Businomics Blog

American Manufacturing and Distribution: Surviving a European Economic Meltdown?

American manufacturers are enjoying a moderate recovery, but Europe’s financial crisis poses a great risk to both factories and the wholesalers who are both up-stream and down-stream from them.

That recovery is shown by an increase of manufacturing output, up 16 percent from the bottom of the cycle in mid-2009. Total wholesale sales have grown much more, but a good portion of that reflects a more than doubling of oil and gasoline prices. However, the bad news is that industry has not grown nearly enough. The level of production remains over seven percent lower than at the previous cycle peak back in late 2007.

What risk does Europe pose for further improvement in manufacturing and industrial distribution? The risks are two-fold: loss of exports as Europe falls into recession, and collapse of spending here in North America due to contagion if the crisis spreads to our financial institutions. I believe these risks are significant, though not at all certain to occur.

European economic activity is certainly slowing, with drops in total industry production in most of the major economies there. Worry about the financial crisis is dampening spending by businesses and consumers both. It is unlikely that the Euro zone will avoid at least a mild recession. Already our exports are dipping, after years of helping to propel the economic recovery.

American manufacturers and their suppliers should worry in proportion to their export volumes to Europe. There will certainly be specific products that are in fashion and specific companies that weather the storm much better than average, but overall it will difficult to maintain last year’s sales volumes to European customers.

If Europe manages to muddle through the financial crisis—which is the most likely case—then American producers will face only a mild slowdown in sales to the Continent. However, there’s a chance of a real financial meltdown triggered by the weak credit of Portugal, Italy, Greece  Spain: the PIGS. This type of crisis typically hits private credit flows as well as government bonds, stifling spending by consumers and businesses. In this event, exports from the United States and Canada will plummet, not only from loss of unit sales but from price cutting as well. We would also feel an “echo recession,” in which our largest Asian trading partners go into a slump from lost sales to Europe. As with all echoes, though, it is milder than the original tone.

A real melt-down of the European financial system could have another significant consequence for American manufacturers and wholesalers: a collapse of lending, and thus spending, on this side of the Atlantic Ocean. Financial crises often spread from one location to another in a phenomenon called contagion. A loss in one market makes financiers get nervous about all other markets. They hunker down, denying loans to everyone. At that point, spending has to slow dramatically, even in sectors that were not originally the problem.  Could contagion spread a financial crisis into American markets?

Let’s first understand the problem we had back in 2007 and 2008. Our financial system had become multi-layered, and required each layer to function smoothly to get credit from the saver to the end user. Bank loans exceeded bank deposits. Banks and other lenders were securitizing all kinds of credit, business and consumer loans as well as mortgages. Third party guarantors assured everyone that risk was low.

When the financial crisis occurred, credit froze up at various steps in this process, and the third-party guarantees were doubted. New credit issuance came to a standstill.

Would history repeat itself in the United States if Europe’s financial system flamed out? I think not. Our banks are now lending out only 80 percent of their deposits, down from over 100 percent in the boom. Securitization of non-mortgage loans is small. A much greater portion of our total credit is plain vanilla: a depositor puts money in the bank, and the bank lends the money to a business. It’s simple and much less prone to sudden halts from panic. There are no guarantees, of course. The financial system is too murky for anyone to be sure what will happen, but I’m fairly confident that our risk is from our exports, not from our financial system.

Thus, manufacturers and distributors of industrial parts should do contingency planning for a European recession. My best guess is that Europe will muddle through, but the risk of a real recession on the Continent is too big to ignore.

For more help on how do the economic contingency planning needed with this economic environment, watch my videos, Economic Contingency Planning with risk of recession:

Business Planning With a Risk of Recession: The Stance

Business Planning With a Risk of Recession: Strategic Initiatives

Business Planning With a Risk of Recession: Economic Contingency Planning

Business Planning With a Risk of Recession: Check Points

Business Planning With a Risk of Recession: Upside Potential 

Exports: Risk of Recession Rising

Maybe I’m a little jumpy, having just created a series of videos about business planning with a risk of recession.

Today’s foreign trade data worry me. If the United States economy is going to turn down, then foreign trade is the most likely source of the slump. Consumers are fairly stable now, spending in pace with their income gains. Housing and non-residential construction are weak, but don’t have much room to worsen. Government spending is not going to suddenly crash. The two major risk areas are exports and business capital spending.

The latest decline in exports may just be a blip. It’s not unusual to have a sawtooth pattern, with the little dips being meaningless in the long run. That could be the case here. However, we know that Europe is slowing down and quite possibly in recession now. China’s economy is growing less rapidly due to its inflation-fighting efforts. (For more details, see myChina economic forecast article.)

It’s too soon to hunker down, but not too soon for some planning. You can start by watching my videos:

Business Planning With Risk of Recession: The Stance

Business Planning With Risk of Recession: Strategic Initiatives

Business Planning With a Risk of Recession: Strategic Initiatives

I posted a video about how to do economic contingency planning for the risk of recession with respect to your business's strategic initiatives on my Forbes.com page. Here's the introduction:

The economic forecast has a major weirdness. Most of my colleagues and I think that this year will bring light-to-moderate growth, but we’re also warning of the possibility of a recession triggered by the European financial crisis. How do you, as a business leader, prepare your company for growth if it occurs, but also protect it from recession?

...

So you had a planning session, maybe an offsite. If it was at a nice resort in a sunny climate, then you should have invited me. I love helping companies with their planning. Anyway, there are two types of results from a planning session:
1)    Goals for key financials, such as sales, expenses and profits, or
2)    Key strategic initiatives, the big over-arching efforts your enterprise will undertake this year. I’m going to talk about those strategic initiatives in this video, then discuss how you deal with routine business processes in the next video.

 

Business Planning With a Risk of Recession

I've posted a new video on my Forbes.com page on the subject Business Planning With A Risk of Recession. Here's the introduction:

We economists are predicting light to moderate growth this year, but we’re also saying there is a significant chance of recession. That sounds weird, but the important question is, “What are you going to do with that information?”

In this series of videos, you will learn how to deal with the weirdness that comes from planning your business operations when the consensus economic forecast calls for moderate growth, but there is also a strong risk of recession.

More videos on this topic will follow.

An Economic Forecast for the Timber Industry, 2012-2013

Wood products demand is far more sensitive to the economy than demand for almost any other product. The outlook for the next two years is moderately positive, at least compared to the weak domestic markets we’ve seen since the downturn began. Log export markets look favorable, but with substantial risk deriving from Europe’s financial crisis. The bottom line is that timber industry executives must plan for moderate growth while protecting themselves from a possible recession.

This outlook focuses on macro-economic forces impacting timber, but not the micro-economic forces. We’ll ignore some important issues, such as competition with Brazil for export markets and Canadian timber policy. These are important, but better covered by other experts. The key issues we’ll address here include:

• Domestic wood products demand, housing starts
• Domestic wood products demand, remodeling
• Domestic wood products demand, non-residential construction
• Domestic wood products demand, industrial
• Export wood products demand

Housing starts will improve in 2012, but a small gain from a starting point of diddly squat leaves you only marginally above diddly squat. The problem with housing is simply too many houses. Upside-down mortgages, short-sales and foreclosures are merely symptoms of a problem: we built too many housing units in the boom, and then the growth rate of demand dropped off due to the recession. Right now the vacancy rate for both single-family homes and apartments is above long-run norms. Apartments are improving, however, as people who cannot make payments on their homes are moving into rentals. Construction of multi-family housing is improving, though from a very low base. Unfortunately for wood products demand, an apartment unit still uses less wood and panel than a single-family home. We’ll eventually see a strong resurgence in total housing starts, because current construction levels are well below our long-run needs. That won’t happen, however, until we work off this excess supply, and that won’t be in 2012. Things should look markedly better by the end of 2013, though.

Remodeling never turned down as much as new construction, but don’t believe it’s not cyclical itself. The Remodeling Market Index compiled by the National Association of Home Builders showed declines in activity every quarter from the end of 2005 through the present. Volume will pick up slowly, along with moderate economic growth, in 2012 and 2013. Don’t expect big gains, though.

Non-residential construction will certainly improve someday, just not in 2012. We are underbuilding compared to our long-term need, but the recession clobbered demand for space. Over the next two years vacancy rates for all property types will gradually improve, but the bulk of the improvement in construction will occur after our two-year time horizon. The good news: it shouldn’t get any worse.

Industrial demand for wood, such as for crates and pallets, typically correlates with manufacturing production. That has been trending upward at a moderate pace and should continue to improve through 2012 and 2013.

Export markets have been the brightest spot in the demand for logs, thanks to strong growth in China, Japan and South Korea. We have recently completed an economic forecast summary of those three countries, published on Forbes.com (China economic forecast, Japan economic forecast, South Korea economic forecast). Here’s the quick summary: all of these countries have positive economic forecasts, but all are at risk from a European recession. In addition, all three countries have appreciating currencies, with will make their exports harder to sell. (That’s a positive to United States companies trying to sell into those markets, of course.) Both China and South Korea have been fighting inflation. That poses a risk of going overboard and triggering a recession. China has seen home prices slip—some say plummet—but that is most likely a brief interruption rather than a long-term concern. Japan’s economic forecast is dominated by rebuilding from the earthquake and tsunami. The reconstruction is a positive for the nation’s purchases of wood products, but limited electricity and supply chain interruptions could stymie industrial activity, slowing demand for wood products.

The rest of the world will grow moderately—assuming that Europe does not collapse in a financial crisis. That’s a big assumption. Right now I estimate the odds at 75-25 that Europe muddles through. Companies should make plans on the basis of moderate growth in timber markets, but also be prepared for another recession. How to do that? Check out my article about recessions and business planning.