Manufacturing Weakness

In light of an unbroken string of atrocious manufacturing survey data, we have decided to update a few of the charts we use to assess the economy. For a discussion of the details of the most recent manufacturing surveys see Mish (Empire State and Philadelphia) and Zerohedge (Empire State and Philadelphia). We would note to these data that the strong decline in new orders is especially noteworthy.

To begin with, we want to point out that there is at least one data series that strongly suggests that the economy is not yet in recession, namely private non-residential fixed investment (it has a long history as a confirming indicator).

1-Non-res fixed investmentReal private non-residential fixed investment. This data series tends to decline or at least flatten out just prior to recessions and is definitely declining as soon as a recession is underway. As of Q2 2015, it was still rising, which suggests that a recession hasn’t begun yet – click to enlarge.

This is incidentally also confirmed by the Atlanta Fed’s “GDP Now” indicator, which currently indicates annualized GDP growth of 0.9% in Q3, which is quite weak, but not yet a contraction. Still, the indicator is currently mired in a downtrend and there are obviously quite worrisome developments underneath the “quiet stagnation”.

One thing that we cannot stress often enough is that the manufacturing sector is far more important to the economy than its contribution to GDP would suggest. Since GDP fails to count all business spending on intermediate goods, it simply ignores the bulk of the economy’s production structure. However, this is precisely the part of the economy where the most activity actually takes place. The reality becomes clear when looking at gross output per industry: consumer spending at most amounts to 35-40% of economic activity. Manufacturing is in fact the largest sector of the economy in terms of output.

Although we have no recent update on gross output yet, both manufacturing and mining output have turned negative in Q1 already, and given the survey data received since then, it is a good bet that this downturn has continued. In fact, the following chart of business spending, inventories and the inventories/sales ratio recently mailed out by our friend Michael Pollaro (keeper of TMS statistics) suggests as much – these data show the situation as of August. If we were to judge the state of the economy based on this chart alone, we would probably conclude that a recession has already begun:

2-Business salesAnnualized growth in business sales, inventories and the inventories to sales ratio – click to enlarge.

A Distorted Production Structure

There are good reasons to believe that the next bust will be a denouement of historic proportions, a.k.a. a real doozy. The enormous expansion of money and credit that has been in train since the gold exchange standard was abandoned following Nixon’s gold default (sorry, “temporary suspension” gold payments) has over time created an ever more “top heavy” production structure. This phenomenon can be observed by looking at the ratio of capital to consumer goods production. The expansion in money and credit from thin air has continually suppressed interest rates below the natural rate, pulling more and more factors of production toward higher order goods production. Over time, the amplitude of the intermittent booms and busts associated with this has steadily increased. The current business cycle is unlikely to be an exception.

The chart below shows the relatively recent situation. What is remarkable is that the trend has begun to stall out in recent years, in spite of money supply growth ranging between 8-16% (currently approx. 8.5%). This is a strong hint that the succession of credit booms over recent decades has severely depleted the pool of real savings available to the economy (note that real savings, or the free capital actually available for longer term investment projects, are distinct from numbers piling up in bank accounts due to willy-nilly money printing).

3-Cap vs. consumer goods ratioThe ratio of capital vs. consumer goods production shows that in periods of artificially suppressed interest rates spending on capital goods production rises sharply vs. spending on consumer goods production. Recently the trend has stalled, in spite of brisk money supply growth – click to enlarge.

For comparison, here is a chart of money supply and credit growth, with the same time period highlighted above shown in a blue rectangle:

4-Money and credit growthAnnual growth rates of the broad true money supply and total bank credit – this indicates that in order to reignite boom conditions, ever greater money supply growth is likely required – click to enlarge.

It is also worth considering the difference between “then” (the time prior to Nixon’s gold default) and “now”. As the long term chart below shows, the ratio actually moved in a well-defined channel before the dollar’s last tie to gold was cut:

5-Cap vs consumer goods, LTPrior to the adoption of a full-fledged unanchored fiat money, the ratio between capital and consumer goods production moved within a well-defined channel. Recessions were more frequent, but also far less severe. It is to be expected that eventually, the entire move since 1971 will be “corrected” – click to enlarge.

In parallel to this, total credit market debt has exploded into the blue yonder. We would point out to this that the ratio between capital and consumer goods production would also rise if the pool of real savings were actually growing. In that case, an increase in economic growth should be expected to ensue, as the investment-consumption ratio would be in line with the actual wishes of consumers. The fact that economic growth has actually slowed quite noticeably relative to the pre-default era can be seen as empirical evidence that amassing all this debt and artificially distorting the structure of production has actually set us back quite a bit. One must always be careful with interpreting empirical economic data of course, as the ceteris are never paribus, but it is clear that we have very little to show for the explosive debt expansion chronicled below:

6-Total credit market debtTotal US credit market debt, which has gone “parabolic” after Nixon’s gold default. Unfortunately, this debt expansion has produced slower rather than faster economic growth compared to the immediately preceding time period (1945-1971) – click to enlarge.

How the vast money supply and credit expansion of recent decades has affected production is also shown by the following chart, which depicts the industrial production indexes of business equipment, durable, as well as non-durable consumer goods separately. Over time, the three data series have drifted ever farther apart.

7-Industrial production dehomogenizedIndustrial production of business equipment (capital goods), durable and non-durable consumer goods. Note how the beginning of the secular downtrend in interest rates initiated by the Volcker Fed coincides with the growing gaps between these production indexes (note that under Volcker, the biggest year-on-year money supply expansion in a single year of the entire post WW2 era occurred in 1982. Today Volcker is widely hailed as an “inflation fighter”, one of the many great absurdities peppering the establishment-approved version of economic history. In reality he was a super-inflationist) – click to enlarge.

We are not surprised that manufacturing data are weakening, given that the distortion of the production structure is at its widest ever. To put this in different terms: the economy is tying up too many consumer goods in long term projects relative to the amount it releases. Those engaged in long term investment projects that will only bear fruit in the form of goods ready for consumption after a very long time need to be sustained – and that means that their demand for the entire plethora of consumer goods needs to be satisfied during the waiting period (they will need more than just food and shelter). This is why an imbalance in the time structure of production cannot be sustained in the long run.

Reality vs. Fantasy

You wouldn’t know any of this watching the stock market, which is best described as “fantasy land” at the current juncture. Then again, the stock market is always the last market to notice that something is amiss; to wit, it made a new all time high in October of 2007, even though the credit and bank funding markets were already in an advanced state of panic.

In Thursday’s session, the Nasdaq and Russell 2000 indexes actually outperformed the broad market, which is normally a positive technical sign. However, if one looks at the ratio charts, one can still see that the Russell remains in a short/medium term downtrend relative to the broader market, and that is generally not a good sign – especially as it has been an upside leader for the bulk of the asset bubble progression since March of 2009. By contrast, the NDX and COMPX have maintained their relative strength trend so far, so in this sense we are looking at a mixed bag.

8-Ratio charts, stocksRUT-SPX ratio, NDX-SPX ratio and the SPX over recent months – a mixed bag of signals – click to enlarge.

We were greatly amused to learn via Reuters that the market allegedly rose because “[…] Of the companies that reported earnings so far this season, 67 percent have exceeded analyst estimates, compared with 49 percent in a typical quarter”. Earnings season not over yet, but this mainly indicates to us that the combination of lowering the bar (by analysts ratcheting own their expectations as the reporting season approaches) and financial engineering (on the part of companies) has likely reached fresh heights of absurdity. If the Yellowstone Caldera were to explode tomorrow while concurrently a three billion ton iron-nickel asteroid planted itself in the Pacific at 70,000 miles an hour, earnings would still “beat expectations” next quarter. The market would probably not rise under these circumstances, though we cannot rule it out either (the fact that trading would have to be conducted underneath a mountain of volcanic ash might complicate things a bit).

As an aside: the Reuters article also mentions the tired old “money on the sidelines” canard. This is not a variable (apart from the growth of money substitutes due to monetary inflation). Someone always holds all the money in the economy, and someone always holds all the stocks in issue. There are no unowned stocks floating about in the ether, and when stocks are sold, no new money comes into existence – the two merely change ownership.

When comparing the entire market (in the form of the Wilshire 5000, the broadest market index available) to new orders for capital goods, one can see that the designation “fantasy land” isn’t too far-fetched:

9-New Orders vs WilshireThe stock market hasn’t really grokked it yet – its celebratory mood is out of line with developments in the real economy – click to enlarge.

As many others have remarked (inter alia the above mentioned Michael Pollaro, as well as our regular correspondent BC), these days the stock market is the economy. This largely explains the extreme reluctance of the central planners to hike rates even by a measly 12.5 or 25 basis points from freaking zero.


There is no recession in train just yet, but it would be a grave mistake to ignore the growing weakness in the manufacturing sector. This weakness is all the more remarkable considering that money supply and credit growth remains brisk, which normally keeps malinvestments on artificial life support and allows them to expand further. The fact that this is no longer the case is evidence of the enormous structural damage the economy has suffered due to loose monetary policy and the succession of credit booms we have seen unfold in recent decades.

Stock market investors have so far been protected by the “central bank put” and the associated strong money supply growth. However, in the euro zone, where money supply growth is currently the strongest of the main currency areas, stocks have performed dismally of late, proving that even pumping up the money supply by 14% p.a. sometimes won’t do the trick. Moreover, there is no law that states that stocks have to be the main beneficiaries of excess liquidity. They have been in recent years, but that won’t necessarily remain so. If our ruminations about the sorry state of the economy’s pool of real savings are correct, one should actually expect this to change.

Lastly, this isn’t the first time the market has ignored a sharp deterioration in the economy. Sometimes it later turns out that market participants were correct in looking beyond the economic data of the day, but often enough they simply turned out to have woefully underestimated the dangers (as the chart above actually demonstrates). Caveat emptor.

Addendum: Gross Output Reminder

Just as a reminder, we reproduce the gross output chart below (gross output by industry is shown until Q1, new orders for capital goods are updated to August):

10-Gross OutputGross output by industry, plus new orders for capital goods ex aircraft. This chart also provides evidence for the correctness of Austrian capital theory: mining and manufacturing are the most volatile sectors, while retail is the least volatile. In other words, the further removed from the consumption stage industries are, the more volatile and boom-bust prone their output becomes. It is worth noting that the output of mining and manufacturing both have already turned negative in Q1 – click to enlarge.