Capacity utilization is concerning

One of the economic data points I like to follow is capacity utilization, which is compiled by the Federal Reserve and reported monthly.

I like this data time series for several reasons.  First, the data are very stable.  Changes are generally easily recognizable.  More importantly, as I distill the numbers into something meaningful, capacity utilization (and the changes) tells me a story about the economy.

What happens as capacity utilization is increasing?  Demand, relative to supply increases.  As more capacity is utilized, businesses have the ability to begin to raise prices.  Eventually this leads to hiring and expansion in order to build more capacity to meet demand.  This produces a virtuous cycle.  If capacity utilization falls, the inverse is true.  Further, as there is surplus capacity, producers/manufacturers might cut price to ensure that their marginal capacity is utilized.  This is productive if they secure contracts but counterproductive if it results in price wars. Those manufacturers that don’t match lower prices might see volumes decline.  In almost any case, excess capacity tends to negatively impact profit margins.

Note the graph of capacity utilization dating back to Jan 2005.  I observe the following:

  1. Until the great recession, values were stable between 80% and 81% (save for a brief blip resulting from Hurricane Katrina in Aug 2005).
  2. As economic activity dropped during the Great Recession, capacity utilization dropped to a low of 66.8 in June 2009.
  3. Capacity utilization began declining prior to the Great Recession, falling below 80 in April 2008.  (Interestingly, the recovery in capacity utilization similarly lagged the recovery in the equity markets.)

Capacity utilization has rebounded strongly since its lows, plateauing over the past six months in the 78.4-79% range.  Since July, there appears to be a trend break, with capacity utilization declining to 77.8% in the data reported on Friday.  Of note, the data are reported with a one month lag, so Hurricane Sandy did not influence this data stream.  I think this trend break and recent downturn is potentially concerning.

We have witnessed industrial production slowdowns across most of the EU, while the US has seemed relatively immune.  Capacity utilization hints that perhaps there is weakness in the US economy that has not widely manifested itself.  An alternate hypothesis, of course, is that the capacity utilization data is the spurious anomaly in a relatively healthy US economy.  While the truth will come to light in future months, I believe this is a data stream not to be dismissed.  At the very least, it is a warning sign that foretells of a potential recession.  The typical caveats remain and include that this data can change and that this is merely one of many pieces of information.

source: Bloomberg

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