It's reasonable to attribute the recent disappointments of domestic demand (retail sales down 0.9% mom in December, down 0.8% in January) to the impact of the oil-price shock. During the initial price shock (which does not hit before November 2014), households are surprised and so do not adjust the rest of their spending patterns, with the result that the savings ratio ticks up swiftly and inadvertently, even as overall retail sales soften. Later, of course, households get habituated to the lower price of energy, and spend the windfall. In short, you get a J-curve impact on domestic demand, so can afford to be relatively relaxed about the initial weakness in sales.
But such complacency may be misplaced when it comes to the industrial sector.
The headline numbers don’t look disastrous: January’s industrial output rose 0.2% mom, and capacity utilization rates were unchanged at 79.4%, and the preliminary reading of February’s Markit manufacturing PMI showed a mild acceleration to 54.3. Nevertheless, by the end of 2014 there were some imbalances opening up between manufacturing supply and demand which would normally be enough to set alarm bells ringing. I track headline industrial momentum by looking at industrial production, inventory/shipment ratios, capacity utilization and exports.
As the chart shows, this combination of measures produced the sharpest fall in momentum in December 2014 since the financial crisis. The two most obvious sources of weakness were a 0.3% mom fall in industrial output which was 1.5SDs below trend, and a 2.3% yoy rise in exports which was 0.7SDs below trend.
But this was not really what did the damage: rather it was a rise in the manufacturers’ all-industry inventory to sales ratio to 1.34, which was the highest since August 2009, and represented a very sharp rise from a ratio which for the previous five years had average 1.29 with a standard deviation of just 0.01pt.
Which sectors were doing the damage? Obviously, petroleum and coal inventory/sales ratios have risen sharply, presumably generated by a fall in speculative demand as prices have fallen: the ratio rose to 0.74x in December from a low of 0.68x in September. Even so, this level of inventory mismatch is not unprecedented: we saw the ratio at this level in mid-2012, in mid-2011 and throughout 2010. But that spike would perhaps have been unremarkable had the overall total not been boosted by a steady climb in the ratios for computers/electronics, chemicals, textiles, printing and possibly beverage and tobacco. One way of interpreting the modest build-up in printing, textiles, beverage and possibly even computers/electronics is that these are sectors which are likely to have been hit by the unexpected shortfall of retail demand in 4Q.
If so, then a continuing deterioration in inventory position usually results in production cut-backs in the short to medium term. The suspicion that such a disequilibrium quietly opened up during 4Q is confirmed when one looks in more detail. In particular, one can compare the momentum of manufacturing output with the momentum of sales and inventories. The red line in the chart below subtracts sales and inventories momentum from output momentum: when the line is positive, it tells us supply momentum is outpacing demand.
If this disequilibrium becomes extreme as it did in 2001 and 2008, it heralds recession. However, quite clearly, we're not there yet, and in addition such a negative result can be sidestepped if export momentum picks up sufficiently to soak up the ‘excess’ industrial production. This is what happened in 2003-2004 and again in 2009-2010. The bad news is that currently, the rise in the dollar coupled with the fact that the US is leading the world economic cycle means that US exports are under pressure (falling 1.1% mom sa in November, and falling 0.8% in December), so this option is not available.
Conclusion? The impact of lower energy prices is having an unexpectedly significant impact on US manufacturing in the short term. The up-sweep of the J-curve in the retail sector therefore will be met with considerable cyclical relief.