JOYG Joy Global Inc. (MM)

Total Industrial Production rose 0.2% in June, which was below the expected 0.3% increase. The report is weaker than that would indicate since both May and April were revised down, May from up 0.1% to down 0.1% and April from unchanged to down 0.1%.

In other words, after the revisions, there has been on balance no growth in overall industrial production in the last three months. That is a very weak performance, and a reason for concern.

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. The strength this month, such as it was, came mostly from the Utilities, and reflects hotter than normal weather, and thus more demand for air conditioning.

Thus it is important to look at just how the manufacturing sector is doing alone. It was unchanged in June, down from a 0.1% increase in May, but up from a 0.5% decline in April. The may figure was revised down sharply; it was originally reported as up 0.4%. April was unrevised. Year over year factory output was up 3.7%.

Utility output rebounded by 0.9%, after it suffered a May decline of 2.0%, but after a 1.4% rise in April. Year over year Utility output is down 1.5%. The utility number is mostly about weather, not changes in economic activity, and can be very volatile. The manufacturing only number is a better gage 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 0.5% in June, down from a 0.7% rise in May, but up from April’s 0.3% rise. Year over year mine output is up 6.1%. 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 fell by 0.2%, after a 0.1% increase in May and was unchanged in April. Relative to a year ago finished goods production is up 3.1%. 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. That means 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 90.8% 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. This month though, things started to turn around. Output of finished consumer goods was unchanged, but that was after two months of declines, 0.3% in May and 0.1% in April. Year over year, output of consumer goods is up just 1.4%.

Business equipment output on the other hand has been consistently strong, but cooled off significantly, falling 0.7% in June after rising 1.2% in May. Business equipment production is up 7.7% from a year ago. Business investment in Equipment and Software has been one of the strongest parts of the economy, contributing 0.61 points of the 1.90% total growth in the economy in the fourth quarter, even though it makes up just 7.38% of GDP. It looks like it will not be as strong a contributor in the second quarter. That is another reason to suspect that the overall growth in the economy will be lower in the second quarter than it was in the first quarter. I have 1.5-1.6% growth penciled in.

Output of materials rose 0.5%, a big acceleration from declines of 0.3% in May and 0.2% in April. Materials output is up 4.3% year over year. The first graph (from www.calculatedriskblog.com) below 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 a year and a half after the end of a recession; it usually takes at lest two years after production bottoms to reach a new high. 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 but has flattened out since the start of this year.

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 unchanged at 76.7%, well below expectations for a rise to 77.0%. The revival of capacity utilization has been going on for more than a year now. A year ago, just 74.5% 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 is 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 wants to do what would be appropriate at capacity utilization levels of 85, when the actual level is less than 77. Capacity utilization of around 80 signals a nice healthy economy, sort of the Goldilocks level, not too hot, not too 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 9.4 point improvement in overall capacity utilization from the lows is highly significant and very good news.

On the other hand, we still have a very long way to go for the economy to be considered healthy, and in recent months the recovery seems to be stalling. The second graph (also from www.calculatedriskblog.com) 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 1990's doing so on two separate occasions).

Factory utilization was also unchanged in June, at 74.4%, but that was only after the May number was revised down from 74.5%, on the other hand April was revised up by 0.2 points to 74.4% from 74.2%. It is up from 71.7% 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 0.4% over the last year, but all of that expansion came in the Mine and Utility segments.

Manufacturing capacity is unchanged 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. 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 88.9% of capacity in June, up from 88.6% in May and from 88.2% in April. A year ago they were operating at 85.2% 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 1.7% 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).

Utility utilization rose to 79.5% from 78.8% in May but is still well below the 80.6% level in April and the 83.2% level of a year ago. We are far below the long term average utilization of 86.6%. We are actually not that far above the great recession 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 3.2% year over year.

By stage of processing, utilization of facilities producing crude goods (including the output of mines) rose to 87.2% from 87.0% in May and up from 87.1% in April. A year ago crude good facilities were operating at just 84.5% 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 1.4%, that is a very solid showing.

Utilization for primary, or semi finished goods rose to 74.1% from 73.7% in May. While that is much better than the 72.3% level of a year ago, and the cycle low of 64.9%, it is a very long way from the long term average of 81.3%. Part of the year over year increase is simply due to shrinking capacity, which was down 0.4%.

Utilization of facilities producing finished goods fell to 75.4% from 75.8% in May and 75.9% in April. It is up from 73.1% a year ago, and a cycle low of 66.8%. It remains below its long term average of 77.3%, but we are getting closer. Interestingly, our capacity to produce finished goods has actually increased by 1.2% 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 weak, and worse than it appears at first glance. The headline was boosted by the Utility segment, and that is as much about the weather as it is about economic activity. The steep rise we had been seeing in Industrial Production and Capacity Utilization looks like it has stalled. On the other hand, 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 sort of like 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. This is pennywise and pound foolish in my opinion. 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. Conversely, big cuts in spending now will slow the economy significantly, to the tune of hundreds of thousands fewer jobs being created in this year and 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 the tax deal will wear off at the end of 2011, but hopefully the economy will be self sustaining at that point (hopefully being the operative word).

Industrial Production and Capacity Utilization rebounded strongly while the ARRA funds were going out, now they are almost all gone, and things have stalled. With fiscal policy on the verge of turning deeply concretionary (even if we get a debt ceiling increase), 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, 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 3.1% (and very high quality growth) in the fourth quarter and 1.9% in the first.

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, we need real GDP growth of over 2.0% to see unemployment fall significantly, and it does not look like we are going to get that in the second quarter. We should see some pick up in growth in the second half, as some fo the temporary headwinds, such as the surge in oil prices and the effects of the Japanese Tsunami fade, but massive fiscal contraction could be a major new headwind that will keep growth sub par, and unemployment high and possibly even rising.

Dirk Van Dijk is the Chief Equity Strategist for Zacks Investment Research. You can follow him at twitter.com/DirkHvanDijk.

 

 
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