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Forecast for 2014: Better, Not Great Experts agree that 2013 has been a rough one for the metals supply chain, and that next year will be better, but most of the speakers at last month’s Metals Service Center Institute Forecast Conference in Chicago predicted the industrial economy will continue to disappoint in 2014. William Strauss, senior economist for the Federal Reserve Bank of Chicago, delivered the good news to attendees of MSCI’s Forecast 2014 Conference. “The U.S. appears to be the strongest economy in the world.” Alas, he said, that’s also the bad news. Despite the United States’ anemic growth in 2013, just 1.6 percent in the second quarter, the U.S. has been the best of the major global economies. But the financial woes of trading partners in Europe and other parts of the world continue to hold the U.S. economy back, he noted. Strauss predicts activity will continue to pick up in the second half, though growth will remain below trend. Blue Chip analysts forecast GDP growth of 2.1 percent for full-year 2013, improving to 2.8 percent in 2014. The Fed’s forecasts point to slightly higher figures in both years. Most economic indicators are heading in the right direction, Strauss noted, but not at rates that would lead to dynamic growth. Rather, they are consistent with the 2.2 percent annualized growth rate since the downturn, which is considerably below the 5.0 percent jumps that followed both the 1980 and 1973 recessions. For instance, housing starts have seen gradual improvement since 2011, but remain well below the 2-million-unit highs of 2004-05. New-home starts are forecast to hit 952,000 this year and 1.1 million in 2014. Likewise, unemployment has improved by 2.7 percentage points from its peak of 10 percent in 2009. However, joblessness remains well above levels in a normalized labor market and will continue that way for some time, Strauss said. The Federal Reserve predicts the unemployment rate will settle around 6.5-6.8 percent in 2014, then drop to about 6.0 percent in 2015, both still higher than trend. On the finance side, banks remain hesitant to loan money. “Businesses are seeing opportunities to expand being lost,” Strauss said. These varying trends are all at play in manufacturing. The sector was one of the engines that propelled the country out of the recession. Though manufacturing fell sharply during the downturn, it has grown at a 4.7 percent clip since then, regaining 79.3 percent of its lost output over the last four years. That growth has largely been the result of increased productivity, however, and has brought with it only a 22 percent gain in the jobs lost, Strauss said. Similarly, manufacturers are making capital expenditures, but not necessarily with expansion in mind. “Investments have less to do with capacity and more to do with quality and efficiency,” he added. “Cost-saving is driving industrial expansion.” A day earlier, Euler Hermes Chief Economist Dan North offered a similar assessment of the nation’s fiscal health. He estimates GDP will check in at an anemic 1.6 percent this year. By next year, he expects it to reach 2.7 percent, a meaningful increase but still short of the great growth that has followed past recessions. Globally, GDP will only hit 2.4 percent this year and increase to 3.1 percent in 2014. North pointed to four key variables that factored into the recession and the slow recovery, all of which are now trending in the right direction: oil prices, the housing market, Fed policies and financial markets. Oil price spikes have accompanied most recessions over the past 30 years. True to form, oil prices surged at the start of the most recent downturn, followed by a second wave sometime later, dampening the recovery. Today, petroleum prices are mostly neutral. Other trends are more positive, North said. The Treasury yield curve is trending the right way, the housing market is improving and the financial sector has resumed lending. Even with these hopeful signs, GDP gains still face significant headwinds. Chief among them are uncertainty regarding taxes and regulations such as Dodd-Frank, the drag of debt on the economy and the structural unemployment issue. The U.S. lost nine million jobs during the recession and remains two million jobs short of regaining that level. And still more jobs are needed to keep up with population growth, North noted. The unemployment issue is even worse than the numbers appear, as the recent drop in the rate was primarily the result of the thousands who have given up looking for work. The extension of unemployment benefits provides a disincentive for some to take jobs. The poor real estate market restricts the mobility of workers’ who would relocate to find jobs if they could sell their homes. And the longer individuals are unemployed, the more their skills deteriorate and the less attractive they become to potential employers. “Based on the level of job openings, unemployment should be 5.5 percent rather than 7.3 percent,” he said. One area of disagreement between the two economists is the Fed’s qualitative easing. North believes the government’s bond-buying policy has done nothing useful but lead to short-term asset inflation. Long-term, it threatens to lead to consumer inflation, he said. Strauss strongly supports the Fed’s continued actions to increase the monetary base and stimulate growth. Moreover, inflation has held below the Fed’s 2.0 percent target, he said. [“Investments have less to do with capacity and more to do with quality and efficiency. Cost-saving is driving industrial expansion.” William Strauss, Federal Reserve Bank of Chicago] Heavy Equipment: Muddling Through The heavy equipment market faces a significant near-term challenge, but the longer term holds great promise for the sector and the companies that supply it, said Eli Lustgarten, senior vice president at Longbow Securities in Cleveland, who drew a large crowd of MSCI Forecast attendees. From 2009-11, the purchasers of heavy equipment saw a surge in prices, a result of strong global demand that drove commodity prices higher. That trend has evaporated, but another is at play that will again push equipment prices higher in North America, Lustgarten predicted. Final Tier 4 emissions regulations for off-road equipment go into effect on Jan. 1, 2014, for equipment from 174 to 751 horsepower. In January 2015, the requirements will be in effect for all equipment. Machinery that emits fewer pollutants must be equipped with more expensive engines and emission controls. Lustgarten estimates the new requirements will result in price increases in the low to middle double digits. Among individual sectors, the forecast for the near-term includes some challenges. On the farm equipment side, a more bountiful summer following several summers of drought is—somewhat counterintuitively—making the ag sector more cautious. In 2011 and 2012, weather conditions curbed farm output. The result was higher crop prices and heavy insurance coverage, which farmers poured back into equipment purchases. But that same dynamic is not in the cards this year. The yields for most major crops are expected to be good, putting pressure on commodity prices. Farm cash receipts in 2012 of $225 billion are expected to drop to $206.6 billion this year and $198.3 billion next year. “The tone of the farm equipment sector has changed. Potential for large crops and slow global growth has caused a cautious approach to farm equipment demand,” Lustgarten said, adding that domestic farm equipment purchases may decline by as much as 10 percent in 2014. Unlike other sectors, no external forces require farmers to buy the newest heavy equipment that meets the more stringent engine standards. Makers of tractors and combines are relying on new bells and whistles such as onboard telematics to entice the ag community to buy the more expensive Tier 4-compliant machinery. The new emissions requirements are likely to have more effect on the construction equipment market, where permitting by local government units can be tied to contractors using the newest, most-compliant equipment, Lustgarten said. Overall, the market for construction equipment has been modest the past few years. In 2013, light equipment sales are up 5 percent, while heavy equipment sales are down 5-10 percent. Lustgarten predicts a similar pattern in 2014, as growth in most building sectors will mostly feed light equipment demand. That will be offset by continued softness in mining equipment, he added. Overall economic growth and industrial production are key drivers of truck demand, thus Lustgarten expects only modest growth of truck fleets in 2014-15 (see Chart 1). On top of that, manufacturers overproduced in the first half of 2012, churning out vehicles at an annual rate of 310,000 units. The liquidation of that inventory is still ongoing, he said. Longer term, new regulations such as CSA2010 and its Hours of Service restrictions will likely require more trucks on the road to service freight and offset the reduced hours drivers can be behind the wheel. On the other hand, Lustgarten said there may be a movement toward Class 6 trucks to replace the Class 8 fleet. Shifting ideas on optimal loads and fuel efficiency, the Panama Canal completion and regionalization of supply chains are prompting companies to consider smaller trucks. A commercial license is not required to drive Class 6 trucks, which expands the driver pool, he noted. While the economy is still “muddling through,” the long-term prospects for the industrial sector are very, very good, Lustgarten said. “The U.S. has potentially one of the most favorable 3-5 year industrial economic outlooks.” The foundation for his rosy prediction is the energy boom and accompanied reshoring trend in the United States. Besides the low-cost source of fuel for manufacturers, the energy build-out carries with it demand for infrastructure such as pipelines, roads, bridges, water projects and downstream facilities. The need for shortened supply chains bodes well for regionalization over globalization, which is huge boon for component suppliers, he added. [“The U.S. has potentially one of the most favorable 3-5 year industrial economic outlooks.” Eli Lustgarten, Longbow Securities] Nonresidential Construction: The Tide is Turning Nonresidential construction holds a special distinction among major metals end markets—it’s the last sector to emerge from the 2008-09 recession. That recovery has finally begun, though it is proceeding at a much slower pace than it plummeted, said Kermit Baker, chief economist for the American Institute of Architects in Chicago, who also spoke at MSCI’s conference. AIA’s forecast for nonresidential construction is quite positive--once 2013 is history. This year, building activity on the nonresidential front has declined 4.0 percent compared to the first half of 2012, with only lodging and transportation trending positive. By year’s end, however, total spending should show a 2.3 percent improvement over last year, according to AIA. Conditions begin to look much more positive in 2014. Baker forecasts a 7.6 percent increase in nonresidential spending next year, spurred by an 11.5 percent gain in the commercial sector (see Chart 2). AIA projects gains of 11.7 percent in retail, 9.5 percent in office, 7.7 percent in health care and 4.8 percent in education construction next year. Buoying that projection is AIA’s Architectural Billings Index, which has been positive for 11 of the last 12 months, the first run of consistently positive scores since the downturn. A leading indicator, increased architectural billing activity generally presages growth in the nonresidential sector 9-12 months down the road. Other market fundamentals are also strong, Baker said. Vacancy and rental rates for all of the major segments—office, retail, hotel and warehouse/industrial—are all positive, with most forecast to improve further in the next two years. In addition, commercial property values have been rising sharply since 2009, while demand for loans has grown considerably. Still, there remain some concerns. Despite the increased demand from borrowers, the financial sector remains tight when it comes to financing construction and land development projects. Cost and availability of labor and building materials also remain volatile. Looking out over the long term, Baker said, the key is demographics. Due to differing aging patterns as a result of the baby boom generation, the past decade was dominated by college-aged people and pre-retirees. This led to greater spending on educational facilities and upper-end homes and retail. Over the next 10 years, the greatest demographic boost will come from young workers and early retirees. This will result in greater spending on office space and starter homes, plus active senior living facilities and health care for early retirees. The one wild card for nonresidential construction is the energy boom in the United States, Baker said. It will undoubtedly have an effect, but it’s too early to know how much. [The nonresidential construction recovery has finally begun, though it is proceeding at a much slower pace than it plummeted. Kermit Baker, American Institute of Architects]