A Hurricane Updraft for the U.S. Factory Sector

The U.S. factory sector has recovered in 2017 thanks to a mining sector rebound that began in mid-2016, an acceleration in factory orders and equipment spending, and a diminished inventory headwind, though still-high inventory-to-sales (I/S) ratios have delayed resumed positive inventory contributions to growth. We now face hurricane rebuilds into Q4-Q1 that should provide a solid additional lift to construction activity and building material, equipment and vehicle sales that will allow I/S ratios to drop, just as headwinds from the vehicle and aircraft sectors diminish.

Though we summarize our view here, see our Action Economics Report for a discussion of the resurgence underway for the U.S. factory sector.

For a broad measure of the factory sector recovery, durable goods orders ex-transportation have climbed a solid 7.5% since June of 2016, following the prior 2-year drop of 6.1%. We should see big gains for this component through Q4-Q1 following storm-related disruption-effects.

Shipments of nondefense capital goods in the durable goods and factory goods reports have bounced 6.9% since August of 2016, following a big 10.8% 2-year drop, and should climb sharply into 2018. We've seen less of a recovery in the equipment component of the industrial production report, following a smaller prior setback for this indicator. We expect a steeper climb for the production metric going forward.

The climb in the monthly capital goods figures accompanied a strengthening trend in the capital spending plans figures from the Philly Fed and Empire State reports, with a steep surge for the Philly Fed component in 2017. We expect a strengthening pattern in the already robust producer sentiment surveys into Q4 that should include solid readings for the capital goods components.

The surge in U.S. demand for capital equipment has fueled a similar bounce in equipment imports, though the recovery in equipment exports has been capped by an only-modest recovery in global economic growth in 2017, and restrained demand for mining-related equipment by foreign buyers despite the shale-oil boom within the U.S. The result has been a sharp deterioration in the trade balance for capital equipment.

The transportation orders component of the factory and durable goods reports has moderated on net since 2013 thanks both to a pull-back in the vehicle sector following a growth boom after the 2009 bankruptcies that left substantial pent-up demand, and a weakening in global aircraft orders with oil price declines that diminished demand for new expensive but fuel-efficient aircraft.

Yet, the hurricanes destroyed up to a million vehicles, leaving a likely pop in replacement demand that will reduce bloated inventories. A bounce in vehicle sales post-Harvey may already be evident in September despite disruption effects from Irma, and a bigger climb should be seen in Q4. Note that vehicle makers had already scheduled outsized plant closures this summer, so a Q4 production bounce was likely even before the hurricane-boost for vehicle sales.

For the aircraft component of the transportation sector, Boeing airplane orders are tracking an 850 figure in 2017 that sits near the 846k level from 2016, versus 908 planes in 2015 and a 1,550 record order total in 2014.

Boeing projects a 2% 2017 aircraft delivery rise to 760-765 planes, following a 1.8% 2016 drop that marked the first decline since 2010, to 748 planes. Deliveries peaked at 762 planes in 2015, after a four-year string of gains that took production well above the prior production peak of 582 planes in 1999. We assume a 7% climb in aircraft deliveries in 2018.

Defense orders have been rising since 2015, following big sequestration-hits in 2013-14, and we expect boosts in defense spending in the FY18 federal budget that extends the uptrend.

The inventory figures for nondefense capital goods have moderated only slightly since a peak in December of 2015, and the climb in shipments has allowed a downtrend in the I/S ratio for this component since March of 2016 that will help to spur new production.

The equipment spending component of GDP has posted a steep climb in the first half of 2017, and we expect healthy gains in Q3 and Q4 that are fueled by hurricane replacement demand beyond disruptive-effects in the August factory data.

The real nonresidential construction component of GDP has also climbed sharply in the first half of 2017 despite a weakening trend in the comparable monthly construction spending component thanks to strength in mining structures that are part of the GDP aggregate but not the monthly report. Though the mining contributions to growth may slow as we approach 2018, the void should be filled by replacement demand in the aftermath of Harvey and Irma.

The real residential component of GDP has weakened over each of the last two summers before a winter bounce, and we expect a similar pattern this winter, though the last two winter bounces were because of mild weather, whereas this year's expected bounce is attributable to post-storm rebuilding. Note that "El Nino" conditions in the last two winters led to mild weather, but most indicators are pointing toward "La Nina" conditions as we approach this winter, which suggests a return of cold weather and a smaller weather-lift.

Weather should also lift industrial production from a depressed August level due both to power station recoveries through September and the shift in weather conditions toward La Nina that will raise utility output in Q4. This will reverse the pattern of the prior two years but reestablish the pattern from the two years before that, providing one more factory sector lift.

Industrial production has climbed 1.9% since May of 2016, and we expect a steeper rise going forward following hurricane-disruptions in August and September. Though the hurricanes should leave a flat figure for Q3 overall following the robust 5.7% clip in Q2, we expect solid growth of 3%-4% in both Q4 and Q1, with gains across the utility, manufacturing and mining sectors.

Capacity utilization should claw-back to July's 76.9% 2-year high by year-end, after the August storm-related plunge to 76.1%. We still have a ways to go if we plan to regain the cycle-high 79.2% seen in November of 2014, or last cycle's peak at 81.0% in April of 2007.

The factory recovery since mid-2016 was fueled by the petro-sector rebound after a 2-year drop-back, and this recovery has room to run as we approach 2018. The petro-sector is highly capital intensive, and it's footprint is much larger than implied by the small mining component in the various factory and employment reports. We've seen a 9.5% rebound since September of 2016, following a 17.7% plunge over the prior two years.

WTI oil prices have stabilized just under $50 since the hurricane strikes, which is sufficient to fuel ongoing growth in oil drilling activity. We will also face massive rebuilding expenditures around the Houston area in the final four months of 2017. With growth in global demand and OPEC production restraint, the massive 3-year oil inventory glut is slowly unwinding, as U.S. producers continue to drive the marginal cost of shale oil development lower.

U.S. oil import volumes have stabilized in 2017 with current WTI price levels as U.S. production ramps up, hence capping the import bounce since 2014. And, the U.S. is increasingly exporting oil and oil-related products to leave net downward pressure in the trade gap.

We more generally see the price stabilization for the petro-sector over the past year as a rebalancing in the historically close relationship between oil prices and world economic growth, after the one-off downward 2014-16 hit to prices from the fracking and lateral drilling innovations. We expect modest oil price gains going forward as the world economy recovers.

Note that the big oil price drop of 2014-16 was associated with a surge in the dollar, and we've seen in the opposite pattern in 2017 of a firming in oil prices alongside a drop-back in the dollar. Both twists in 2017 are supportive for the U.S. factory sector.

The U.S. trade price figures posted big declines from late-2014 to early-2016 with the dollar surge, and we've yet to see a commensurate big bounce as the dollar falls. Yet, we may see commodity price boosts from Harvey and Irma that lift the trade price measures, and a weak dollar may allow the elevated prices to hold into 2018.

The petro-sector recession of 2014-16 reflected an overshoot of inventories to sales, and the I/S spike for the petroleum sector was particularly large given that price-swings seem to have a bigger observed effect for sales than inventories. These ratios are now slowly unwinding.

The overshoot of total business inventories to sales during the 2014-16 pull-back, and ensuing big inventory subtraction from GDP growth over the nine quarters ending in Q2, has proven slow to reverse course, as I/S ratios remain high across the factory, wholesale and retail sectors. The drop in these ratios will likely gain steam into early-2018, however, as hurricane rebuilding activity more rapidly depletes stocks and allows firms to ramp up production more visibly.