Industrial Production: Capacity Utilization Trends

A mixed report from Industrial Production combines with a very strong Retail Sales report to keep the -50 bps advocates on edge.

Aug 15, 2024

We update our monthly capacity utilization (“cap ute”) review for some angles on manufacturing trends and as a useful proxy for theoretical pricing power across industry groups.
Industrial production reversed the positive move of June (+0.3%) with a decline of -0.6% in July at the headline level, but the line-item story among major Durables subsectors was mixed.
Weaker IP flowed into a lower total headline cap ute level with Manufacturing also slightly lower as Durables declined and Nondurables rose.
We see some bellwether industry line items such as Motor Vehicles down hard but Machinery, Aerospace, and Computers/Electronics higher.

The above time series runs across the cyclical swings in capacity utilization. At the very least, the pattern offers a reminder of how ugly it can get in a downturn for manufacturing overall with a wide range across industries as well. The recent level of 77.2% is just below the median. We would note that the recent cyclical highs in 2022 and 2018 were not “all that high” in historical context.

As we discuss below, high or low utilization relative to history does not always directly correlate to higher or lower profitability even if we all know “higher is better.” Numerous US industry groups had been plagued by cost structure issues and generated higher profits in recent cycles at lower utilization levels. The swing factor was unit costs. That opens up a major area of focus for companies and policy makers who might unwind some of those structural cost improvements made across the cycle by sending tariff costs soaring. Doing that for votes is old school politics, but the “dismal science” of economics is unforgiving. Then again, so is basic financial accounting.

The Industrial Production numbers have been soft for a while with total Manufacturing cap ute of 77.2% running below the long-term average (1972-2023) of 78.3% and the cyclical Durables line at 74.9% vs. the long term average of 76.9%. For Durables, the 2Q24 average of 75.8% had eased to 75.6% in June and 74.9% in July. Nondurables ticked higher in July to 79.4%, which is above the 2Q24 level of 78.8% but below the long-term average of 80.1%.

Our recurring story on Industrial Production is how profitable many manufacturers have been at cap ute levels well below historical levels as they overhauled their cost structure after the credit crisis and ensuing long, deep downturn. The idea was to bring breakeven volumes lower.

During 2009, the low point in cap ute for Manufacturing was 63.5%, so the ability to take costs out of the supplier-to-OEM production chains was critical. That led to a lot of supplier chain overhauls (and globalization) that already had been ongoing for years.

The above chart looks across some of the major manufacturing sectors, and the sequential moves were higher for some (Machinery and Computers/Electronics) and much lower for others (Motor Vehicles). The trends were mixed as noted with some stronger and some weaker.

For an industry such as Motor Vehicles, it will be very interesting to see how the transplant automakers manage their supplier chains. Many of the OEMs have major local US-based supplier chains by US companies or non-US companies that set up operations here.

The next chart and discussion give more history of the context of past cycles and what the tariff fixation in policies could mean.

The chart above lines up the average cap ute trend for past expansions and recessions. With so many recessions above current levels unfolding in a cyclical peak, we would argue that more sweeping, blanket tariffs are the last thing the current manufacturing base needs. Some will want tariffs, and some will dread them. It takes precision and planning and careful thought and targeting at its best case (which will still be dilutive to many companies). For those pitching the asset class rotation trade into US-centric small caps, they could rename that “Rotation Roulette.”

The tariff threat part N+1…

If we get into a period ahead that sees tariffs on all imports (the Trump plan), the ability to reshape the supplier chain into onshore (or near shore) chains will put many to the test. This week in North Carolina, Trump pushed up his across-the-board tariff target above the earlier 10% level to a 10% to 20% range, so the economics of tariffs are due for a lot of discussion from now until the election. He is not backing down on this, and his formerly free trade followers will cave on his tariff jump and say, “How high?”

As most of us know, the buyer pays the tariff (i.e. the US collected zero from China…not “billions and billions”), and the buyers can either find substitutes onshore or hope that free trade partners are exempted from the “all imports” tariff plan. The buyer hit with the tariff either can pass the cost on in higher prices, eat the cost in the form of deteriorating margins, or strike some balance between.

We sound like a broken record on the tariff disinformation, but the manufacturers will face some difficult pricing and capital budgeting decisions and unit cost forecasting in their numbers for 2025 subject to election outcomes. Those are analyses for another day.

Double entry bookkeeping did not make Newton’s “three law checklist” but it qualifies on the equal and opposite effect in financial context. You pay a tariff, and then someone gets a combination of a higher price or lost margin. That effect caused considerable damage and a lot of capex stalls back in 2018-2019. Economists talked about it nonstop, but it fell victim to the usual fact denials in Washington and disinformation that cover so much of the political discourse these days. Trump sent a message to his GOP Senate lapdogs in his attacks on GOP Senators Corker and Toomey: “Don’t mess with my tariffs.” Assigning tariffs is Trump’s second favorite activity.

Trump finds psychic value in kicking major trade partners in the face with a speed skate. This is a fragile time in the cycle to do that, and especially when you are also talking about engaging in competitive currency devaluation and weakening the dollar in the next breath. That is the proverbial second kick of the mule, and trade partners are preparing responses.

There are also the “lost revenue” effects to consider for the retaliation impact when the trade partners take aim and fire back. That set of trade dynamics overall is the wrong “multiplier effect” that is supposed to worry managers of an economy.

Other non-US manufacturers operating in the US still import a range of higher value-added components from the home country or from Mexico. The delicate politics of so many major red-state manufacturers with global supplier chains intrinsic to the lean manufacturing evolution of the past 3+ decades cannot be unwound quickly. It is both impossible to change supplier chains quickly. It takes cycles and not necessarily in low single digit years. Unit costs will rise without material volume growth (harder to make a case for volume growth when you raise prices to recover the tariff), and that means lower profits, lower margins, and outright losses. In theory, that all could backfire and mean less capex, less hiring, or even downsizing.

Backtracking or just holding the status quo is an option as some will simply seek to wait out the politics of the tariffs for another administration in 4 years. That was not a rare reaction in 2018-2020 as economists were quick to point out. Companies will not highlight the problem too visibly (publicly) or spend too much time assigning blame given the partisan political toxicity of the issues. They also need to keep their cards closer in case they have room to negotiate exemptions.

We wrap with our updated multicycle chart that offers another angle on the cyclical history and how capacity utilization levels framed up across time. The current level is not inspiring, but it is weak enough to give the FOMC room to maneuver after the ugly ISM numbers for manufacturing that were on the short list of worries during the recent VIX spike.

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