A Bad Week in a Good Year

Aug. 14, 2007
Declaring it the worst week for the Dow Jones Industrial Average, the headline in a recent issue of the New York Times could spark some real concern for

Declaring it the worst week for the Dow Jones Industrial Average, the headline in a recent issue of the New York Times could spark some real concern for the future of the US economy. But headlines rarely tell the whole story, and looking at the level of the Dow in the chart that accompanied the story reveals the index may have dropped from historical highs touching 14,000, but at over 13,000, it is well ahead of year-earlier levels that were in the 11,000 range.

Shippers, who arguably have some preview of how the economy is shaping up based on freight volumes, remain moderately optimistic. Responding to the Morgan Stanley Freight Pulse Survey, shippers gave the economy a 6.0 on a scale of 10 (with 10 being a strong economy and 1 indicating recession). That may be down from prior reports and equal to January 2003 (the last 6.0 ranking), but it doesn't sound as dramatic as the "freight recession" headlines that are cropping up in analyst reports. Asked to project freight volumes over the next six months, shippers who responded to the Morgan Stanley survey just ahead of the peak shipping season did anticipate slower volume growth in all modes, but it's worth noting that while the pace of volume growth may have slowed, the trend was still up.

Economist Donald Ratajczak waded through the confusing and, at times, conflicting figures and trends to put the changes in the US economy into perspective. Speaking at the SMC3 summer conference, he noted the US economy had shed $4.5 billion in inventories in the first quarter (see State of Logistics Report, pg. 38). In his view, the second quarter was in balance on inventories, and he expected to see some inventory growth in the second half as the economy grows. We had some reductions because there were inventory imbalances, he said. They weren't overall imbalances, however.

For example, offers Ratajczak, the US had too many cars going into the autumn of 2006, but automakers have shut down some production and are now in balance on vehicle inventories. Building materials and related inventories were high because housing production fell faster than manufacturers' ability to adjust production. But autos, appliances, and furniture were all in balance, and other inventory levels will get in balance.

Housing is a complex area of the economy and building at a rate of 2.1 million new homes per year was well ahead of what Ratajczak considered to be equilibrium for the sector. He points out that the sub-prime lending market helped drive housing prices in part because prices had to rise to maintain the collateral behind the mortgages. He suggests 150,000 housing sales were likely the result of buyers being able to borrow their down payment. Any market with excess inventory will eventually put downward pressure on pricing, he continues. The equilibrium level for housing was probably below what Ratajczak projected, he admitted, so with a lower equilibrium level and greater inventory overhang, the price correction was bigger. Of 217 housing markets measured, 153 showed declines, he said.

Housing prices could continue to decline for another year and then stabilize at a lower level before starting to climb out, Ratajczak projects. With production slowed, the housing market is beginning to work down its inventory, so Ratajczak feels the worst of the housing drag is over.

In a consumer-driven economy like the US, how does the housing drop affect consumer confidence? The "wealth effect" as Ratajczak describes it, has shifted. While more people won't be able to use their home equity line to make purchases, there's an offsetting effect in the stock market rally. Growth in wealth is not diminished, he says, it has just moved from being real-estate based to being finance-based. In context, 70% of US households have some degree of home ownership, but only 40% have discretionary stock positions. This could mean a move from mass wealth to concentrated wealth, says Ratajczak. That won't help Wal-Mart, but it's good for Tiffany's he quips. Adopting a more serious tone, he points out this could mean a slowing in growth of consumer spending.

As the US growth slows, world activity is still strong, he continues. Canada exhibited a 3.7% growth rate in the first quarter while the US grew by only 0.6%. Europe is doing better than expected. The increase in the value-added tax (VAT) in Germany slowed them down for about a month and a half, says Ratajczak, but then the growth rate was back—which was a faster recovery from the impact of the tax change than initially anticipated. China and India's economies continue to fly at an 11% growth rate for China and 8.5% for India.

Everyone is raising interest rates, says Ratajczak, and passing the US in growth rates. Stronger growth rates mean better profit opportunities. Higher interest rates lead capital to flow away from the US. All of this weakens the US dollar, and it will weaken further, he points out.

From a trade perspective, imports could slow slightly, but exports should increase. This will improve the trade balance, but the US still faces a heavy trade deficit.

Ratajczak anticipates 2007 to stack up with quarterly growth rates of 3.5% in the third quarter and 2.8% in the fourth. Projecting into 2008, he suggests 2.75% for the year.

The Federal Reserve will continue to worry about inflation, but there are some special circumstances that bear discussion, he notes. The number one factor, unit labor costs, has been reasonably well behaved. But a slower economy means you produce under less than optimal conditions.

The strong productivity gains of recent years (in the 4% range) are vanishing. The US recorded a 1% productivity gain in 2006.

Hourly labor costs topped out in October at 4.3% year-on-year and it was at 3.7% at the time Ratajczak provided his comments.

There has been essentially no increase in stock market contributions to pension funds, so benefit costs have not changed. That won't continue, and those costs will return to the 4% to 4.5% range.

Labor cost per unit of production will hit 2.5%.

After-tax operating profits have been running at 10 cents on the dollar, an all-time high. Export industries will have some pricing power with the weak dollar, and they will be able to raise prices domestically or else they'll take their product abroad. But, for domestic producers and domestic markets it will be more difficult to leverage prices, so profit margins will erode for those companies.

Core inflation will go up, but it won't be excessive—in the 2.25% to 2.5% range. And, 2008 should be about the same. Ratajczak believes the Federal Reserve has no reason to raise interest rates, and if job growth becomes anemic, it could lower rates.

Sales and profit growth will continue, and stocks will go up— because they've been undervalued.

Fuel gets everyone's attention. For the average consumer, gasoline is an inflationary item that affects their spending. In the transportation industry, it's a significant operating cost. Energy economist Michael Economides took the position that once oil went over $75 per barrel, "the toothpaste was out of the tube." We're just two headlines away from $100 oil, he says. What two headlines? "Israel Attacks Iran" or "Terrorists Disrupt Production," he suggests, among other possibilities.

On the supply side, some of the biggest producers present major concerns. OPEC has no excess capacity behind the valve, says Economides, but that doesn't mean OPEC can't produce more oil. "Venezuela is an absolute basket case," he says. Nigeria has major problems. And, Iraq is "an absolute, unadulterated disaster when it comes to oil." The oil producers tend not to have refining capacity, and there have been no new refineries built in the US in 30 years. Currently, alternative energy is sucking away investment from refinery upgrades, says Economides, so the oil refining capacity won't be improving in the short term.

On the demand side, everyone is looking at China, the fastest growing consumer. China increased oil consumption 20% in a year, says Economides. That's unprecedented, and they did it two or three years in a row. Natural gas is an even bigger story. By 2030, demand will increase by 60%, and oil and gas will continue to dominate energy demand.

Alternative energy is getting a lot of headlines, and politicians want to talk about solar, but, says Economides, solar power will never amount to more than one half of one percent of world energy. The discussion, he says, "Is loaded with ideologically driven misinformation." Hydrocarbons are 86% of the world energy demand and will still account for 86% in 2030. Sunshine is free, but solar energy is very expensive, continued Economides.

He separates oil into two streams. One flows to material production (i.e. plastics) and the other to transport. Transport doesn't use anything but oil. Meanwhile, oil is almost non-existent as a fuel for power generation. "It doesn't matter how much you raise the thermostat on your air conditioner, it won't save a single barrel of oil because oil is not used for power generation," says Economides. Driving home his point, he adds, "Even China doesn't use oil for power generation."

Remembering that the US uses oil for both materials and for transport, Economides cautions that by 2010 or 2011, the US will import more oil than it uses for transport. "You can't talk about America's energy independence unless you address the transport problem."

Economides refers to the "Axis of Energy Militants," saying they dominate oil production and price. He doesn't subscribe to the theory that the producer countries can't produce more oil. The energy militants are headed by Hugo Chavez, says Economides and include Russia under Vladamir Putin. "Energy imperialism from Russia is beginning a new era of cold war," warns Economides.

Natural gas will enter the economy in a much bigger way in coming years, he continues. It will be significant either by conversion of natural gas to liquid or by direct use.

Looking at other alternative energy sources, he says, "The press thinks the future is going to happen tomorrow, not in 20 years." Hydrogen, he points out, is an indirect fuel. You have to use something else to produce it. The technology is not really here yet. To produce hydrogen energy from vegetable matter, for instance, you have to heat it to 437 degrees Centigrade. "But for the researcher, electricity [to do that] comes from a socket in the wall," chides Economides, an engineer himself.

If we convert all of the corn grown in the US into ethanol, he continues, with nothing left for food, we'll produce 20% of the gasoline demand today. Ethanol, he notes, has a negative energy balance and with a 50-cents-per-gallon subsidy, it's politically motivated.

His conclusion is that there are no remedies to hydrocarbon energy sources for the foreseeable future. Suggesting by example that transport would have to be electrified—and not with batteries—the future starts now but it takes 40 to 50 years to happen. If we outlaw all sport utility vehicles, says Economides, demand would change by less and one half of one percent. (Ratajczak disputes this number, but agrees the effect would be negligible).

The reason we use oil and gas is not some globally driven conspiracy by the industry, says Economides, it's because it's the most convenient and best source of energy. Ethanol is the equivalent of $120- to $150-per-barrel oil, he points out. Wind is equivalent to $150-per-barrel oil. And solar energy would be like using $1,000-per-barrel oil. If, as an oil producer, you can extract oil at $30 per barrel, your profit margins increase by a huge amount if the public becomes desensitized to the price. Moving to his next point, he says the oil companies are all talking about solar, wind and hydrogen power. BP brags about investing $200 million in solar, he points out. In the last six years, claims BP, they have become one of the world's largest producers of solar power. Economides takes that $200 million investment and divides it by the six years to come up with a little over $30 million per year. He points to BP revenues in a recent earnings statement at $253,621,000,000 and says, that $30 million basically takes the place of the $21 million in their revenues, having almost no effect on the $253 billion.

Many of the factors affecting the economy are being managed better—auto production and inventories are bottoming out, inventory liquidations in the first quarter have helped, and going forward, Ratajczak suggests, there are some major issues looming. The presidential election will be important. He expects Democrats to retain control of Congress and, he points out, what effect that will have on the presidency remains to be seen.

Immigration will continue to be a significant issue. The current situation is untenable, says Ratajczak. There were 1.5 million people filing taxes with no Social Security Account Number, he points out. Many are probably illegal, working for the last five years to get a proper visa. "People who think we can remove 7 million people from the economy and not see an impact are fooling themselves," he says, referring to the extreme approach of deporting all illegal workers. "We have to protect the borders and we have to change the immigration program."

A third major economic driver is tax policy, and here, Ratajczak points out, the current tax rules are due to expire unless they are made permanent.

Asked about labor, he responds that the world has changed and the problem with compensation is that older companies have inappropriately priced their labor. They were encouraged to do so by the unions, he continues, noting that the old model accepts that a person with 20 to 30 years of experience is more valuable than a person with five years of experience. In today's technology-laden economy a worker may reach peak performance after five or 10 years. Under the old model that rewards loyalty, at 30 years, you're paying them twice what you are paying a newer worker. You are overpaying people, he says, and at some point you can't compete. We need to get unions to share in the performance of the company, concludes Ratajczak, saying that the old compensation model of experience vs. incentive puts unusual pressure on companies and lowers our competitiveness as a nation.

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