Wells Fargo Securities Economics Group: Industrial Production & Business Spending Outlook
We just returned from the Twenty-Sixth Annual Economic Outlook Symposium hosted last Friday by the Federal Reserve Bank of Chicago. The event drew participants from manufacturing, banking and the auto industry, as well as academia and consulting and service firms. The consensus view expressed by participants at the symposium was roughly in line with our outlook for slow growth of 1.3 percent in 2013. With speakers representing dominant players in a variety of industrial sectors including automotive, heavy machinery and the steel industry, our outlook is now informed by the insight from these captains of industry.
No one knows whether or not lawmakers will come to a solution that avoids the upcoming tax hikes and spending cuts, but that will not prevent the calendar from rolling over into 2013. Deal or no-deal, businesses will have to make decisions on capital spending plans in the next few months. In this report, we lay out the various scenarios that businesses may face in the coming year and offer our take on what the business spending climate might look like after the dust settles around Congressional negotiations to avoid the tax increases and spending cuts set to take effect at the beginning of next year. While our base-case scenario is not particularly rosy, the fallout from a failure to reach a compromise may not be as cataclysmic for business spending as many commentators fear.
The Present State of Output and Orders Industrial Production
From its recession low in 2009 until July 2012, industrial production rallied 17.3 percent and seemed on track to return to pre-recession highs. However, at about that time, in August 2012 we cautioned that “we cannot afford to ignore evidence that orders are falling. The unraveling in orders may lead to a broader weakening in the outlook for industrial production and overall economic growth.1”
As it turns out, the July level of industrial production ended up being the high watermark for the year. The broader weakening about which we had cautioned in August materialized, with output falling in two out of the next three months and overall industrial production falling back to a level last seen in January.
In the October report of industrial production, the Federal Reserve offered additional text to help assess the effect of Hurricane Sandy on that month’s data. According to the official release, “The largest estimated storm-related effects included reductions in the output of utilities, of chemicals, of food, of transportation equipment, and of computers and electronic products. In October, the index for manufacturing decreased 0.9 percent; excluding storm-related effects, factory output was roughly unchanged from September. The output of utilities edged down 0.1 percent in October, and production at mines advanced 1.5 percent.”
If we consider the fact that manufacturing output was “roughly unchanged” in September after accounting for Sandy, then the factory sector is not in good shape. After falling 0.9 percent in August, September’s industrial production report revealed a tepid 0.2 percent bounce-back. That initially reported gain was halved by revisions in the October report. It is hard to blame the weather for the revision to September. The revised level of manufacturing output from last month was 93.8—the same level as manufacturing output in January. In other words, factory output is in no better shape than it was at the start of the year, even after accounting for Sandy. Manufacturing accounts for 75.3 percent of overall industrial production, so without improvement in this core component, it would take substantial moves from utilities or mining output to move the needle on the overall measure.
Manufacturers’ Orders for Durable Goods
Durable goods orders followed a trajectory that was roughly similar to that of industrial production, with orders hitting a plateau in July. The overall peak for orders in this cycle was actually back in December 2011, which is partly attributable to a tax law change, but orders dropped off in the summer and have recovered little ground since then.
After two months of aircraft-driven swings, durable goods orders stabilized in October, with an unchanged reading. The flat print was better than the 0.7 percent decline expected but comes on the heels of a 0.7 percentage point downward revision to what was first reported for September. On net, the headline was roughly in line with consensus, but recent underlying details are slightly more encouraging. Stripping out transportation, new orders rose 1.5 percent in October, beating expectations for a 0.5 percent decline.
Nondefense capital goods ex-aircraft orders, an indicator of future business spending, also posted a better-than-expected gain, rising 1.7 percent. This is the strongest increase since May, but “core” orders remain down 15.6 percent on a three-month average annualized basis and are 7.0 percent below year-ago levels. Given the weakness we have seen in recent months for new orders, it was of little surprise to see core shipments fall in October. Nevertheless, the turnaround for this key series is a significant positive in an otherwise murky outlook for capital expenditures.
With new orders stalling in October and trending below shipments, there does not look to be much of a reprieve for business spending in the fourth quarter. We look for equipment and software spending to slow at an annualized rate of 0.5 percent in the fourth quarter and contract at a 2.3 percent clip in the first quarter of 2013.
Can We Avoid Upcoming Tax Hikes and Spending Cuts?
Output seems poised to downshift again as businesses “wait and see” what happens with regard to critical negotiations in Washington to make a last-minute deal to avoid pending tax hikes and spending cuts. Many businesses have cash on hand, and access to credit has improved, but there is a diminished willingness on the part of these businesses to invest capital. An environment of fiscal policy uncertainty has been cited by businesses as a reason they are reticent to spend.
Full Implementation of Tax Increases and Spending Cuts
In a separate report, our group considered the effect of a failure to reach a deal and concluded that if the tax hikes and spending cuts went into full effect, it would plunge the economy back into recession.2 Reading the tea leaves under this scenario is pretty straightforward: recessions are bad for business; as our colleagues said in the report, “business spending and thus employment growth would grind to a halt as businesses brace for a recession.”
Our baseline expectation is that Congress will come to a short-term deal that briefly extends tax cuts and maintains similar spending levels. While this outcome should stave off recession, it will only prolong the uncertainty that has paralyzed business spending in recent months. Recent purchasing managers’ surveys have offered some color on the extent to which a lack of concrete framework has weighed businesses.
Let us not be content to wait and see what will happen, but give us the determination to make the right things happen. Horace Mann
The supplemental notes from a recent Empire State Manufacturing Survey from the New York Federal Reserve noted that when asked about negative influences on 2012 hiring and capital spending plans, “by far the most widely cited factor behind the downward revisions—for both hiring and capital spending plans—was increased uncertainty.” The Business Outlook Survey from the Federal Reserve Bank of Philadelphia got even more specific and posed special questions that asked firms about demand for their own goods and to characterize the reasons for slowing. According to the survey, “Of those firms that experienced some slowing, the most frequently cited reasons were increased uncertainty about the economy (65 percent) and about future taxes and government regulations (52 percent).”
The take-away here is that a short-term deal would only prolong the recent weakness we have seen in business spending. For the economy as whole, this scenario would be clearly preferable to doing nothing, as it would steer around recession. However, for business spending specifically, this would not be as much of an obvious improvement. More temporary measures and promises to fix problems at a vague point in the future would not alleviate business anxiety.
Another factor to which we can attribute at least some of the recent weakness in business spending is a softening in exports. As the sovereign debt situation in Europe continues to weigh on the outlook for global growth and emerging market economies like China have experienced slower economic growth, U.S. exports have shrunk 8.2 percent from their cycle high in March.
If businesses cite uncertainty as a reason for slowing capital spending activity, then it stands to reason that if that uncertainty were removed, the path would be cleared for business spending to pick up again. Unfortunately, we do not expect political leaders to come to comprehensive reform before year-end 2012. A so-called “grand bargain” would offer a long-term compromise that would spell out fiscal policy for the next several years, with provisions to raise revenue and scale back spending in a manner that would not impede the current economic expansion. In our view, the likelihood of both sides agreeing to a grand bargain is close to zero.
Most analysis of the negotiations to prevent the impending tax hikes and aggressive budget cuts has focused on the effect of tax hikes on American taxpayers. At an estimated $221 billion, the effect of a return to Clinton-era tax rates would most assuredly be the largest direct impact on the economy.
Having said that, there has not been much discussion about the fact that bonus depreciation is not going to continue into 2013. This temporary provision underpinned capital spending for the past two years by allowing businesses to deduct the cost of capital equipment in the first year the business owns that equipment, instead of spreading it out over several years. In 2011, businesses could deduct the entire cost of the new capital equipment. In 2012, the amount of the first year deduction was reduced to 50 percent of the cost. Under current law, there is no bonus depreciation in 2013 and businesses will return to the standard Modified Accelerated Cost Recovery System.
While it is difficult to specifically account for the influence bonus depreciation had on business spending, there are some clues. In January 2012, the month that the depreciation limit dropped to 50 percent from 100, durable goods orders fell 4.9 percent, which at that time was the largest single-month drop since the recession. Some of the categories that posted the largest declines that month were those that would have been most affected by the tax credit, such as computer products orders, which fell 10.1 percent on the month, and machinery orders, which fell 10.4 percent. We have durable goods data through October, and so far in the 10 months that have passed, the total level of durable goods orders has yet to return to the level reached in December 2011, the last month during which the full bonus depreciation was in effect. We do not expect the expiration of the bonus depreciation to cause spending to completely fall apart, but it may pull forward some of next year’s spending into the final months of 2012. It would be unfair to attribute all of the recent weakness in orders and production to the phasing out of bonus depreciation, but its absence will be conspicuous at a time when businesses are apparently already being cautious about capital outlays.
So Where Is Business Spending Headed?
In our view, the most likely outcome of Congressional negotiations will be a short-term fix that temporarily extends current tax rates and maintains spending at similar levels until the newlyelected Congress convenes next year to work on a more permanent solution. This does not alleviate the uncertainty that has had the effect of a ship trying to sail while dragging its anchor. The result, in our view, would be three consecutive quarters of slowing in equipment and software spending, as weakness in the third quarter carries on into the fourth quarter of this year and the first quarter of 2013. It would also likely result in “more of the same” in terms of industrial production and orders. We would likely see little change in the absolute levels, and monthly ups and downs would be influenced by one-off factors like pops in aircraft bookings or a weatherrelated spike in utility output. Without a clear fiscal policy direction, businesses have little incentive to increase capital outlays in a significant way.
However, if there is a silver lining in all this, even the worst-case scenario—a failure to reach any kind of deal—may not be the death knell for business spending. Inventories are already running rather lean and the bonus depreciation rates have likely already brought forward a lot of demand, neither of which would change in this scenario. The resulting recession that would likely come in the wake of a full implementation of the tax increases and cuts in government spending would certainly be bad and may result in a larger drag on overall growth from business spending, but it is not a wildly different outcome, at least for business spending, from our perspective. In the study we referenced previously, our colleagues shocked our econometric model to forecast the outcome of full implementation of tax increases and spending cuts. It did send the economy into recession, and there were larger drags from equipment and software spending. However, even in that scenario, outlays on equipment and software returned to positive territory by the second quarter of 2013. This is the same timing as our base-case scenario.
We referenced earlier that slowing exports weighed on business spending in the second half of this year. Our forecasts for economic growth in various economies around the world show a gradual firming in 2013 and 2014. As the largest economy in the world, economic growth in the United States plays a vital role in the global economy, but it is not as though fiscal policy here will hold back global growth in other parts of the world. A recovery in global growth would boost exports, which should support domestic business spending, regardless of the outcome of present negotiations.
Back in August, when we first rang the alarm on an impending slowdown in orders and production, part of what tipped us off was a sudden deterioration in the orders components of various regional purchasing managers’ indices (PMIs). It was not long before several of these PMIs were showing contraction in their orders components. The winds seem to be changing more recently, as many of these surveys have returned to positive territory in the most current readings, which may signal the slowdown in business spending will not last long.
What we would consider a wildly unlikely outcome is a true grand bargain. If lawmakers could actually come to a lasting bipartisan solution to fiscal budget imbalances, we would have a clear set of ground rules for fiscal policy. Businesses could then plan and implement long-term strategies to compete in such a framework. Given the amount of cash on hand, particularly at large corporations, business fixed investment spending would flourish under such a scenario, and we would be thrilled to upwardly revise our forecast accordingly. Unfortunately, given the current political landscape, this simply does not seem plausible. Consequently, we must maintain our baseline expectation that businesses will hunker down and continue to scale back outlays for equipment and software spending in the current quarter and in the first quarter of 2013.
1 “Orders and Production: No Time for Complacency,” Silvia, Quinlan and Watt, August 6, 2012.
2 “The Economic Impact of the Fiscal Cliff: An Update” Silvia, Brown, Swankoski, November 19, 2012.
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