Storm clouds gathering
Expect growth in manufacturing to slow because of high energy and commodity costs.
By Tom Stundza -- Purchasing, 11/18/2004 2:00:00 AM
Statistical gauges, the barometers of an economy's direction, have been falling since summer—a sign that the fair winds of the past are about to switch direction and bring about stormy weather. Indeed, all the economic weather vanes point to the brakes being applied to growth in manufacturing. More evidence: Only 46% of the buyers polled by PURCHASING in September and October reported growth in business activity, the first time that number has fallen below 50% since October 2003.
Economists are now suggesting that the seasonal (fourth quarter) softness in demand may require temporary inventory readjustments (due to year-end accounting practices), thus creating an immediate slowdown in manufacturing. And most of the soothsayers—and buyers, for that matter—disagree with the Federal Reserve Board's contention that the U.S. economy is about to pull out of a temporary pause and grow well for the rest of 2004 and the start of 2005. "Persistent high oil prices, rising interest rates, waning consumer confidence, and a record Federal deficit are making manufacturers understandably nervous," says economist Tom Runiewicz at Global Insight's office in Eddystone, Pa.
At the same time, however, the declines in the various leading indexes over the last four months have not been large enough— or persistent enough— to signal an end to the current economic expansion. Still, Ken Goldstein, economist at the Conference Board, a private research firm in New York, cautions that if high debt and concern over weak job growth causes consumers to become more cautious about spending, then the overall economy could slow before the holiday season.
That type of scenario would cause weaker gross domestic product growth in the fourth quarter and the first quarter of 2005. "Weak growth and no pricing power, or deflation" is a more likely scenario for the United States in 2005, as consumers struggle with rising energy bills, which could dent spending, agrees Joe Quinlan, chief market strategist for Banc of America Capital Management inn New York.
In combination with the record-high crude oil prices and persistently high raw materials prices, it portrays an industrial economy that is losing momentum heading into 2005. Higher prices for energy and basic materials are the headwinds slowing the pace of growth in manufacturing activity, says Gary Thayer, chief economist at A.G. Edwards & Sons, a brokerage firm headquartered in St. Louis. Buyers are in agreement. Surveys in September and October by PURCHASING found that the number of buyers who are planning to boost purchasing to support production are at their lowest level since November 2003. That struggle by manufacturing to regain traction means that the Federal Reserve may have to slow its interest rate increases and that 2005 may not be as robust as forecast earlier.
That's reflected in the erratic economic growth so far this year. Economic growth of 4.4% in the first quarter was faster than forecast, but the 3.3% annual rate in the second quarter was far slower than expected. Then, despite the apparent softness in economic activity in the third quarter, gross domestic product (GDP) expanded by 3.4%, thus continuing its upward growth path. To wit, business confidence remains elevated (although off from its peak), credit conditions are favorable and corporate balance sheets are healthy (although not as healthy as had been expected).
But the ups-and-downs will likely continue into the foreseeable future because of the uncertainty about oil prices, Iraq, terrorism, and jobs. So what's the growth expectation for the U.S. economy? Most business economists now expect real GDP to grow by 4.3% this year. This is better than the 3% growth registered in 2003—and the largest advance in the U.S. since 1984, when the economy expanded at a 7.2% annual clip. But, the new 2004 forecasts are down from earlier projections because economists now see a second half with weaker personal consumption expenditures, a sharper worsening of the trade deficit, fading benefits from the 2003 tax cuts, and sky-high energy and raw materials costs.
Less confidence
In addition, manufacturing executives are less confident about the U.S. and global economies than they were three months ago, according to a survey from PricewaterhouseCoopers that was released late last month. About 75% of the executives questioned about the economic barometers for manufacturing in the third-quarter expressed optimism about the direction of the U.S. economy over the next 12 months—but that's down from 84% in the second quarter.
"The majority of manufacturers are less upbeat about the economy—a sentiment that is consistent with the consensus across all industries," says Jorge Milo, leader of the group's U.S. industrial manufacturing practice. And, in fact, the current industrial recovery has been more conservative than previous upturns. The six-year recovery under President Reagan saw manufacturing grow by a 5.0% average annual rate. During the President Clinton years, manufacturing activity averaged 5.5% growth annually. So far under the second President Bush, manufacturing expansion has been barely 4.5% annually.
The manufacturing sector—factories, mines and utilities—continued to be active during September/October, but at a slightly slower rate of growth than earlier in the year. Still, overall factory orders are up more than 12% from a year ago—especially for durable goods—products designed to last three years or longer. However, there was some slippage in orders for durable goods in August, so production will slip in the final quarter.
The Federal Reserve says capacity utilization has been holding steady at 77%, a rate that is lower than economists had been expecting. That's largely because automotive manufacturers have adjusted downward their second-half production plans. Plus, there is a concern that appliance manufacturing output may slip soon as it has been running 8% ahead of the 2003 pace, or about twice the growth in sales. In other manufacturing industries—ranging from electronics equipment to offroad construction machinery, market fundamentals remain favorable.
"To keep the factory sector striving, healthy spending by both the consumer and the government is vital," says economist Runiewicz. "A third component, namely strong investment, is also required. For the past 18 months, spending on computers and high-tech equipment has been leading the growth in investment. Last year, investment in computers advanced 12%. This year, 17% growth is projected, with continued robust growth expected in 2005. Investment in traditional capital goods [had] been in a tailspin the last three years" before bottoming out in 2003.
Indeed, real investment in industrial machinery contracted more than 8% in 2001 and nearly 6% in 2002, before bottoming out in 2003. So far this year, orders and output have risen sharply, triggering a 12% increase in investment this year in the machinery sector as corporate America began to loosen the purse strings and exports staged a comeback (see sidebar on page 42).
Looking ahead
Some economists say 2004 will be the best year of manufacturing performance in this business cycle because U.S. demand for steel, nonferrous metals, plastics and other production materials has increased after three-plus years of lethargy. And that has spiked prices of numerous commodities and raw materials. In fact, this year's explosive prices for steel, nonferrous metals and plastics have dampened earnings—especially for those firms that manufacture parts for industrial, commercial and consumer products. The makers of many end-use products also reported lower-than-expected third quarter earnings.
The weaker-than-expected profits are due partly because end-use consumption in the second half isn't growing as fast as supply, partly because costs of energy and raw materials were much higher than expected, and partly because producers were unable to boost end-market prices for many fabricated and finished products.
The outlook for 2005 suggests continued expansion in manufacturing, but at a slower rate than during prior expansions. Economists at BMO Nesbitt Burns in New York and Toronto are among those that suggest the U.S. manufacturing growth "is poised to moderate somewhat" in 2005. Even Federal Reserve Board Governor Susan Bies now forecasts the economy will grow at a slower pace through 2005 because of oil prices.
"Fiscal policy is poised to contribute less to economic growth in 2005 than in 2004 regardless of the outcome of the upcoming presidential election," says Tim O'Neill, chief economist. "Policymakers will need to tighten the fiscal purse strings in order to rein in the deficit." On the other hand, he and his staff suggest: "Countering these negative factors, growth will be [buoyed] by several positive influences. Strong profit growth and rising confidence in the sustainability of the expansion should support business investment."
Forecasts of key indicators
(U.S., annual, % change)
| '01 | '02 | '03 | '04 | '05/f | |
| SOURCE: BLUE CHIP CONSENSUS, NATIONAL ASSOCIATION OF BUSINESS ECONOMISTS |
|||||
| Gross domestic product | 0.3 | 2.5 | 3.0 | 4.3 | 3.7 |
| GDP price index | 2.4 | 1.7 | 1.8 | 2.2 | 2.1 |
| Gross domestic purchases | 0.4 | 3.0 | 3.3 | 3.5 | 3.3 |
| Consumer price index | 2.8 | 1.6 | 2.3 | 2.6 | 2.4 |
| Consumer spending | 2.5 | 3.1 | 3.3 | 3.6 | 3.2 |
| Construction spending | 2.9 | 1.0 | 4.9 | 1.5 | 2.9 |
| Residential starts | 1.9 | 6.9 | 8.2 | 4.4 | -8.0 |
| Nonresidential investment | -5.2 | -5.7 | 2.8 | 9.7 | 9.0 |
| Industrial production | -3.4 | -0.6 | 0.2 | 4.7 | 4.9 |
| Capacity utilization, mfg | -7.2 | -2.0 | -1.1 | 5.0 | 3.0 |
| Motor vehicle sales | -1.7 | -2.3 | 8.2 | -0.6 | 0.6 |
| Off-road vehicle sales | 9.1 | 0.1 | 20.6 | 9.7 | 3.4 |
| Machinery assembly | -11.4 | -7.4 | -0.8 | 7.8 | 5.4 |
| Major appliance sales | -0.6 | 5.1 | 2.0 | 3.4 | -1.7 |
| Transportation services | -1.4 | 0.5 | 0.4 | 2.6 | 2.5 |
| Unemployment rate | 4.7 | 5.8 | 6.0 | 5.5 | 5.3 |
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