Sean McCarthy, CFA, Southwest
Marc Doss, CFA, CFP, California, Nevada
David Roda, CFA, Southeast
Cam Hinds, CFA, Great Lakes
Michael Serio, CFA, CAIA, Mt. Northwest
Kei Sasaki, CFA, Northeast

In this Monthly Market Advisor:

  • The Federal Reserve publishes a monthly index of industrial production and related capacity utilization rates that cover manufacturing, mining, and electric and gas utilities. These numbers tell us that there have been declines in both industrial production and capacity utilization over the past 2½ years.
  • Lack of investment in capacity limits how much an economy can increase productivity. And there is a growing consciousness about the need for investment that leads to productivity evident in proposed changes to fiscal policy.
  • Fiscal policy proposals may provide an opportunity to improve productivity in the present as well as raise the standard of living for current and future generations.

Download the report (PDF)

How much of the country's capacity is used for production the U.S.? 

The Federal Reserve publishes a monthly index of industrial production and related capacity utilization rates that covers manufacturing, mining, and electric and gas utilities. The release of February's data reported capacity utilization of 75.4%, reflecting an industrial sector that is beginning to find its footing. Said another way, the U.S. is using about three-fourths of its factories, mines, and utilities. While above its recent lows, this number is still more than four percentage points below its long-run average. The industrial economy has been running below this cycle's peak in the second half of 2014, around the time when energy prices began to turn lower. Chart 1 illustrates the declines in both industrial production and capacity utilization over the past 2½ years.

Do we have the right stuff?

On the surface, it appears one-quarter of the country's capacity to produce is not being utilized. One might question whether some of the capacity not being used is outmoded. Chart 2 shows that since 2012 corporations have generally increased spending on stock buybacks. Over the same time period, Chart 3 confirms that the amount of additional business fixed investments (red line) has declined. Examples of such investments are equipment, technology, or research and development (R&D). Acquisitions aside, companies with cash to deploy can choose to invest it for the longer-term or return it to shareholders in the near-term. That decision in recent years has favored the latter.       

Chart 1. Declines in industrial production and capacity utilization


Graph comparing the Industrial Production Index to Capacity Utlization over the period of January 2014 through January 2017. Contact your Relationship Manager for more information.

Source: Federal Reserve Economic Research, Federal Reserve Bank of St. Louis https://fred.stlouisfed.org/

Chart 2. Number of companies repurchasing shares and S&P 500 Index price


Graph of the S&P 500 Price Index compared to the number of companies purchasing shares during the period of 2005 through 2017. Contact your Relationship Manager for more information.

Source: FactSet, 12/19/16

A recent article from Modern Machine Shop1 discussed the manufacturing capacity issue with the Director of Business Operations for MakeTime, a company that matches manufacturer needs with machining supplies. The director points out that throughout MakeTime's network there is excess supply of older or simpler machine tools. Conversely, their network demand for high-complexity machining is more than two times what is available. The article suggests that this mismatch likely encapsulates a situation that exists more broadly in the U.S. industry.

Chart 3. Amount of additional business fixed investments has declined


Graph comparing private nonresidential fixed investment to nonfarm business sector (real output) during the period of Q3 2013 through Q3 2016. Contact your Relationship Manager for more information.

Source: Federal Reserve Economic Research, Federal Reserve Bank of St. Louis https://fred.stlouisfed.org/

What is the consequence of not upgrading capacity?    

Lack of investment limits how much an economy can increase productivity. The most recent report from the Bureau of Labor Statistics revealed that year-over-year labor costs in the U.S. increased 2%, double the rate of productivity that was up just 1% over the same time period through Q4 2016. Chart 3 shows the lower growth rates of real economic output (blue line) that follow a similar pattern of reduced business investment. Further, most of the economic growth in recent years has been driven by more labor, not by increases in labor productivity.

This is outlined in a mid-February research note from the Federal Reserve Bank of St. Louis reminding its readers that productivity is key to improve the standard of living: 

"… a small difference in labor productivity growth leads to a dramatic difference in the standard of living over the long run. For example, if labor productivity growth held steady at 2%, which is the rate seen in the expansion from 2001 to 2007, the living standard would double in 35 years. If labor productivity continues to grow at 0.7% (the rate since the beginning of 2011), it would take 116 years to double the standard of living."2  

How can this change? 

There is a growing consciousness about the need for investment that leads to productivity evident in proposed changes to fiscal policy. Some aspects have been well-publicized, including an overall lower corporate tax rate and an even lower rate on earnings held overseas using receipts from that "repatriation" tax to help upgrade infrastructure. More directly the House GOP Blueprint3 proposes: 

  • Providing businesses with the benefit of fully and immediately writing off the cost of investments. This will apply to both investments in tangible property (such as equipment and buildings) and intangible assets (such as intellectual property). It will not apply to land.
  • Continuing a business tax credit to encourage R&D while evaluating options for making the R&D credit more effective and efficient.

What sectors could benefit?

There could be broad, positive benefits to many areas of the economy if these proposed changes in fiscal policy take effect. We currently recommend tactical positioning for the Health Care and Industrials sectors above their respective S&P 500 Index weightings. These sectors are recommended based on current fundamentals, and reasoning in their favor would be enhanced should fiscal proposals be enacted. 

Instant write-offs, instead of deductions spread over a period of time, may act as a catalyst for many manufacturers and businesses in other capital-intensive areas, like railways and airlines. The Industrials sector includes several sub-industries that may benefit. Additionally, access to overseas capital may drive new investment activity. Pharmaceutical companies repatriating cash could foster deal activity for viable drug candidates in development. Competition for such assets could further increase valuations. Some Health Care companies may also decide to invest in new manufacturing or R&D to take advantage of the preserved credit, potentially lowering the cost of funding such programs. 

Summary

The lack of additional business investment during the current expansion has limited improvements to U.S. capacity and hindered productivity growth. Fiscal policy proposals may provide an opportunity to improve productivity in the present as well as raise the standard of living for current and future generations. It's possible that all sectors of the economy may benefit to varying degrees. Health Care and Industrials are two sectors with compelling fundamentals that could be enhanced if expected fiscal changes are enacted.


1 Source: The Unseen Capacity, http://www.mmsonline.com/columns/the-unseen-capacity
2 Source: https://fredblog.stlouisfed.org/2017/02/slow-labor-productivity-growth/
3 Source: A Better Way, Our Vision for a Confident America, https://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf