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Three Reasons that the Economic Slowdown in Manufacturing Might be Temporary

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The gloom and doom brigade has been out in force for the last few weeks. Some of this reaction is justifiable when one looks at the numbers that have been released lately. The housing market is still skidding to lower levels. The consumer has retreated in the face of more inflation threats. The jobless rate worsened as the private sector slowed its hiring. Suddenly, there are conversations about double dips and Great Depressions and the very end of the world as we know it. The manufacturing sector in particular seemed to lose its position as the engine of the recovery. The PMI and CMI numbers both slumped, and there was no good news in the durable goods category either. All in all, it was a pretty miserable week, and the markets reflected the new sense of impending doom.

There are three reasons to think that all this is temporary and not the start of another breakdown in the core economy. The first and perhaps the most important factor is the unexpected surge in inflation that took place at the start of the year. This is not yet an increase in the all-important core rate that motivates the Fed to make decisions, but when the real rate of inflation spikes there is an almost instant consumer reaction, when the inflation comes from hikes in commodity prices. The emergence of the “Arab Spring” took the world by surprise; within days the price per barrel of oil had thrust ahead by almost $20, and the price of gas jumped by 70 cents. The consumer was fresh off the memory of 2008 and assumed that it was only going to get worse, and the talking heads reinforced that perception. The result was a rapid withdrawal of consumer confidence which took a big chunk out of overall demand.

However, as outlined in the commodity story below, the price of oil may be heading down soon, and gas prices have already eased a little. They are still higher than they were a few months ago, but the $4 barrier was broken for only a short time and in select regions of the country.

More important, the inflation threat is not yet manifesting in a way that will shift consumer behavior permanently. The three factors that beget inflation are hikes in commodity prices, shifts in the wage structure, and an overall abundance of money in the system. At the moment only commodity prices have become a factor. The high unemployment rate has kept wages low, which is good as far as inflation is concerned. The supply of money has been substantial, but for the most part it has not leaked into the system; as long as it is not leaving the banks it is not fueling price hikes. In other words, the inflation pressure felt by the consumer is coming from fuel and food, and there may be some modest relief on the way for both of these sectors. If the consumer thinks that the threat of much higher pricing is not so immediate, they will likely relax and get back to their old patterns.

The second reason that the downturn might be short-lived is that much of the decline of the last few weeks has been related to the issues stemming from the Japanese earthquake. This was a cruel reminder of just how interdependent the world has become and how fragile the supply chain really is. The devastation in Japan set the industrial sector back by months. The flow of parts and supplies for the world was interrupted and many manufacturers felt the pinch. The Japanese are already starting to recover, and most of those parts will be flowing soon, but the damage will linger for a while longer as the whole notion of just-in-time has been challenged. The response to the disaster will take some time to digest and accommodate, but this process is already under way, and by the end of the year there will be a return to some semblance of normal.

The third reason that this slowdown is likely to be temporary is that some of the conditions that led to the expansion of the recession are fading, and these improvements will start to show up in the months ahead. The one factor that has observers a little baffled is that banks and corporations have more money on hand than they have had in years, but that cash is not going anywhere. The banks have been sitting on it partly because they have had to contend with the wave of rule changes that stemmed from the Dodd Frank legislation, and partly because they have returned to their old-school ways. Slowly but surely, the new system is getting in place, and banks are interested again in expanding their business through loans. Credit is still far from loose, but it isn’t as tight as it has been. The business community has been holding on to cash more aggressively as well, partly because they are not sure what they can count on from the banks anymore and partly because they are just more cautious than they have been. The need to spend that money is not pressing as yet, but if the competition starts to move or there appears to be more demand, they will start to let loose that cash, and the economy will be stimulated again.

Of course there is no way of knowing just when this money will start to flow. It is a bit like the Catch-22 dilemma. Business will spend when there is demand to justify it, but the consumer will not boost demand until business starts expanding — and hiring. The wait will not be permanent, but it is also unlikely that a shift is imminent.

What does this mean for manufacturing?

The industrial sector has been pulling the economy along on the strength of expanded exports and the need to rebuild inventory. Is this something that can be counted on to start up again in the coming months? It is likely that the export demand will return and in fact it has not declined all that much in the past few months. The big drop has been in inventory build, and until the consumer gets more aggressive there will not be a drawdown sufficient to provide much impetus for the manufacturer. As in most other recoveries, the consumer will hold the key.

Summary by Dr. Chris Kuehl, FMA’s economic analyst and founder of Armada Corporate Intelligence.


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C Marshall Fabrication Machinery, Inc.