April 2007 Business Topics by Tim Triplett, Editor-in-Chief

Lustgarten: Mid-cycle Pause
Little Cause for Concern
The U.S. economy and metals markets are in a mid-cycle pause, during which growth will slow yet remain relatively healthy, according to analyst Eli Lustgarten. President of ESL Consultants and senior vice president at Longbow Research in Independence, Ohio, Lustgarten delivered his economic forecast Feb. 23 at the Metals Service Center Institute’s Carbon Conference in Ponte Vedra Beach, Fla.

A frequent speaker at MSCI events, Lustgarten reported a few years ago that 2004 was the beginning of a multiyear uptrend that would extend at least through 2006. “Not only did it go through 2006, but it is going to extend through the end of the decade. This is an industrial decade,” he asserted. “The only guarantee was that the growth wouldn’t be linear—and we are in that nonlinear part today.”

Though the economy has slowed, fears of recession are unfounded. “Inventories—the big­ gest cause of recession—have been kept under control, and money is still available. So we don’t expect a recession by any means,” he said.

Companies must adjust to moderating sales and profits, however. “Mid-cycle means top-line growth in the low to mid single digits, at best,” he said, well below the double-digit gains most industrial markets saw from 2004 to 2006. “Seven to 10 percent bottom-line growth during a mid-cycle period is good,” he added.

Business conditions data from the Institute for Supply Manage­ ment indicate that manufacturing lost momentum in the second half of 2006 and started out 2007 in less than robust fashion, Lustgarten said.

January’s Purchasing Managers’ Index of 49.3 percent, New Orders Index of 50.3 percent and Production Index of 49.6 all toed the margin of the 50 percent level that signals growth. (Editor’s note: February data released later in March showed rebounds in all three categories, with the PMI increasing to 52.3, New Orders to 54.9 and Production to 54.1.)

January’s Price Index of 53 percent (which rose to 59 percent in February) showed that manufacturers continue to pay higher prices than they did late last year. The Inventory Index of 39.9 percent in January (and 44.6 percent in February) suggested that industrial inventories continued to contract. However, he added, the Customer Inventories Index at 52 percent in January (and 53 percent in February) indicated that customers continued to have more than sufficient inventories on hand.

January was the beginning of a big inventory correction as manufacturers reacted to the slowdown by trying to cut inventory levels. Likewise, service centers scaled back steel orders to work down their excessive stocks.

Lustgarten emphasized that this “mini correction” bears no resemblance to recessionary conditions earlier in the decade. Characteristic of almost every recession—in addition to excess inventories—is tight availability of capital, he noted. “Today, there is plenty of money available. Price levels are good. And we don’t
have the effects of a massive inventory correction hitting the economy—though in some industries it may not feel that way.” 

Looking back, 2005 was a strong year for the industrial economy, though some of that underlying strength was masked by rising interest rates, a strengthening dollar, a mini-inventory correction in the first half and the effects of the hurricanes in the Gulf Coast.

The economy was still surging in first-quarter 2006 at an unsustainable 5.6 percent growth rate, but hit the brakes in the second quarter. The lagging effects of the hurricanes, along with increased energy costs and a slowdown in residential construction, trimmed growth to 2.6 percent. The downtrend continued into the third quarter, where GDP dipped to just 2 percent. Though still improving late in the year, Lustgarten expected fourth-quarter 2006 growth estimates to be revised downward to around 2.5 percent due to the widening trade deficit and lighter than expected consumer spending.

Though the first half of 2007 “appears a bit dicey,” with the mini-inventory correction and weakness in the automotive, housing, light construction, farm and truck sectors, he expects improved domestic economic growth in the second half. “Once it comes out of the current mid-cycle pause, the industrial sector should be in a good place for 2007 and beyond,” he said.

Current economic data showing uneven jobs growth and the huge trade deficit can be misleading, he warned. Despite the trade deficit total, U.S. exports grew by 14.3 percent in 2006. A 4.2 percent gain in wages boosted consumer spending. “Consumers proved they can handle gas prices in the $2 to $3 range,” he noted.

Likewise, inflation and productivity look better than the data suggest. Following an unexpected dip in business investment in machinery, equipment and software in the fourth quarter, capital spending is poised to rebound, fueled by strong corporate balance sheets, high levels of capacity utilization, the weaker dollar enhancing export demand and continued strong domestic spending outside the housing sector.

The odds still favor an interest rate cut sometime in the second half, he added. “It is politically correct for the Fed to cut in the second half of this year. 2008 is a big election year; the last thing the Fed wants to do is get involved in presidential politics. Remember, there’s a six- to nine-month lag from Fed action. Therefore, if they want to do anything to stabilize the economy in 2008, they have to do it in the second half of 2007.”

Forecasting the prospects for specific markets in 2007, Lustgarten reiterated that automotive, housing, trucks, light construction and appliances may experience further weakness.

Markets with the most strength remain: aerospace, heavy equipment, nonresidential construction, energy, power generation, fluid power and machine tools.

Areas of uncertainty include material handling, defense, packaging, rail cars, farm and medium construction.

The U.S. economy will see real GDP growth of 2.7 percent in 2007 and 2.8 percent in 2008, he forecast, down from 3.4 percent in 2006, but still at healthy levels, especially for the industrial sector. “Not only is growth good in this country, it is even better outside the United States,” he added. “The economic picture looks fine.”