What to Make of This New Fork in the Road to Recovery
“Straight roads do not make skillful drivers.” — Paulo Coelho, novelist
The disproportionate economic impact of the pandemic on different industries has been the story for the economy over the past year, and one we’ve discussed many times, whether for impact under the hood in labor markets or under the hood for inflation.
But it’s not only under the hood that we’re seeing these massive shifts, as two important data points released last week continue to show. As of February, the industrial sector has seen production drop by nearly 5% compared to a year prior, while retail sales have increased by over 6%. Such a forking between two key parts of the U.S. economy is rare and has been increasing again in 2021.
The reason for this divergence is, duh, the pandemic. For consumers, retail spending has shifted online, with nonstore retail up a staggering 25% from a year ago while other retail is up a modest 3%, below historical averages for in-person spending. Manufacturers, meanwhile, don’t have the same option. Beyond rolling shutdowns to stop the spread of the virus, manufacturing projects often have a long lead time, with early pandemic decisions to slow production having a ripple effect a year later.
The most prominent example is semiconductor chips. As auto sales plummeted to start the crisis, replacing demand for home electronics gear, foundries shifted production to match the change. But as the recovery started, motor vehicle retail sales, aided by cheap financing, resumed at a torrid pace, up 9% from a year prior. Facing heightened demand but missing key production parts, auto companies which depend on microchips have been left lacking, with many factories forced to halt car production entirely. February’s winter storm didn’t help, with many Texas chipmakers forced offline.
But the shortages aren’t limited to this one item. Factories in general have been left operating far below capacity to meet health and safety protocols, with quality control auditor QIMA noting factory-critical noncompliances doubled in the second half of 2020 from the first.
The Institute of Supply Management, or ISM, surveys for February 2020 showed a skyrocketing of supplier delivery times for manufacturers, consistently lengthening through the pandemic.
All 18 manufacturing sectors noted slowing deliveries as “issues with absenteeism, short-term shutdowns to sanitize facilities, and difficulties in hiring workers remain challenges and continue to cause strains that limit manufacturing-growth potential.”
Another way to look at this dynamic is through retailer inventories. Motor vehicle dealers, home furnishing and electronics retailers and general merchandising stores all had inventory levels at their lowest compared to the sales pace since 2015 in February.
The Economics 101 lesson would say this means retailers should respond by raising prices, either in order to more successfully coax employees back to work with higher wages and more sanitized environments, or else to help locate new suppliers. And this may happen in the coming months. But the facts of the virus are difficult to work around, and a pick-up in vaccinations should solve these problems on its own. A more preferable way to manage these shortages may be just to put new retail orders on backlog, as well argued in this Bloomberg piece, and also measured as near-record highs in the ISM reports.
The Census Bureau’s "Small Business Pulse Survey" showed companies are finally consistently marking up when they expect conditions to normalize. We’ve seen false starts here, as last summer companies expected a full recovery by the start of 2021, but the current vaccination pace gives us hope this trend is more meaningful.
And when health conditions do return to normal, hopefully by this fall at the latest, factories will have plenty of capacity to quickly pick up production. As of February, factories were only using 75% of capacity, about 5 percentage points below the pre-crisis peak (when, we should note, inflation was also not a major concern).
But it is true manufacturing capacity growth has slowed. Tracking lease signings by manufacturing companies, we see over the past six months that demand for commercial real estate has been the weakest since the depths of 2009.
While this will surely reverse as safety conditions return to normal, it is another stark reminder that prolonged periods of operating below capacity can mean a reduction in future capacity. We are confident in the recovery at this stage, but speed bumps will be inevitable for the most impacted industries, and we can’t guarantee the makeup of the economy will be the same a year from now.
The Week Ahead …
Economic data releases keep apace in the coming week, headlined by personal income and outlays data for February. The January figure was buoyed by the $600 checks from the December relief package, with February sandwiched in between stimulus deals, meaning less income is likely to be counted in this report. Likewise, February’s weak retail sales print hints at a weaker consumption figure for the month, a result of inclement weather and a reduced impact of January’s stimulus checks.
Elsewhere, new home sales figures for February are set to be released on Tuesday, likely to show weather impact as well. The pace of mortgage applications appears to be slowing somewhat since the end of 2020 as interest rates tick up.
Federal Reserve officials plan to make a variety of speeches, as last week’s Federal Open Market Committee meeting resulted in increased divergence of expected policy paths.
While Chairman Jerome Powell holds a firm grip on policy communications which remain overwhelmingly dovish, any internal dissent would be of note.