FCX Freeport McMoRan Inc

Total Industrial Production rose 0.8% in March, which was well above the expected 0.6% increase. That is a very solid performance. The revisions were a bit of a wash, with the February number being revised up to 0.1% from unchanged, but January revised down from 0.2% to 0.1%.

In any case, this is a big-time acceleration from what we saw in the first two months of the year. Relative to a year ago, total Industrial Production is up 5.9%. In normal times, that would be great growth, but for coming out of a deep recession, it is just OK.

Behind the Headlines

Total Industrial Production includes not only the output of the nation’s factories, but of its mines and utility power plants as well. The production and consumption of electricity generally has as much to do with the weather as it does with overall economic activity. December was much colder than most Decembers, at least in the U.S. and thus a higher than normal demand for electricity.  January, while cold, was closer to a normal January than December was. February was warmer than normal.

Thus it is important to look at just how the manufacturing sector is doing alone. It rose 0.7% in March, up from February’s 0.6% increase but down from a 0.8% increase in January. Both previous months were unrevised. Year over year factory output was up 6.6%.

Utility Output

Utility output rebounded by 1.7%, after it suffered a February decline of 3.6% on top of a 2.3% decline in January but that is after it surged by 4.7% in December. Year over year Utility output was up just 1.5%. The utility number is mostly about weather, not changes in economic activity, and can be very volatile. The manufacturing only number is a better gage of overall economic activity.

The third sector tracked by the report is Mining (including oil and natural gas). The output of the nation’s mines rose by 0.6% in March, a nice acceleration from a rise of just 0.3% in February and a decline of 1.2% in January. Year over year mine output is up 5.4%.

Stages of Production

By stage of production, output of finished goods rose by 0.8%, after a 0.3% increase in February and a 0.5% rise in January. Relative to a year ago, finished goods production is up 6.3%. Finished goods are separated into consumer goods and business equipment, and there is a real dichotomy between the two, particularly year over year.

Consumers are trying hard to rebuild their balance sheets. That means spending less on current consumption while paying down debt and building up savings. That is a tough thing to do when you are unemployed, but the 91.2% of people who are working are doing their best to get their personal fiscal houses in order.

In addition, a large part of consumer finished goods are imports, not made here in the U.S. This month though, things started to turn around. Output of finished consumer goods rose by 0.9%, but that was after two months of being unchanged. Year over year, output of consumer goods is up 4.0%. Electricity is considered a finished good, so the rebound utility output probably played a role in this month’s rise.

Business equipment output, on the other hand, has been consistently strong. But it cooled off a bit in March, rising 0.4% in March after rising 1.0% in February and a 1.9% in jump in January. Business equipment production is up 13.4% from a year ago.

Business investment in Equipment and Software has been one of the strongest parts of the economy, contributing 0.41 points of the 3.20% total growth in the economy in the fourth quarter, even though it makes up just 7.21% of GDP. That, however, was a big slowdown from the third quarter when it added 1.02 points of the 2.60 points of total growth. It looks like it will be another strong contributor in the first quarter as well.

Output of materials rose 0.8%, a big acceleration from declines of 0.1% in February and 0.2% in January. Materials output is up 6.1% year over year. The first graph (from http://www.calculatedriskblog.com/) below shows the long-term path of total industrial production (blue), and manufacturing only industrial production (red). As manufacturing output is the bulk of total output, it is not surprising that the two lines track pretty well with each other over longer periods of time.

While we are in much better shape than we were a year ago, production is still well below pre-recession levels. That is not particularly unusual a year and a half after the end of a recession; it usually takes at lest two years after production bottoms to reach a new high. In the Great Recession it fell much more than it had in any previous downturn. Notice, however, that the slope of both lines in this recovery is much steeper than in previous recoveries.



Capacity Utilization

The other side of the report is Capacity Utilization. This is one of the most under-appreciated economic indicators out there -- one that deserves a lot more attention and ink than it usually gets. Total capacity utilization suffers from the same weather-related drawback as does Industrial Production. That served to help it this month.

Total Capacity Utilization rose to 77.4% from 76.9% in February. However, February was revised lower by 0.1%. The revival of capacity utilization has been going on for more than a year now. A year ago, just 72.8% of our overall capacity was being used, and that was up from a record low of 67.3% in June 2009.

The basic rule of thumb on total capacity utilization is that if it gets up above 85%, the economy is booming and in severe danger of overheating. This is effectively raises a red flag at the Fed and tells them that they need to raise short-term interest rates to cool the economy. It is also a signal to Congress that it is time to either cut spending or raise taxes, also to cool down the economy (Congress seldom listens to what capacity utilization is saying, but the Fed does).

Capacity utilization of around 80 signals a nice healthy economy, sort of the "Goldilocks level" -- not too hot, not too cold. The long-term average level is 80.4%. A level of 75% is usually associated with a recession.

The Great Recession was the only one on record where it fell below 70%. Thus a 10.1% improvement in overall capacity utilization from the lows is highly significant and very good news. On the other hand, we still have a very long way to go for the economy to be considered healthy.

The second graph (also from http://www.calculatedriskblog.com/) shows the path of capacity utilization (total and manufacturing) since 1967. Note that the previous expansion was sort of on the pathetic side when it came to capacity utilization, barely getting over the long-term average at its peak, the previous two expansions both hit the 85% overheating mark (the 1990’s doing so on two separate occasions).



Factory & Mining Utilization

Factory utilization rose to 75.3% in March, up from 74.9% in February (revised down from 75.0%) and from 74.5% in January (unrevised). That is up from 70.0% a year ago, and the cycle (and record) low of 64.4% in June 2009. That is still well below the long-term average level of 79.0%, so as with total capacity, we still have a long way to go on the factory utilization level. Total capacity fell by 0.5% over the last year, and manufacturing capacity was down 0.9% from a year ago.

Decreased capacity is a tailwind for increased capacity utilization, but at the current level it is a breeze, not a gale. For most of the last two years we have seen year-over-year declines in capacity. While shrinking capacity makes it easier to use the remaining capacity at a higher level, it is not a good sign for the economy. It represents a permanent loss, rather than a temporary idling, of the country’s economic potential.

Mines were working at 88.1% of capacity in March, up from 87.8% in February and from  87.7% in January. A year ago they were operating at 84.1% and the cycle low was 79.0%. We are actually now above the long-term average of 87.4% of capacity. When we are at or above the long-term average, minor fluctuations should not be a big macro-concern.

Since there is a lot of operating leverage in most mining companies, this probably means very good things for the profitability of mining firms with big U.S. operations like Freeport McMoRan (FCX) and Peabody Energy (BTU). Mine capacity increased 0.6% year over year. As depreciation is more than just an accounting exercise when it comes to mining equipment, the high operating rates are also good news for the equipment makers like Joy Global (JOYG).

Utilities

Utility utilization rose to 79.7% from 78.5% in February but is still well below the 81.6% level in January and the 81.4% level of a year ago. We are far below the long-term average utilization of 86.6%.  We are actually not that far above the Great Recession low of 79.2%. Increasing utility utilization faces a headwind because unlike manufacturing, our power plant capacity has actually been increasing significantly, up 3.7% year over year.

With virtually no strain at all on the power grid right now, we could safely take the most vulnerable nuke plants off line to inspect them from top to bottom, a step that Germany took response to the Japanese disaster. Shutting them down a few months from now when the weather gets hotter and power demands increase would be much less attractive than doing it now when power demands are very low.

Unlike the last two months, the weather actually helped the utility part of the total capacity utilization, and made the overall report look better than it actually was, but the distortion was relatively minor. In assessing the state of the overall economy, it is better to just look at the manufacturing numbers. In February, including the Utilities made things look soft, when the weather related effects of the Utilities are removed, it was a fairly solid report. On the surface, this looks like a great report, but considering the Utility effect, it was only very good.

Stages of Processing

By stage of processing, utilization of facilities producing crude goods (including the output of mines) rose to 87.2% from 86.7% in February and up from 86.8% in January. A year ago, crude good facilities were operating at just 84.0% of capacity, and the cycle low was 77.6%. We are now above the long-term average of 86.4%. Considering that crude goods capacity is up by 0.6%, that is a very solid showing.

Utilization for primary, or semi-finished goods rose to 74.4% from 73.8% in February, but is only slightly above the 74.3% level in January. While that is much better than the 70.0% level of a year ago, and the cycle low of 64.9%, it is a very long way from the long-term average of 81.4%. Part of the year-over-year increase is simply due to shrinking capacity, which was down a steep 1.1%.

Utilization of facilities producing finished goods rose to 76.8% from 76.8% in February and 75.8% in January. It is up from 71.9% a year ago, and a cycle low of 66.8%. It remains below its long-term average of 77.3%, but we are getting closer. Interestingly, our capacity to produce finished goods has actually increased by 0.4% over the last year, so the rise in utilization there is facing a headwind. Part of that is due to Utilities, since electricity is considered a finished good.

A Sweet Smelling Rose with Some Thorns

Overall, this report was very good, but slightly worse than it appears at first glance. The headline was boosted by the Utility segment, and that is as much about the weather as it is about economic activity. The decline in capacity makes increasing the utilization of the remaining capacity easier, but it is not what we really want to see. Still, the rebound off the bottom has been extremely strong, and the year-over-year numbers are very robust.

While the economy is recovering, it is still running at levels far below its potential. The capacity utilization numbers can be thought of as sort of like the employment rate from physical capital, much like the employment to population ratio is the employment rate for human capital. Both are running well below where we want them to be.

While additional monetary stimulus would be useful at the margin, the cost of capital is not the major issue right now, it is lack of aggregate demand. As such, additional fiscal stimulus would be much more effective in getting the economy going again. Unfortunately, the debate in DC has nothing to do with getting the economy going faster, it is all about the short-term budget deficit. This is "pennywise and pound foolish" in the extreme.

Getting the economy back into high gear would also start to raise tax revenues, and so the net cost of additional stimulus should be less than the advertised amount. Conversely, big cuts in spending now will slow the economy significantly, to the tune of hundreds of thousands fewer jobs being created in this year and 2012. That means fewer people without income, and hence fewer people paying income taxes. Cutting $39 billion from spending will not cut $39 billion from the deficit. The actual deficit reduction is likely to be less than half that amount.

Anti-Stimulus in Effect

We have been seeing anti-stimulus from the State and Local level throughout the Great Recession, and it is the total amount of fiscal stimulus that counts for the economy, not just what happens at the Federal level. De-stimulus from the lower levels of government has offset about half of the Federal Stimulus we got from the ARRA. The combination of QE2 and the tax compromise will help growth at the margin in 2011, but we still face some pretty serious headwinds.

The main stimulus from both QE2 and the tax deal will wear off at the end of 2011, but hopefully the economy will be self-sustaining at that point (hopefully being the operative word). The recently agreed-to compromise to keep the doors of the government open has pretty much offset the positive effects of the lame duck session tax deal. If we are going to counter the effects of the tax deal by drastic spending cuts, then not much good will have been done in getting the economy moving forward at a faster rate.

Austerity Proven Not to Work

The attempt to cut spending now, as in the cuts of $39 billion for the rest of fiscal year 2011 is deeply misguided. The U.K. has gone down that path, and the net result was that its economy fell by 0.5% in the fourth quarter. China took the most stimulative fiscal path after the financial meltdown, and now it is concerned about its economy overheating.

We have taken a moderately stimulative path with overall fiscal policy (stimulus at the Federal Level offset by austerity at the State and Local level) and grew by 3.1% (and very high quality growth) in the fourth quarter. Budget cuts that end up slowing the overall growth of the economy will slow the recovery in tax revenues and will result in much less progress on cutting the deficit than is advertised.
 
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