Last Friday the Federal Reserve released the industrial production numbers for May, which showed stagnant growth with zero growth over April's levels and capacity utilization falling two-tenths of a percent to 81.3%.
Figure 1
Source: Moody's Economy.com
What I would like to point out is the weakness in industrial production and capacity utilization in the current economic cycle compared to those of the past half century. Both industrial production and capacity utilization are already coming down from their highs this cycle while never surpassing or even reaching the levels of the past cycle. The reason this is important is to put to task the whole argument that businesses will come to the economic rescue and increase capital investment to offset slower consumer spending and a housing recession.
Here's a simple question. Why would corporations increase their capacity through capital investment when the economy is currently not running at full capacity to begin with, nor at peak capacity levels seen in previous economic cycles at the same time the consumer is slowing demand?
Need proof of a consumer slowdown? Just take a look at consumer plans for purchasing big ticket items and their optimism levels, not to mention what small business owners are saying in their optimism polls. Consumer plans to purchase homes and automobiles over the next six months are declining with plans to purchase autos falling to a new low.
Figure 2
Source: Moody's Economy.com
Corporations are paying close attention as consumer durable goods industrial production (automotive products, computers & electrical equipment, appliances, furniture) is slowing, while nondurable consumer goods industrial production (food & tobacco, clothing) remains strong.
The relative rates of durable goods production to nondurable (essential items) production is a good indicator of economic health. When the economy is strong, consumers increase purchases on big ticket items and conversely, when the economy is weak they continue spending on essential items (nondurable goods) while reducing demand for durable good items. For this reason, the ratio of durable goods to nondurable goods production often turns south prior to recessions as seen in Figure 3 below, and also follows the trend in the yield curve with a 16 month lag.
Figure 3
Source: Moody's Economy.com
The housing slowdown is clearly weighing on small business owners' minds as seen in Figure 4, and automobile production is likely to fall further when looking at the correlation to the yield curve, indicating weak auto demand out to next year (Figure 5).
Figure 4
Source: Moody's Economy.com
Figure 5
Source: Moody's Economy.com
The slowdown in consumer spending appetites (retail sales) is quite visible after peaking in early 2006, and has turned south sharply following the bursting of the housing bubble. This trend will likely continue heading south if retail sales follows its historical relation to the yield curve as it has in the past, as the yield curve leads the trend in retail sales by roughly two years (advanced in chart below). The trend in the yield curve indicates retail sales will continue to decelerate until bottoming in the first quarter of 2009, as the yield curve is just now beginning to normalize with long-term interest rates moving northward.
Figure 6
Source: Moody's Economy.com
It's not hard to envision why retail sales will continue to decelerate when looking at the current housing situation that is far from bottoming and continues to weigh on households for quarters to come. On Monday the National Association of Home Builders (NAHB) released their June Housing Market Index, which fell to 28 as every component of the index was down, with the traffic of prospective buyers index falling to 21, the lowest reading in more than 16 years.
Figure 7
Source: Moody's Economy.com
Revealing the bleak outlook on housing is commentary provided by DismalScientist below:
The bottom of the housing market is unlikely to occur this summer or fall. The record low numbers for the June survey begs the same question that the record low numbers for April and May did, "can the housing market get any worse without a recession?" The non-seasonally adjusted profile of home builders who recorded optimism for the traffic of prospective buyers index is so low that one wonders which builders are prospering during this housing market.The fed funds rate may be too high for this sector to recover in the current economy. One concern is the rising number of bankruptcies and other insolvency issues for subprime lenders. A number of mortgage originators have been required to buy back defaulting loans or close their doors. There is little evidence that the expected return on these 'junk' mortgages justified the risk, so much tighter lending practices are evident this year. Tighter lending standards will lower the demand for single family housing, making it difficult to work off the already high levels of inventory.With such a negative housing backdrop, it's understandable why retail sales are falling and consumers are ratcheting down their plans to purchase big ticket items. With this being the case it's not surprising to see industrial production falling, not rising as many financial pundits claim would happen as corporations are flush with cash.
As the shape of the yield curve affects consumer spending by increasing the cost of borrowing and shows a significant correlation with a lag of two years, it makes sense for the yield curve to affect business spending by raising their cost of borrowing. As the trend in the yield curve points towards deceleration in retail sales, so does the yield curve with industrial production, putting a kink in the argument of business spending picking up in the near-term.
Business equipment industrial production has clearly peaked on a year-over-year (YOY) basis and lags the shape of the yield curve by one year, indicating continued weakness for the rest of the year.
Figure 8
Source: Moody's Economy.com
Overall manufacturing industrial production has peaked with continued deceleration ahead as indicated by the yield curve. Investment spending is unlikely to increase as manufacturing capacity utilization is well below previous highs and has displayed a series of lower peaks in utilization rates over the last fifty years as the U.S. has shifted away from a manufacturing economy to a service economy.
Figure 9
Source: Moody's Economy.com
Figure 10
Source: Moody's Economy.com
Don't expect spending on technology to make any headlines either as capacity utilization for computer and technology equipment production is well below peak levels and has already begun to roll over.
Figure 11
Source: Moody's Economy.com
In short, businesses are unlikely to be the economic miracle to offset a bursting housing bubble and weakening consumer spending in the near future based on decades of historical precedence in the relationship of industrial production and the shape of the yield curve. With housing in the midst of a recession, consumers retrenching, and businesses unlikely to step up to the plate, the dismal first quarter GDP number may be the beginning of a trend in weak economic performance, not a one-time event. So what does Wall Street see that Main Street is missing?
TODAY'S MARKET
The markets moved southward despite falling energy prices as rising interest rates sent jitters through the markets once more. The Dow put in a triple-digit loss on the day, falling 146.00 points (-1.07%) to close at 13,489.42, while the S&P 500 fell 20.86 points (-1.36%) to close at 1512.84 and the NASDAQ closed at 2599.96, down 26.80 points (-1.02%).
Investors sold Treasuries today with the 10-year note yield rising 3.7 basis points to close at 5.123%. The dollar index was up on the day, rising 0.06 points to close at 82.60. Declining issues represented 75% and 69% for the NYSE and NASDAQ respectively, with down volume representing 76% and 78% of total volume on the NYSE and NASDAQ, reflecting a strong selloff in the markets.
Energy prices took a beating after a strong build in petroleum inventories. West Texas Intermediate Crude (WTIC) fell nearly a dollar a barrel (-1.32%) to close at .19 a barrel. Precious metals were down on the day with gold closing at 4.75/oz (-1.03%), with silver down __spamspan_img_placeholder__.15/oz to close at .19/oz (-1.12%). Base metals were mixed with lead putting in the strongest positive performance (+2.99%), while nickel displayed the weakest performance (-1.30%).
Overseas markets were mixed up with the Taiwan Taiex index putting in the strongest performance (+2.13%), while other Asian and European markets were down more than one percent, with the Chinese Shanghai index down the greatest, falling 2.07%.
The selloff in the markets was broad based as all ten of the S&P 500 sectors were down on the day, with the consumer discretionary and consumer staples sectors holding up the most, down 0.27% and 0.60% respectively. Energy took the brunt of the selloff on the news of a strong build in petroleum inventories, falling 2.93%, while rising interest rates weighed on the utility and financial sectors, down 2.57% and 1.68% respectively.
