has been increasing. The ISM Manufacturing Index came out Tuesday with solid gains which, along with other data, would normally indicate that an economic recovery is being led by the manufacturing sector:

I don't think that is what is happening, at least not the way most analysts see it.

Current Data

The economic data has been generally positive:

Non-manufacturing data from ISM (mostly the service industry) was up to 59.4 in January from 57.1 in December:

New factory orders were mixed, up 0.2% but mostly as the result of price increases. The report noted that inventories were tight:

According to Thursday's report in the Wall Street Journal, retail sales in January were up 4.2%, a good move considering the weather:

Tightly managed inventories were a plus. Retailers ordered less for this holiday season than the last couple of years and didn't have to resort to major markdowns as they closed out the quarter. Those that did a lot of discounting were able to clear merchandise and move in spring wear, which they are hoping to sell at fuller prices, given consumers' increased propensity to continue buying.

The 28 retailers tracked by Thomson Reuters posted same-store sales gains of 4.2% on average for January, compared with analysts' projections for a 2.7% gain. The figure compares with 3.3% a year ago and follows December's 3.1% gain and the 5.6% growth in November. Same-store, or comparable store, sales are sales at stores open at least a year.

Businesses are still not hiring sufficiently to bring down unemployment because they are not sure of the economic and political future. That conclusion is derived from the productivity report which showed that businesses are still squeezing what they can out of existing workers through efficiencies:

This report shows that productivity was up 2.6% in Q4 2010. Also unit labor costs declined by 0.6% showing stagnant wage gains. On an annualized basis:

Year-on-year, productivity was up 1.7 percent in the fourth quarter-down from 2.6 percent in the third quarter. Year-ago unit labor costs lost ground with an annualized minus 0.2 percent from minus 1.1 percent in the prior period.

Productivity measures output per worker and there are two ways output can increase: workers work longer and harder, or new machinery enables them to produce more. Since unit labor costs are not increasing (from overtime or additional hiring for example), then worker efficiency has to come from capital goods such as machinery that increases output. And the data support this: manufacturers' shipments of durable goods, excluding defense and transportation, increased about 10.2% YoY in 2010. Shipments of capital goods, excluding defense and transportation, increased 9.4% YoY in 2010.

Manufacturing is Dependent on Consumer Spending

Most economists are predicting that hiring in the manufacturing sector will increase in 2011 and 2012 because manufacturers can't get much more out of existing employees. But we need to see consumer demand first.

When it comes down to it, all production and manufacturing is ultimately for consumer goods. That is Econ 101. Yes, I understand the defense industry is an exception to that rule; that is a government function, not a market function. So, if we have all this manufacturing, where is consumer demand? If consumer demand finally responded to the wealth created from increased manufacturing, then surely manufacturers would expand and hire more employees.

Retail sales were up strongly in January (+4.2%). But if wages are flat to declining and unemployment remains high, does this spending reflect a strong economy? I don't believe so.

There are three reasons for this.

1. Spending increases are mainly from wealthier Americans as a result of a booming stock market and the wealth "effect" that comes from that. I believe we have a two tier economy and the spending from the other America is coming from savings because their income is still flat and they are uncertain about their future, the polls notwithstanding. I will bet that retailers did well in warm winter clothing--a necessity.

This wealth effect, however, is somewhat ephemeral. While wealthier Americans always lead the recovery cycle, the same forces that would cause a classic recovery are missing: real savings (capital) amassed from productive activity, not from fiat money.

What is driving the markets are two related things: cheap Fed money (quantitative easing) and a cheap dollar.

If you flood Wall Street with cheap dollars freshly created by the Fed, as the Fed is doing with quantitative easing, the money first goes to the Fed's primary dealers, Wall Street's big banking houses. Because lending activity is still tight, it is obvious that most of the new money went into the financial markets, and thus we have a stock market boom. I believe the broad market rise will be propped up only as long as we have QE.

The other effect of QE and its corollary, deficit spending, is that it tends to drive down the value of the dollar. While some companies are growing, much of the earnings we are seeing are related to cheap dollar exports which give US multinationals and exporters an advantage in foreign markets. This chart compares the dollar (blue) to the euro (olive):

2. The second reason that manufacturing will not lead us to recovery is that consumer spending in the other America is weak. The fact is that most of the money to spend came from savings:

I've been beating on this drum for quite a while now, as my readers may recall. The savings rate in 2010 steadily declined from about 6.2% to 5.3% (from 5.5% to 5.3% in December alone). In part the decline in savings and increased spending is in response to learned spending behavior from consumers who gained the spending habit during the boom days of the economy. Another part is that consumer confidence in January as measured by the Conference Board and the U of Michigan surveys were very positive. Another reason, and the main reason, is that wage growth has been stagnant for some time.

It is nice to see Dave Rosenberg agrees with me. This from Monday's Breakfast With Dave:

On a high note, personal consumer expenditure spending (PCE) rose 0.7% MoM in December and once adjusted for inflation real PCE increased 0.4%. But as we saw in last Friday’s real GDP number, part of the increase in spending came as consumers drew down their savings as organic income remained weak. Personal income was up 0.4% but after accounting for taxes and inflation, real personal disposable income was only up 0.1%. Had consumers not taken their savings rate from 5.5% to 5.3% in December, real consumer spending would actually have been much weaker in fact (0.1% vs 0.4%). While the momentum heading into the first quarter is very good and it looks like Q1 GDP will be strong (a similar or better reading than Q4) we remain concerned over Q2 and believe there could be significant slowing.

While it may be that some consumers are more optimistic, the reality is different, especially for the other America. The Department of Agriculture reported Wednesday that some 43 million Americans took food stamps or government nutritional assistance in November. That is up 14.2% from a year ago. Also, wage growth has been relatively flat and manufacturing has not been increasing unit labor costs. Average hourly earnings have increased by only 1.8 % in the last 12 months.

3. Unemployment remains high and that will continue to put a damper on consumer spending. The unemployment report will come out today, but I do not expect any significant change. Thursday's Gallup unemployment reports were negative:

Manufacturing Will Stall Along With Consumer Spending

Getting back to my original premise on the classic business cycle on how manufacturing can lead us to a recovery, it is obvious that the economic requirements for such are lacking this time. If wages remain flat and unemployment and underemployment is high, and if the stock market boom is based on the Fed's money pumping and not organic growth, where will demand come from to spur manufacturing?

Manufacturing is based ultimately on consumer spending. It is unlikely that manufacturers will significantly increase employment until they see substantial demand from intermediate producers and consumers. If much of demand and spending is based on the stock markets' wealth effect, then what will happen when the Fed chooses to exit its quantitative easing strategy? And, will the other America be more likely to hold on to their savings rather or continue to spend them?

The economy has not yet recovered from the damaging boom that led to the inevitable bust. The Fed and the government are doing everything they can to thwart a recovery. While the economy is repairing itself naturally despite government intervention, that is not yet sufficient to carry us forward. Manufacturing in this case will run into an inevitable wall.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.