Monday, July 26, 2010

Where Economic Success is Going to Come From

One piece of economic information that I have focused on over the past 18 months has been the Federal Reserve’s figures on capacity utilization of the industrial sector of the United States.

The story that can be read from this information is that capacity utilization in the United States has fallen from the middle of the 1960s to the present time. In 1967 when the data series was started, capacity utilization was about 90%. Over the past fifty years, every cyclical peak of capacity utilization has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85% while in the middle 2000s the peak dropped to 82%.

Currently, although capacity utilization has risen above its recent cyclical trough of about 68%, it is still languishing around 74%. One should note that as cyclical peaks during this period have been at lower and lower values, cyclical bottoms have also been at lower and lower values.

The conclusion one can draw from this is that United States industry does not seem to be “tooled-up” for the right output.

If the United States is going through a major secular restructuring both economically and financially, as some of us believe that it is, then United States industry will be restructured so as to shed some of this excess capacity.

There are many indications that such restructuring is taking place and will continue to take place over the next few years. This, of course, will mean that the economy will not recover real quickly which will mean that it will take just that much longer to resolve the “under-employment” problem.

The evidence of this restructuring can be observed in places like the front page article in the New York Times, “Industries Find Surging Profits in Deeper Cuts”: See The gist of the article is that companies are producing very good profits, not through revenue growth, but through the reductions in their cost structure, predominately through cuts in labor costs.

Of course, the real “economies of scale” in this effort are found in the larger companies. Smaller companies can reduce labor costs but they don’t have anywhere near the impact that large companies achieve when they go through a major restructuring.

Rod Lache, of Deutsche Bank: “These companies cracked the code of a successful turnaround. They’re shrinking the business to a size that’s defendable and growing off a lower base.”

Over the past fifty years industry did not downsize in this way because success seemed to come from “hoarding” labor and getting the company positioned for the next surge in sales revenue. This attitude was re-enforced by the federal government that underwrote the “nest surge” in consumer spending through fiscal stimulus programs created through deficit spending and the expansion of the money stock.

The “artificial” underwriting of economic growth by federal government largesse can only go so far. Throughout this period, the question that always lurked in the background concerned the burden of the debt being created, both private and public debt, and the economic mismatch that was being created between where the country should be technologically and where it was both in terms of physical and human capital. The growth in labor under-employment and the decline in capacity utilization over this time pointed to the fact that at some time an economic and financial restructuring would have to take place.

And how are these companies that are doing so well using their profits? They are building up their cash reserves. Jamie Dimon at JPMorgan Chase has indicated that it is not time to pay these profits out in dividends. There are just too many uncertainties present in today’s economy…and there are just too many other possible ways to use the funds in the future. Many other CEOs agree with this assessment.

The New York Times article contains a chart that shows the relationship between “Corporate Cash as a Share of Corporate Assets.” The most recent data show this relationship to be 6.1%. Guess what? One has to go back to the middle of the 1960s to find this figure at such a high level. Through most of the last fifty years the share of cash ran between 3% and 5%. This shift is huge and is taking place primarily in the larger, better positioned companies.

This same thing is happening in the commercial banking arena. The larger, more successful banks are piling up cash reserves. The smaller banks are not the ones with the profits or with the cash resources.

What does all this mean?

It means that the next few years will see a massive restructuring of industry, in manufacturing, financial services, and in other services. Reconsolidation will be in vogue, not expansion. The cash will be used for mergers and acquisitions, for rationalization of industry, for capacity reduction, and for control.

The one caution about this is that these companies cannot get too far ahead of the financial markets for investors will punish those that seem to be “jumping-the-gun”. In the Wall Street Journal we observe the warning, “Markets Say No to Expansionist Companies”: See The economy, in the near term, does not look strong. Profit performance is not seen as coming from increasing revenues, but from continued cost containment or cost reduction. Companies that appear to be moving too quickly in this environment are getting hurt by investors that believe cash should be conserved for use on another day at a different time.

Financial markets seem to want prudence now and not outright aggressive behavior.

Yet, people are getting prepared for the time when action is called for. But, the action will not be toward expansion, but toward containment. In the Financial Times we read of the return of “merger arbitrage funds”: See These funds attempt to profit from the spread between the price of a merger target after a deal is announced and the closing price at the completion of the deal. The funds “smell” something in the wind and they want to be ready when the time is right.

Gerard Griffin of GLG Partners’ event-driven team is quoted as saying: “Companies have built up large cash balances and the economy is not looking particularly strong, so earning growth will have to come through synergies.”

That is, consolidation will have to take place within industries reducing industry capacity and thereby increasing capacity utilization. For the time being, however, this rationalization of industry will reduce the number of jobs that are available and will also result in changing the nature of who is employed in these more technologically advanced and productive firms.

The evidence is growing that a massive restructuring of industry is taking place. This restructuring will not speed up either economic growth or the reduction of unemployment or under-employment in the near term, only over the longer term. But, the types of things managements and companies are doing are similar to what has happened at other times. However, these restructuring events are captured in the economic writings of Joseph Schumpeter, and not in the economic writings of John Maynard Keynes.

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