Manufacturing crash sets stage for rebound

Bloomberg

The news about global manufacturing is so bad, it might be good.

As factory production collapses around the world, excess inventories that stand in the way of an eventual recovery are disappearing even faster. That may allow manufacturing to stabilize later this year, providing some relief for a global economy that is contracting for the first time in six decades.

"The drop in inventories is good news," says Ethan Harris, co-head of U.S. economic research at Barclays Capital in New York. "Just as unusually low valuations set the stock market up for recoveries, unusually low inventories set up the economy for recovery."

The really good news, economists say, would be if stockpiles were shrinking because of greater demand for the world’s autos, earth-movers and refrigerators. There’s no sign of that: Factories around the world are making the sharpest and swiftest cuts to production ever, the International Monetary Fund says.

Caterpillar and Renault are drawing down their stockpiles to align excess supply with diminished demand. A JPMorgan Chase index of global inventory growth is close to an 11-year low, economist David Hensley said in a March 11 note.

In the U.S., factory inventories have fallen every month since September; in December, they dropped by 1.9 percent, the biggest monthly decline in 62 years of record-keeping. Data last week showed U.S. industrial output in February was down 11 percent from a year earlier, the biggest annual decline since 1975. The drop in the euro area in January was a record 17 percent from a year earlier.

Collapsing trade

Spurring the cutbacks is a collapse in world trade, which is contracting the most in 80 years, according to the World Bank. U.S. industrial companies suffered what the National Association of Manufacturers calls an unprecedented drop of 20 percent or more in business investment, exports and durable-goods orders at the end of last year.

That means empty warehouse shelves and factory lots may have to stay that way, at least until the second half of the year, before things pick up.

What’s more, the process of working off the stockpiles still has a way to go, pointing to more months of economic pain and job losses. Already, 1.3 million U.S. factory jobs have disappeared since the U.S. recession began in December 2007.

Goodyear Tire & Rubber, the largest U.S. tiremaker, plans additional cost savings and inventory reductions after reducing output in the last three months of 2008 by 17 million tires.

"While inventories bottom at the end of recessions, we don’t know how deep that bottom goes," Harris says. "A sharp decline in inventories has little information about the timing of the recovery."

Still, the rapid reduction is a change from previous slumps, when businesses were slow to whittle down inventories and the eventual drawdown held back recovery, says Elga Bartsch, chief European economist at Morgan Stanley in London. Now, just-in-time inventory management and closer interaction between firms at different stages of the supply chain mean companies’ stocks are in better synch with the economy, she says.

For example, Caterpillar, the world’s largest maker of construction equipment, has been allowing dealers to cancel orders as it cuts production. The goal is to match output with an expected 30 percent drop this year in demand for wheel loaders, pipelayers and other equipment.

A decent job

"We’ve done a pretty decent job trying to keep a lid on inventory," though "it needs to go down further," says Mike DeWalt, head of investor relations at Caterpillar.

"Manufacturers are feeling more of the pain, and until they get the inventories cleared out, they will feel a slowdown," says Stephen Gallagher, chief U.S. economist at Societe Generale in New York.

European factories are at a similar stage, says Peter Vanden Houte, chief European economist at ING Wholesale Banking in Brussels. "Inventory reduction threatens to be a major drag on growth in the first half of the year," he says. "There will then be some stabilization in manufacturing in the second half."

Mark Wall, an economist at Deutsche Bank in London, estimates that while inventory management will reduce euro-area gross domestic product by 0.6 percentage point in the current quarter, it will add to growth in the rest of the year.

"Still, the level of stocks remains far out of line with demand and will thus continue to weigh on production prospects," he says.

Cutbacks among manufacturers around the world will push global industrial production down at an annual rate of between 25 percent and 30 percent this quarter, JPMorgan Chase’s Hensley estimates. The decline should slow to between zero and 10 percent in the second quarter, he says.