JOYG Joy Global Inc. (MM)

Total Industrial Production rose 0.2% in August, which was above the expected unchanged reading. It is slower than the July increase of 0.9%, which was unrevised. The June reading was revised down to a 0.1% increase from 0.4%. The absolute increase is on the anemic side, but at least it was better than expected, and the underlying details are stronger than the headline number would suggest (not great, but better than 0.2%). Relative to a year ago, total Industrial Production is up 3.4%. In normal times, that would be OK, but for coming out of a deep recession, it is anemic and is a substantial slowdown from what we were seeing last year.

Total Industrial Production includes not only the output of the nation's factories, but of its mines and utility power plants as well. The production and consumption of electricity generally has as much to do with the weather as it does with overall economic activity. A big part of the weakness this month came from the Utilities. This could be a Hurricane Irene effect, as millions were left without power. Also, the heat wave in the South, particularly in Texas and Oklahoma, was more intense in July than August, and thus the need for air conditioning was not quite as intense.

Thus it is important to look at just how the manufacturing sector is doing alone. It was up 0.5% in August, down from a 0.6% increase in July (unrevised) but better than the unchanged reading for June (revised down from a 0.2% increase). Year over year factory output was up 3.8%. The increase this month still makes this a very solid performance, and much better than expected (although we don't have an official consensus expectation for manufacturing output alone - at least it was better than I was expecting). Part of the increase in factory output is probably due to the easing of supply chain constraints growing out of the disaster in Japan.

Utility output plunged by 3.0%, reversing a jump of 2.8% in July (most likely due to the Texas Heat wave). In June, utility output edged lower by 0.1%. Year over year Utility output is down 2.4%. The utility number is mostly about weather, not changes in economic activity, and can be very volatile. The manufacturing only number is a better gauge of overall economic activity.

The third sector tracked by the report is Mining (including oil and natural gas). The output of the nation’s mines rose by 1.2% in August, up from a 1.1% increase in August, and up from June’s 0.5% rise. Year over year mine output is up 5.6%. That is a very solid performance, and reflects rising domestic oil and gas production, largely due to the new shale plays (mostly in North Dakota for Oil and in the Marcellus Shale of the Northeast for natural gas).

By stage of production, output of finished goods rose by 0.4%, after a 0.9% increase in July and a 0.3% decline in June. Relative to a year ago finished goods production is up 3.3%. Finished goods are separated into consumer goods and business equipment, and there is a real dichotomy between the two. Consumers are trying hard to rebuild their balance sheets; businesses on the other hand, especially large businesses, have extremely strong balance sheets. That means consumers are spending less on current consumption while paying down debt and building up savings. That is a tough thing to do when you are unemployed, but the 90.9% of people who are working are doing their best to get their personal fiscal houses in order. In addition, a large part of consumer finished goods are imports, not made here in the U.S. Output of finished consumer goods was up 0.2% in August, down from an increase of 0.9% in July but up from a decline of 0.4% in June. Year over year, output of consumer goods is up just 1.2%.

Business equipment output on the other hand has been consistently strong. It rose 0.7% in August, down from an increase of 1.1% in July but up from an increase of just 0.1% in June. Still, a 0.7% increase for the month is very respectable. Business equipment production is up 9.4% from a year ago. Business investment in Equipment and Software has been one of the strongest parts of the economy, contributing 0.55 points of the 1.00% total growth in the economy in the second quarter, even though it makes up just 7.33% of GDP. The first two thirds of the third quarter are very strong in this regard, so look for investment in Equipment and Software to be another solid contributor to growth in the third quarter.

While I would not expect spectacular results, this data suggests that we might see a bit of acceleration from the anemic 1.0% pace of the second quarter. However, it is not likely to be above the 2.0% growth rate we really need to start to bring down unemployment in any significant way.

Output of materials rose 0.1%, way down from the 0.9% rise in July and the 0.6% increase in June. Materials output is up 3.9% year over year. The first graph below (from http://www.calculatedriskblog.com/) shows the long term path of total industrial production (blue) and manufacturing only industrial production (red). As manufacturing output is the bulk of total output, it is not surprising that the two lines track pretty well with each other over longer periods of time. While we are in much better shape than we were a year ago, production is still well below pre-recession levels. That is not particularly unusual two years after the end of a recession. In the Great Recession it fell much more than it had in any previous downturn. Notice however, that the slope of both lines in this recovery is much steeper than in previous recoveries.

The other side of the report is Capacity Utilization. This is one of the most under appreciated economic indicators out there, and one that deserves a lot more attention and ink than it usually gets. Total capacity utilization suffers from the same weather-related drawback as does Industrial Production. Total Capacity Utilization was at 77.4%, in line with expectations. However, July was revised down to 77.3% from 77.5%, and June was revised down to 76.7% from 76.9%. Thus, it is ambiguous whether the total industrial production actually increased or decreased for the month. It is better than the current read of last month, but worse than we thought last month was. The revival of capacity utilization has been going on for over two years now. A year ago, just 75.5% of our overall capacity was being used, and that was up from a record low of 67.3% in June 2009.

The basic rule of thumb on total capacity utilization is that if it gets up above 85%, the economy is booming and in severe danger of overheating. This effectively raises a red flag at the Fed and tells them that they need to raise short term interest rates to cool the economy. It is also a signal to Congress that it is time to either cut spending or raise taxes, also to cool down the economy (Congress seldom listens to what capacity utilization is saying, but the Fed does).

Congress now wants to do what would be appropriate at capacity utilization levels of 85, when the actual level is less than 78. Capacity utilization of around 80 signals a nice healthy economy; sort of the Goldilocks level, not to hot, not to cold. The long term average level is 80.4%. A level of 75% is usually associated with a recession. The Great Recession was the only one on record where it fell below 70%. Thus a 10.1 point improvement in overall capacity utilization from the lows is highly significant and very good news. On the other hand, we still have a long way to go for the economy to be considered healthy.

The second graph (also from Calculated Risk) shows the path of capacity utilization (total and manufacturing) since 1967. Note that the previous expansion was sort of on the pathetic side when it came to capacity utilization, barely getting over the long term average at its peak; the previous two expansions both hit the 85% overheating mark (the 1990s doing so on two separate occasions). It does not signal a good economy by any stretch of the imagination, but it also looks like fears that we were already falling back into recession are overblown. On the other hand, these days industrial output makes up a much smaller share of the overall economy than it used to.

Given the weather influences on Utility Utilization, and thus the total, it is important to look at how Manufacturing alone is doing. Factory utilization rose to 75.0% from 74.7% in July, but that was only after July was revised down from 75.0%, so it would be equally valid to see factory utilization as being unchanged. June was also revised down to 74.4% from 74.6%. Factory utilization is up from 72.6% a year ago, and the cycle (and record) low of 64.4% in June 2009. That is still well below the long term average level of 79.0%, so, as with total capacity, we still have a long way to go on the factory utilization level.

Total capacity rose by 0.9% over the last year, but most of that expansion came in the Mine and Utility segments. Manufacturing capacity is up 0.4% from a year ago. Increased capacity is a headwind for increased capacity utilization, but at the current level it is a breeze, not a gale, particularly for manufacturing. For most of the last two years we have seen year over year declines in capacity, but now that is turning around. While shrinking capacity makes it easier to use the remaining capacity at a higher level, it is not a good sign for the economy. It represents a permanent loss rather than a temporary idling of the country’s economic potential.

Mines were working at 90.8% of capacity in August, up from 89.9% in July and from 89.0% in June. A year ago they were operating at 87.7%, and the cycle low was 79.0%. We are actually now above the long term average of 87.4% of capacity. When we are at or above the long term average, minor fluctuations should not be a big macro concern. Since there is a lot of operating leverage in most mining companies, this probably means very good things for the profitability of mining firms with big U.S. operations like Freeport McMoRan (FCX) and Peabody Energy (BTU). Mine capacity increased 2.0% year over year, making the year over year increase in capacity utilization even more impressive.

As depreciation is more than just an accounting exercise when it comes to mining equipment, the high operating rates are also good news for the equipment makers like Joy Global (JOYG) and Caterpillar (CAT), although the U.S. is a relatively small part of their overall business.

Utility utilization plunged to 78.7% from 81.2% in July and 79.4% in June. A year ago Utilities were operating at 82.8%, We are far below the long term average utilization of 86.6%. We are actually now below the 2009 low of 79.2%! Increasing utility utilization faces a headwind because our power plant capacity has actually been increasing even faster than our mine capacity, up 2.7% year over year. The sharp drop for the month though has more to do with weather than the increase in capacity.

By stage of processing, utilization of facilities producing crude goods (including the output of mines) rose to 88.1% from 87.6% in July and up from 87.0% in June. A year ago crude good facilities were operating at 86.3% of capacity, and the cycle low was 77.6%. We are now above the long term average of 86.4%. Considering that crude goods capacity is up by 1.6%, a very solid showing.

Utilization for primary, or semi finished goods fell to 74.4% from 74.7% in July. While that is much better than the 72.8% level of a year ago, and the cycle low of 64.9%, it is a very long way from the long term average of 81.4%. Part of the year over year increase is simply due to shrinking capacity, which was down 0.1%.

Utilization of facilities producing finished goods rose to 76.4% from 76.0% in July and from 75.6% in June. It is up from 74.2% a year ago, and a cycle low of 66.8%. It remains slightly below its long term average of 77.3%, but we are getting closer. Interestingly, our capacity to produce finished goods has actually increased by 1.6% over the last year, so the rise in utilization there is facing a fairly still headwind. Part of that is due to Utilities, since electricity is considered a finished good.

Overall, this report was a fairly good one; better than it appears at first glance. The increase in Industrial production was better than expected, and that was in the face of a massive decline in the utility segment. The revisions for July were more or less neutral with capacity utilization revised down but production unchanged. In other words the downward revision in utilization came from an upward revision in capacity. That is a long term positive for the economy.

The numbers for June, though, were revised lower, so it is not advised to get too excited about this report. We are actually starting to see increases in capacity, unlike the declines we were seeing last year, and while that hurts capacity utilization, it is a positive sign for the economy’s long term potential.

While the economy is recovering, it is still running at levels far below its potential. The capacity utilization numbers can be thought of as similar to the employment rate from physical capital, much like the employment to population ratio is the employment rate for human capital. Both are running well below where we want them to be. While additional monetary stimulus would be useful at the margin, the cost of capital is not the major issue right now; it is lack of aggregate demand. As such, additional fiscal stimulus would be much more effective in getting the economy going again.

Unfortunately, the debate in DC has nothing to do with getting the economy going faster; it is all about the short term budget deficit. The latest Obama proposal would be useful in getting the economy going by raising the after tax incomes of the vast majority of workers, and thus raising total demand. If it is not passed, after tax incomes for the median worker will fall by about $1,000, further slowing the economy. That would be pennywise and pound foolish in the extreme.

Getting the economy back into high gear would also start to raise tax revenues, and so the net cost of additional stimulus should be less than the advertised amount. The tax increases/deduction eliminations to pay for the program will offset some, but hardly all, of the positive impact of the program. Big cuts in spending now, as many in Congress are demanding, will slow the economy significantly to the tune of hundreds of thousands fewer jobs being created this year and in 2012. That means fewer people without income, and hence fewer people paying income taxes.

We have been seeing anti-stimulus from the State and Local level throughout the Great Recession, and it is the total amount of fiscal stimulus that counts for the economy, not just what happens at the Federal level. De-stimulus from the lower levels of government has offset about half of the Federal Stimulus we got from the ARRA. The main stimulus from both QE2 and last December’s tax deal will wear off at the end of 2011. Industrial Production and Capacity Utilization rebounded strongly while the ARRA funds were going out. With fiscal policy on the verge of turning deeply concretionary, there is a very good chance that they will start to fall again. Deep spending cuts don’t just kill jobs, they also idle physical capacity as well.

The attempt to cut spending now is deeply misguided. The U.K. has gone down that path, and the net result was that its economy fell by 0.5% in the fourth quarter and only grew by 0.5% in the first quarter and by 0.2% in the second quarter, far below the U.S. growth rate. China took the most simulative fiscal path after the financial meltdown, and now it is concerned about its economy overheating. We have taken a moderately simulative path with overall fiscal policy (stimulus at the Federal Level offset by austerity at the State and Local level) and grew by 2.3% in the fourth quarter and just 0.4% in the first, rebounding ever so slightly to 1.0% growth in the second quarter.

Budget cuts that end up slowing the overall growth of the economy will slow the recovery in tax revenues and will result in much less progress on cutting the deficit than is advertised. As a general rule of thumb (a.k.a. Okun's law), we need real GDP growth of over 2.0% to see unemployment fall significantly. We might get above that level in the second half, but not much and not for sure. We should see some pick up in growth in the second half, as some of the temporary headwinds fade, such as the surge in oil prices and the effects of the Japanese Tsunami. However, massive fiscal contraction could be a major new headwind that will keep growth sub par, and the unemployment high and possibly even rising.

While the effects of the actual Japanese Tsunami are fading, there is a potential figurative Tsunami coming from Europe as the Euro project seems to be in its death throes. The disruption potential from that is huge. Unless Europe can move towards fiscal integration in a big way, the demise of the Euro seems inevitable, but the timing is an open question. The political obstacles of fiscal integration in Europe are massive, and I don’t think they will happen. While I would like to see the project succeed as it would make another major European war almost impossible, and would lead to greater long term prosperity, I doubt that it will happen. On the other hand, the short term damage done from trying to unscramble the Euro egg could be massive, so those 17 countries may have no choice.

 

 
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