Thursday, September 17, 2009
Exit from Excess: Setting the Stage for Sustainable Growth
September 16, 2009 By Richard Berner in San Francisco Despite the evident improvement in the US economy, fears of a ‘double-dip' recession linger. Small wonder: Recoveries rarely go in a straight line, the economy is still tender and thus vulnerable to shocks, and when temporary incentives for vehicle and housing demand expire, ‘paybacks' will almost surely follow (see Recovery Arrives - but Not a ‘V', September 8, 2009). If we are correct and real growth fades from 4% annualized or so in 3Q to just 1.5% in 4Q, the debate around a potential double-dip will only grow more heated. Lost in this double-dip debate, however, is analysis of some time-honored forces that drive the business cycle - in both directions. Recessions result from excess, and this time the housing and credit imbalances were the one-two punch that promoted a record contraction. Moreover, in our view, those and other excesses - in inventories, capacity and commercial real estate - persist, likely keeping the recovery moderate when compared with historical norms. But recessions also facilitate the clean-up that is essential for recovery. The good news is that this clean-up phase is underway in all four areas. The bust is promoting inventory liquidation and ‘capital exit' - a much-needed housecleaning for Corporate America. This is setting the stage for a sustainable recovery. Stock-adjustment process. Why consider these four loosely related excesses together? First, just as gauging their progress as they inflated was helpful to calibrate recession, measuring how they shrink will be important to track the recovery. Stocks in relation to demand are key metrics for gauging excess; for example, the stock of vacant houses is a critical measure of excess. Second, to analyze each of these imbalances requires a so-called ‘stock adjustment' model - a model that is the basis for business cycle analysis. Indeed, such adjustments typically call the tune for the business cycle. Changes in the stock of inventories relative to sales drives inventory liquidation or accumulation, and these stock adjustments drive the flow of output or demand (in the case of housing and capex). Deep excesses, deep recession. Cheap and available credit fueled all four excesses, especially in housing. The housing and commercial real estate excesses were apparent in both investment and prices. A variety of housing metrics started to flash yellow in 2005 and 2006, and bright red by late 2007 when it seemed to us that recession was inevitable. Inventories of new and existing unsold homes began climbing steeply in 2005, as did a measure of one-family homeowner vacancy rates. Our ‘P/E' ratio for housing prices began to get frothy around the same time and reached bubble territory in 2007. In commercial real estate, after several years of discipline, construction activity soared in 2005-07 (hitting a 23%+ growth rate in each of the latter two years), and commercial real estate ‘cap rates' - essentially the ratio of net operating income to prices - collapsed to unheard-of lows (around 5% nationwide). The inventory and capacity gluts were only apparent after the recession began, unmasked by plunging sales and production. Indeed, the secular decline in inventory-sales ratios fostered by just-in-time inventory management techniques makes it more difficult to detect excess. Survey metrics, such as the customer inventories series in the ISM manufacturing reports and the percentage of respondents in the NFIB (small business) canvass reporting that inventories were ‘too low', did flash warning signals as the recession began. Operating rates, however, were quite stable through 2007, as capacity and production were growing in tandem. Soon thereafter, both quickly revealed that significant production and investment adjustments would be needed. Obviously, the credit crunch first made these excesses worse by killing demand and production. Housing demand measured by home sales plunged by 41.5%. Office employment tumbled by 1.6% over the past year, and our REIT team projects that the demand for commercial space - in terms of net absorption or net change in occupied square feet - will swing from 158.6 million square feet in 2Q05 (office, industrial, retail and multi-family) to a trough of minus 199.6 million square feet in the current quarter. This downturn in demand will boost vacancy rates from 9% in 4Q06 to an estimated 15.1% in 2Q10. The team expects negative net office absorption to trough this quarter, to remain negative through 3Q10 and turn positive in 4Q10. Office vacancy rates troughed at 14.6% in 3Q07 and are expected to peak around 21% in 3Q10. Meanwhile, real manufacturing and trade sales plummeted by 13.1% over the 19 months ended in June - three times the decline seen in each of the previous two recessions. And industrial production slid 14.6%, a decline eclipsing that in the 1982 recession. But the credit squeeze has also helped to purge the excesses; intrinsic to the stock-adjustment process is an overreaction or ‘accelerator' that curbs investment well below replacement in order to reduce the capital stock, and in the case of inventories, cuts production below demand to reduce the level of inventories. Stocks adjust slowly, however, especially in real estate. As a result, especially in commercial construction, the purging process is not over, implying that some important downside risks to growth linger. Equally, however, the weaker the additions to stocks and capacity supply are now, the more sustainable will be the coming expansion as stocks become lean and the accelerator gathers momentum on the upside. Time-honored drivers: Not all cylinders firing. Two factors will drive the investment recovery: An improving economy will facilitate the positive ‘accelerator' mechanism, and easing the credit crunch continues to make funding more available. Measured by the second derivative in output, or the change in the growth rate, the process began in 2Q when the growth decline diminished from -6.4% to -1% - an acceleration of 5.4pp. And in inventories, it is also the change in the change in inventory stocks that matters for growth, so if companies are liquidating inventories but at a slower pace, that adds to GDP growth, as in the current quarter. However, persistent excesses in inventories, capacity and vacancies signal that a vibrant recovery will take time to develop. The aggressive liquidation in inventories has promoted a peak in inventory-to-sales ratios, but outside of motor vehicles, they are still high so liquidation will continue at a slower pace. Independently from the accelerator, increases in idle capacity depress capital spending. They signal that managers should scale back expansion plans as falling operating rates indicate that there is plenty of capacity to accommodate future expansion. Stated in the vernacular of standard investment models, falling operating rates postpone the adjustment of today's capital-output ratio to the desired stock in relation to output. The plunge in factory operating rates in this downturn has been breathtaking: From the peak in 2007, capacity utilization in manufacturing fell by 14 points to a record low of 64.8%, or fully 16pp below the average of the past 60 years. But production is now rising and, with it, operating rates. Likewise, single-family homeowner vacancy rates remain at 2.5%, or 100bp above their long-term average. But they have declined by 20bp from their peaks, signaling that imbalances are easing. Purging excess. The silver lining in this housing, capital-spending and inventory bust is that it will help to purge investment excesses; indeed, it is essential to do so. Most of the excesses in this cycle have been concentrated in housing, and we are mindful of the fact that foreclosures could fuel vacancy rates and supply-demand imbalances. But as noted above, easy credit did fuel exuberance in commercial construction as well, and the downturn has unmasked acres of obsolete plant and equipment. The cure for excessive investment is the exit of capital from what my former colleague Steve Galbraith calls the ‘capital pigs' - overcapitalized industries - and the redeployment of that capital into new products and new industries that can use it productively. That process will take time. But there is some more good news: Judging by the rate of growth in industrial capacity, we believe that it is already well underway. Capacity in manufacturing excluding high-tech and motor vehicles and parts industries has shrunk by 0.7% over the past year - a pace comparable to the post-tech bubble bust. And capacity in another industrial subaggregate - including primary metals, electrical equipment and appliances, paper, textiles, leather, printing, rubber and plastics, and beverages and tobacco - has contracted by a whopping 2% over the past year. As a result, the current bust in high- and low-tech equipment outlays will eventually lay the groundwork for renewed growth. And investors will likely reward those companies that rediscover the discipline of producing high returns on invested capital.