The Economy Starts to Work Harder
In our last issue, we reviewed the indicators that led us to believe we would see a marked improvement in the economy by the end of 2003. The current indicators show this forecast to be well founded, but there is much room for improvement. There are three things still holding the US economy back: 1. Low manufacturing capacity utilization, 2. Continued deterioration of the trade balance, especially in manufactured goods, and 3. A reluctance to create new jobs, especially in manufacturing, which is largely due to the first two items. In essence, what we are now seeing is what some call a "jobless recovery", although it might be more accurately described as a "service recovery". By this, I mean that the service sector is showing signs of decent growth while manufacturing continues to shed jobs.
In our last commentary, we predicted that some of the economic aftershocks of the Iraq war would continue into the Fall. Some of the impact may extend far beyond this year. As Americans tightened their purse strings, many players in manufacturing, retail and distribution channels responded by seeking lower cost sources of supply overseas. This can clearly be seen in the ballooning trade deficit with China, which will be nearly 120 billion dollars for 2003. One clear impact of this shift is that the recovery of US manufacturing is likely to lag significantly behind recovery in retail, distribution and services, because many of the buyers involved see no compelling reason to shift back from cheaper overseas sources. While there are good reasons to shift back - due to supply chain issues, quality, and political risk, among other reasons - most of these reasons are very strategic in nature (read "important, but not urgent"), and thus are unlikely to be considered until they create serious problems for the customers involved.
Looking at the 2nd quarter 2003 numbers, we see that growth in consumer spending and GDP perked up a bit from Q1 2003, as we predicted. While orders for plant and equipment did not match the heady 7.5% jump we saw in the first quarter, it is important to note that they did not drop back to the 2002 level either. If you are in capital equipment, this is a key indicator, and you should be relieved to see that the Q1 surge was not just a spike, but probably - as these numbers suggest - a shift to a higher sustained level of activity. A pleasant surprise for us is that we did not see those numbers or the inventory numbers deteriorate in the second quarter. The net effect for the US economy in the coming year will be decidedly positive, as these indicators show that the Iraq war had a far milder impact on the economy than we expected.
As we have said for some time now, low interest rates have created a boom for construction and bank refinancing - but they are showing signs of bottoming out. Fortunately, the Fed has signaled pretty strongly that we should not expect a sharp increase in rates in the near term, but we should probably plan on seeing a gentle increase sometime in the coming year. Interestingly, we can see in the big increase in housing starts that this anticipation appears to be driving another surge in construction, perhaps a last-ditch effort to take advantage of low rates before they start moving up.
The second quarter employment numbers clearly support the "jobless recovery" idea. Some of this may be the effect of "war paralysis", but we will need to watch the employment statistics in the next few months to see if this is a trend or a blip from the war. With employment and manufacturing hours flat in the second quarter, and unemployment up, the jobs picture looks mediocre at best. It is particularly worrisome that capacity utilization declined a full point in the second quarter, as hiring will remain stunted until capacity utilization increases significantly. The weak employment statistics don't tell the whole picture - employment looks particularly light in manufacturing and travel-related industries. Some of this may be due to increased productivity due to technology in manufacturing and increasing acceptance of technological alternatives to travel. Interestingly, the weak manufacturing numbers are not just a US phenomenon - the Wall Street Journal reported on October 20 that worldwide manufacturing employment is down. This means that we are not merely seeing the effects of manufacturing business moving offshore - although that movement is a noticeable factor in some industries.
Crude Materials Prices continued to rise in the second quarter. How much of this was continued war jitters is open to debate. Interestingly, the strong quarterly increase in producer prices we saw last quarter did not continue, which means that most intermediate producers took it on the chin and did not pass on the increased costs they experienced in the first quarter. As we pointed out in our last issue, retailers and consumer products manufacturers are still contending with the issue of whether (and how) to pass along these increasing costs to the consumers. As the US economy becomes more comfortable with foreign sourcing - especially from Asia - this question will become strategically critical for US manufacturers who risk losing most of their commodity sales. Strategically, there has never been a time when it was more important to build and maintain specialty status.
The worry about higher interest rates appears to be just that - a worry, and nothing more. The Fed appears to be quite interested in allowing the current low interest rate environment to buoy the economy. This is smart, since the US economy is in no danger of overheating in the near future. However, we should keep a close eye on inflation, as it may induce the Fed to raise rates even if that would slow down economic growth. As we said in the last issue, we will be particularly concerned about rates when the Fed decides that the economy is growing quickly enough.
The slight increase in Composite Leading Indicators tells us that the possibility of recession has probably evaporated. We said in our last issue that last quarter's decline in leading indicators was most likely driven by the growing impact of the war on the economy in the first quarter, and this assessment was correct. From this point forward, the war in Iraq will have a mildly depressing effect on the third quarter and very little effect beyond that. As before, we recommend keeping a close eye on the longer term trends and serious consideration to fundamental changes in strategy warranted by the shifting global situation in your strategic planning.
Robert Bradford is President of Center for Simplified Strategic Planning, Inc. He can be reached via e-mail at
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