Businomics Blog

Markets Don’t Stay Bad Forever: Cycles, Trends, and an Oil Refining Example

Valero Energy Corp. is selling oil refineries that it had bought a few years ago.  We used to have a shortage of domestic refining capacity, but now we have an excess—even though there has not been a new refinery built in the United  States in years.  Capacity at existing refineries was expanded through new technology, our demand for refined products lagged, and imports of refined products have increased, thanks to expanded capacity overseas.  (It used to be that only crude oil was shipped in, but now gasoline and diesel are imported in tankers.)

Who would buy those refineries from Valero?  One very sharp businessman named  Thomas  O’Malley, the same guy who sold the refineries to Valero back in 2005.  He’ll likely pick up his old properties at a steep discount to the price he received for them near the peak of the market.  The Wall Street Journal quotes O’Malley:  “Markets don’t stay bad forever.”

O’Malley sounds wise, but let’s no go overboard. The buggy whip market never did come back.  Carburetors, vacuum tubes, asbestos ….  The list goes on.  Here’s how we economists think about these things.  Begin with a long-term trend.  (We often say a “secular” trend.)   That could be upward (Internet advertising) or downward (newspaper readership.)  Now add a business cycle.  Advertising is very cyclical, and has suffered in both print and on-line media during the recession.

Most markets will, indeed, bounce  back in the recovery, but some will bounce higher than they ever had been before (rising trends), while others will bounce back but never recover their  past peaks (declining trends).  The danger in O’Malley’s words (which I would guess he understands) is that the opportunistic buyer at the cyclical low had better pay a price that  reflects the long-term trend after the recovery is over.  I can easily envision newspaper investors being forever disappointed, even though they bought at a cyclical trough.   On the flip side, I can also envision investors passing up great opportunities because they see the recent cyclical downturn but confuse it for a long-term trend.  This is one of the reasons that it’s wise to bring in an economist, and ask for an analysis that includes both the long-term and the short.

Inventories in the Economic Recovery: Caterpillar Snaps the Bullwhip

The recession is the time to cut inventories.  The recovery is the time to re-stock.  First, though, you have to make sure that your vendors are up to the challenge.  The Wall Street Journal recently ran an excellent front page story about Caterpillar Inc. entitled, “’Bullwhip’ hits firms as Growth Snaps Back.”  The so-called Bullwhip effect is the  cyclical inventory swing, which I describe in more detail in my book, Businomics.  In the recession, three forces reduce orders from vendors:

1. With a lower level of sales, there is less ordering to replace recently-sold merchandise.
2. At a lower level of sales, an inventory-sales ratio targets dictates lower inventories.
3. Many companies lower  their inventory-sales ratio target to conserve working capital.

When the economy begins to recover, the opposite happens.  One dollar’s worth of sales first triggers one dollar’s  worth of orders from the supplier.  Then  the  higher sales level  triggers a few additional cents worth of orders due to the higher average sales level. Finally, the company realizes that having inventory in stock is a competitive advantage, and it now has adequate cash, so it raises its inventory-sales target.  The swing in inventories is highly disproportionate to the underlying change in sales.  

(I’ve previously written about how tight inventories can cost businesses both immediate sales as well as customer loyalty, and I think the inventory swing across the economy will have a large impact on economic growth in 2010.)  

Caterpillar anticipated this bullwhip effect in its own operations and had the wisdom to wonder if its vendors would be able to deliver increased shipments.  Now let’s talk about  how a company whose CEO is a Ph.D. in economics handles this challenge.  The Journal reports,

“…Caterpillar took the unusual step late last year of visiting with key suppliers to ensure they had the resources to quickly boost output. In extreme cases, the equipment maker is helping suppliers get financing."

This is a genuine challenge.  I’m hearing stories of businesses that cannot get the materials they need from their vendors.  The reasons are various, but all tie to the recession.  The vendor may lack the working capital needed to buy raw materials and pay newly re-hired workers. Caterpillar is wise to help its vendors with financing.  Trade credit usually helps vendors with their raw material costs, but companies  battered by the recession may have  to pay cash up front from their nervous and cash-poor suppliers.  Labor, of course, has to paid promptly.  Even if the vendor has adequate working capital, it may have laid off workers with key skills, and it may have deferred maintenance on some of its equipment.   A corporate buyer typically talks to a sales representative, who is not inclined to report potential problems with deliveries.  The  conversation with vendors has to be elevated to higher level officers knowledgeable about the companies finances and operations. Caterpillar also inquired about their vendors’ exposure to the automobile industry, a key risk to survival in this economic climate.  

If your company depends on its vendors, read the entire Wall Street Journal article.  Then start a program to meet with your critical vendors.  (Personal plug: I have been talking to businesses about business strategy in the recovery, and I can help firms that want to engage in their own recovery readiness assessment, or want to make sure their vendors are ready.)

Employment and a Lost Decade? A Warning on Data Analysis

Some say that we have added no jobs in the past 10 years, and they are calling it a "lost decade."  What they see is a product of bad data analysis.  Here's the actual U.S. employment data, plotted in blue:

Actual data in blue.  The green line goes from December 1999 through December 2009, showing virtually no growth in a decade.  But it's always to calculate changes from a peak to a trough if you want to understand long term trends.  The economy's ability to generate jobs over a long period of time is better examined by looking at peak-to-peak growth, which is the purple line.

So, you can say that we ended the decade at the bottom of a business cycle, but everyone already knew that.  Or you can say that the economy grows jobs over the long run, but not during the down stage of a business cycle.  I think the latter statement is more useful.

Going forward, businesses should recognize the slower growth of the working age population that we'll have in the 2010s.  Plenty of companies are planning on expansion, but won't find the workers easily, unless they start thinking about this challenge ahead of time.  (A year before the recession, I wrote about 6 Steps to Hiring in a Tight Labor Market.  It's useful to read even before the market tightens.)

The Future of Banking

I've been spending a lot of my time working on the future of finance and banking.  If you're a banker (or bank association officer), take a look at this summary of my work on The Future of Banking.  Related to the banking work is analysis of the future of global capital flows and securitization.

Massachusetts Senate Race: Implications for Business

I try to avoid politics in this blog, but sometimes I cannot.  Republican candidate Scott Brown has won Ted Kennedy's senate seat, in "the Scott heard round the world."  You are a business leader who has planned on seeing the Democratic Party's agenda rolling through, with health care reform, regulatory reform, and a larger role for the federal government in the economy.  Should you change your political planning assumptions now?

Gerald Seib had an extremely insightful column in Tuesday's Wall Street Journal (subscription required, I think, but who wouldn't subscribe?)  He said that the Democratic victory in 2008 did not reflect a change in ideology, but rather a change in political preference.  The public had not changed its view of the role of government in society and economy, but rather had decided that the Republicans were not competent and the Democrats were worth a shot.

The ideology of America, I think, consists of three parts:

1. Those who prefer a smaller role for government
2. Those who prefer a larger role for government
3. Those who go one way or the other depending on the issue, the circumstances, and the latest news.

If Seib is right, the Democrats have advanced an agenda not in touch with the American populace, either because

• they misinterpreted the American attitude, or
• they seized the opportunity given to them, knowing that the people didn't really support the agenda.

After the Massachusetts Senate race, every politician with the slightest chance of opposition will think twice about the Democratic agenda.  Remember, our politicians are not leaders, but followers.  Where ever they see the voters going, that's where they head.

Business planning implications: the most extreme part of the Democratic agenda will be difficult for them to achieve.  But don't expect a return to Bush-Cheney style rule.  Look for a generally liberal direction, but without the extremes that were pushed in the past year.

Inventory Change Will Help Economic Outlook

Inventory swings have always been destabilizing, a point I made strongly in (if I may be so bold) a good book about economics and business.  Here's what the change in inventories did to the economy over the past two years:

The blue line shows the actual growth rate of GDP; the red line shows all components of GDP except the change in inventories.  Especially in the first quarter of 2009, the change in inventories made the recession significantly worse (though we were in a recession even without the inventory swing).  This was not just a statistical issue.  Factories cut back production because their customers were lowering inventory levels.

Going forward, businesses will eventually have to restock their shelves.  When that happens, a dollars worth of retail sales will trigger more than a dollar's worth of production, as companies both replace what they just sold plus add a little more to their inventory level.  And the inventory gain is happening right now.

The meek economic forecasts may not be anticipating a bounceback in inventories, which make them too pessimistic.  However, after four quarters of inventory recovery, the end of re-stocking will push down GDP growth for a quarter, so look for a little bit of roller coaster in your economic data.

Business Planning and Inventories: I wrote a few months ago about a company that lost a sale--and a loyal customer--due to lack of inventory. (Blog post about inventories.)  I was recently talking to executives who had a very nice sales boost because they had more inventory than their competitors.  When sales started to recover, they gained market share.  Friends, the business cycle is changing.  The time to slash inventories is past.  Now is the time to ensure that you can serve your customers.

Businomics Newsletter: A Quick View of the Economy

The January issue of the Businomics(R) Newsletter was released today.

Employee Attitudes in the Economic Recovery: Take This Job ...

I always loved listening to Johnny Paycheck sing Take This Job and Shove It.  Now some workers are actually saying that.  Here's the number of quits in the entire economy:

Quits are still well down from the boom days, but the latest news suggests that there will be more to come.  In the recession, managers can get sloppy without losing workers.  It's not that the managers are inherently bad (most of them, anyway), but that they became preoccupied with cash flow and business survival.  The often did not recognize that their staff were stressed out, worried, and maybe angry and resentful.

As the economy improves, business leaders need to make employee relations a higher priority.  Employees will have more choices, and more of them will quit.  Most quits are not about pay and benefits so much as about feeling valued and respected.  So here's the agenda for managers and small business owners:

• Thank employees for their efforts in general
• Recognize specific employee achievements
• Acknowledge that the work environment has been difficult
• Acknowledge that management has been preoccupied with corporate survival
• As business earnings improve, evaluate how to boost compensation.  Perhaps reinstating old benefits that were suspended in the recession is not the best strategy; this is a time when old benefits can be replaced with new benefits.

When Will China Be Larger than the U.S. Economy?

I got this question twice this week, once from an interest reader and once after a speech.  I expect China's economy to be larger than ours within the next decade, most likely around 2018.  Here's a picture of the two economies:

Data notes: These are low-fidelity data.  The U.S. GDP figures are decent, projected out at our historic average growth rate.  Actual data end in 2008, so the 2009 low figures are not incorporated.  Chinese GDP data are of low quality, but roughly indicative of the trend.  They were also projected out using the historic growth rate.  Converting the Chinese data into figures comparable to U.S. dollars is tough.  This conversion was done with an estimate of purchasing power parity, but consider it only a w.a.g.

At some point China's economic growth rate will slow down, but only after their per capita production rises to that of advanced economies.  That's still quite some ways away.  The the strong China economy in 2020 will continue reflect low per capita income, but lots of capitas.

But what's it mean for the United States?  Some folks like to swagger and say "We're Number One," and they wont' be able to say that in a decade.  However, economics is not like a game, in which there's a winner and a loser.  We can all be winners.  In fact, engage in the following thought experiment.  Would you be better off

• making $40,000 a year in a neighborhood where everyone else makes $30,000, or
• making $50,000 a year in a neighborhood where everyone else makes $60,000?

If you are focused on envy and keeping up with the Jones, the first choice is for you.

If, instead, you are focused on income as a means of enjoying life, then you prefer the second choice.  If you care about your fellow man, you prefer the second choice.  If you think that social problems spill over from low-income households to their neighbors, then you prefer the second choice.

I certainly would rather live in a rich neighborhood, even if I cannot keep up with the Joneses.  (Right now my neighbors wonder how I keep such old cars running, while they buy new BMWs and Mercedes, so I'm comfortable not being Number One.

Back to reality.  A richer China will increase demand for American-made goods and services.  Right now China is the third largest buyer of American exports (after Canada and Mexico).  We export all sorts of stuff to China: consumer goods, capital goods, food, industrial commodities.  Detail here.

Business planning idea:  China will increasingly be a market, not just a production location.

Will We Ever Recover from the Great Recession?

An interested reader asks, "One question I would like to ask is whether you see the US ever fully recovering from this recession?"

Good question.  In the common sense of the term, yes we'll fully recover.  The level of economic activity will fully recover all lost ground, and then hit new record highs.  No problem.  Let's take a look at the long-run history:

(Data note: the chart shows the logarithm of real GDP.  For those of you who don't usually live with logs, the key point is that the slope of the shows the percentage growth rate.  Roughly speaking, long-term growth has been fairly steady, but if you look at the chart long enough, you'll see a bit of concavity with respect to the lower-right corner, meaning that our growth rate has slowed just a touch in the latest half-century.)

The only downturn that stands out on the chart is the Great Depression, and look how above-normal growth after the recession brought the economy back up to the trend line. 

Some academic research has confirmed this rough eyeball analysis, but other studies find that there is a permanent loss of "potential output," which is the level of production you have when the economy reaches full employment.  Reasons for a permanent loss include lower capital investment that is not fully made up later.  Some folks may leave the labor force early, so "full employment" after the recession may imply fewer people working than before the recession.

Another important thread is the composition of output in both the boom and the bust.  The measured GDP in the years of the housing boom included residential construction spending, valued at then-current prices.  But we now know that we overbuilt, meaning that the new housing we built was not really worth the price at the time.  So in one sense, we didn't really produce as much as the statistics say we did.  However, we did invest in the ability to produce that stuff.  Contractors bought backhoes, nail guns and pickup trucks.  Some of that physical capital may find work to do, but some of it will never be fully employed.  (Some nail guns may rust out before they are put back to work.)  This means that some of the capital spending we did back in the boom does not really add to today's productive capacity.  Oh sure, it could add to productive capacity if we wanted more houses, but we don't.  It's like spending money on a state-of-the-art buggy whip factory.  How much does that help the economy produce goods and services?

So there will be some permanent effects of the recession, but I think they'll be relatively small.  In short, Yes, we will (pretty much) fully recover from the recession.