Fed Watch: Industrial Production Stalls

Industrial Production Stalls, by Tim Duy: Sober Look is questioning just how temporary will be the impact of Hurricane Sandy on the data. I tend to think about this in somewhat different terms. I am fairly confident that the impact of Sandy on the national data will be almost entirely transient. I am less confident that we are identifying underlying trends in the data as we dismiss any weaker than expected numbers as artifacts of Sandy. At the moment, however, I think this issue is largely confined to manufacturing data.

As is well known at this point, industrial production slipped 0.4% in October, but the Federal Reserve estimated that Sandy contributed to a 1 percentage point decline in production. The manufacturing side of the ledger, almost three-quarters of the index, was flat after accounting for Sandy, which is pretty much par for the course of the last year:

Obviously, the flat trend in manufacturing was in place well before Sandy, and could get much worse if the core durable goods new orders data is any indicator:

Seeing the trend in place makes me a little less comforted by the fact that the October slide can be attributed to Sandy. What if we see another slide in November? Will that too be attributed to Sandy, or is there something more than meets the eye? Should we be worried about recession? I think that answer depends on whether or not you view the manufacturing drag as largely caused by domestic or international factors. If it is largely external, I think it slows the US economy but does not tip us into recession. We experience something closer to 2007/8, with the housing rebound taking the place (albeit weakly) of the tech boom. A domestic event, would be more significant.

So which is it? The Wall Street Journal reports this morning:

U.S. companies are scaling back investment plans at the fastest pace since the recession, signaling more trouble for the economic recovery.

Half of the nation's 40 biggest publicly traded corporate spenders have announced plans to curtail capital expenditures this year or next, according to a review by The Wall Street Journal of securities filings and conference calls.

But why is capital spending weak?

At the same time, exports are slowing or falling to such critical markets as China and the euro zone as the global economy downshifts, creating another drag on firms' expansion plans...Corporate executives say they are slowing or delaying big projects to protect profits amid easing demand and rising uncertainty. Uncertainty around the U.S. elections and federal budget policies also appear among the factors driving the investment pullback since midyear....Companies fear that failure to resolve the fiscal cliff will tip the economy back into recession by sapping consumer spending, damaging investor confidence and eating into corporate profits.

Firms see the real impact of an external slowdown, and they fear the consequences of fiscal austerity. But which firms?

Snapon Inc., which makes equipment for auto technicians, reports healthy investment among the 800,000 small businesses it serves across the U.S. "Their confidence is fair and reasonable," said Snap-on CEO Nicholas Pinchuk. "As you move up to bigger companies, their foresight becomes broader and their confidence starts to erode."

This should not be surprising; large firms with significant international exposure are feeling the heat from Europe, China, etc. Already impacted by this weakness, they are especially sensitive to the potential impact from the fiscal cliff. This contrasts greatly with the evolving domestic side of the equation:

The slowdown in capital spending contrasts with a rebound in U.S. consumer spending and confidence, which has returned to a five-year high. Meanwhile, the latest survey by the Business Roundtable, which tracks expectations for sales and investment among its big-company CEOs, found the worst sentiment about the economic outlook in three years.

Consumer confidence has rebounded in recent months, and now looks consistent with the current pace of spending. Job growth continues while the unemployment rate continues to track down. The impact of Sandy on retail sales was relatively small, and note that the September number was revised up. And, importantly, it is hard to deny the upward progress in housing markets:

It would be a historical anamoly to experience a recession when housing is on the upswing, and I am challenged to believed that trade channels are by themselves sufficient to defy that history and trigger a domestic recession.

That said, I understand completely firms' lack of confidence. Particularly for larger, international firms, the impact of slowing growth overseas is real, and going over the fiscal cliff will only make their problems worse. Indeed, a rapid turn to austerity is the kind of domestic event that could turn history on its head and induce a recession despite a housing recovery.

At the moment, however, consumers seem far less concerned about the fiscal cliff than their corporate counterparts. Perhaps this is an artifact of the lack of partisan bickering since the election. Or maybe households rationally believe that since Congress has worked this out in the past, they will work it out now. But whatever the case, housesholds are not expecting Congress to disrupt their holiday spending plans. Let's hope that remains the case.

Bottom Line: The external sector is having an impact on manufacturing, and this was evident in the data well before Sandy, so we can't just ignore data weakness in that sector. The impact is greatest on just where you would expect - large multinationals. But the domestic economy still appears to be chugging along, with the housing market picking up the slack from manufacturing. On net, that suggests no great acceleration in aggregate activity in the near-term, especially when combined with more fiscal austerity. At the same time, however, the US should be able to escape the international turmoil without a recession. So what is the near term risk? Aside from the usual suspect (oil price surge from Mideast war, etc.), the fiscal cliff is still at the top of the list.

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