Could this economic slowdown be different for industrial companies? There are valid reasons to think so, but it’s becoming harder to make the argument.
The unwinding of the pandemic surge in consumer demand for physical goods has picked up in recent weeks, with retailers from Target Corp. to Walmart Inc. and Dick’s Sporting Goods Inc. sounding a cautious note on inventories and future sales. This is to some extent unavoidable and reflects a normalization of buying habits rather than a collapse in consumer demand, but a slowdown is underway and may gain momentum as inflation eats into purchasing power. However, partly because of those Covid distortions in behavior, some investors and analysts have posited that industrial capital spending might prove more resilient in the face of a consumer downturn than history would suggest.
For one, industrial companies have yet to see the benefits of the US’s $550 billion infrastructure bill. Structural shifts such as a shortening of global supply chains and a need to invest in making factories more environmentally friendly offer another leg of potential growth outside of normal cyclical economic factors. The pickup in automation overhauls is unlikely to reverse, even if the labor shortage eases. Plus, there is the simple fact that the only way to combat inflation in housing and oil prices in a lasting fashion is by investing in more domestic energy infrastructure and residential construction. Supply chain logjams have prevented many industrial companies from following through on plans for higher spending, meaning there actually hasn’t yet been much of a spike in capital investments post-Covid. Globally, the number of greenfield manufacturing projects was about 40% below pre-pandemic levels in 2021, Melius Research’s Scott Davis notes, citing data from the United Nations Conference on Trade and Development.
By most measures, there should be an industrial spending boom. It’s arguably economically irresponsible not to have one. That doesn’t mean it will happen.
Consider the housing market. Mortgage rates have surged toward 6% this week, effectively pricing a significant swath of potential buyers out of the market. Even before the latest uptick in rates, there were signs of a cooldown: New home construction in the US fell in May to a 1.55 million annualized rate, the lowest in more than a year, according to data this week from the Census Bureau and the Department of Housing and Urban Development. Applications for building permits, a proxy for future construction, fell to an annualized 1.7 million units, the lowest since September. This data set is subject to significant revisions, and supply chain challenges complicate the translation to actual available inventory; builders are still sitting on large backlogs of unfinished homes. But US homebuilders are seeing yellow lights: The National Association of Home Builders/Wells Fargo gauge of industry sentiment slid in June to the lowest level in two years, according to data released this week.
That’s a problem because even at the headier building rates of previous months, the supply-demand imbalance in the housing market was on track to linger for around a decade by some estimates. The ideal scenario is enough of a cooling in consumer demand to ease inflation pressures but not so much of a slowdown that builders decide to materially pull back on construction. That is an incredibly difficult needle to thread. Given the choice between bringing inflation under control in the short term and fixing the longer-term housing shortage, the Federal Reserve appears inclined to prioritize the former. “We’re well aware that mortgage rates have moved up a lot and you’re seeing a changing housing market,” Federal Reserve Chair Jerome Powell said this week in a press conference after the central bank raised benchmark interest rates by 75 basis points. “We’re watching it to see what will happen. How much will it really affect residential investment? Not really sure. How much will it affect housing prices? Not really sure, it’s — I mean, obviously we’re watching that quite carefully.”
There are more encouraging signs in the energy market. Rental revenue to oil and gas companies jumped 43% in the quarter ended April 30 at Ashtead Group Plc, the UK-based equipment lessor said in an earnings update this week. Oil and gas rig counts are up about 60% year-over-year, according to Baker Hughes data. The top oil companies are increasing their capital expenditures this year, and the Biden administration in recent weeks has sought to put even more pressure on domestic suppliers to ramp up capacity amid soaring gasoline prices. But Barclays Plc analyst Julian Mitchell points out that industrial production was volatile during the 1970s despite a period of oil price shock, suggesting that alone may not be enough to support the sector’s fundamentals. It’s also worth noting that many multi-industrial companies have exited or significantly reduced their energy exposure through spinoffs and divestitures in the wake of the manufacturing recession of 2015 and 2016, which was driven by oil prices.
A significant portion of the post-pandemic announcements for new US factories have come from the semiconductor industry. The chip crunch that has bedeviled everything from cars to electronic cigarettes shows that the world clearly needs more semiconductor manufacturing capacity. And yet, demand for consumer electronics, including TVs, computers and smartphones, appears to be faltering. Nikkei reported this week that Samsung Electronics Co. is temporarily halting new procurement orders and asking some suppliers to postpone or cut their shipments because of concerns about inflation and rising inventories. Is there enough demand from other industries to support semiconductor manufacturers taking the long view on capacity expansion? Theoretically yes, but time will tell. “We’re going to go through some choppiness for sure in the near term as everyone else will as well,” Intel Corp. Chief Financial Officer David Zinsner said earlier this month at a Bank of America Corp. conference. “And what we’ve got to do is kind of keep our heads down and drive the business, execute to the plan and things will have a good outcome for us.”
Anyone hoping for a clear read on industrial demand from the coming second-quarter earnings season is going to be disappointed. Covid lockdowns in China most likely compounded the noise in the numbers from stubborn supply chain challenges. The best indicator of underlying demand and the manufacturing sector’s resiliency to recession worries will be what companies say about their spending plans. Kennametal Inc., Emerson Electric Co. and Rockwell Automation Inc. modestly trimmed their 2022 capital expenditure targets last quarter, citing a mix of labor shortages, supply logjams and higher costs. Should the list of companies making cutbacks grow, maybe this time isn’t so different after all for the industrial world — unfortunately, for everyone.
Bloomberg
