Friday, June 10, 2011

Now it's official: A temporary negative supply shock

In the last blog post I suggested that US economic data should turn around soon given that at least part of the apparent weakness during spring should be down to seasonality issues. These seasonal adjustments render the data weaker than the underlying trend during spring but should render the adjusted data stronger than the underlying trend during the June-August period. Clearly, though, the strong weakness in economic data relating to April and May has not only been down to seasonality issues. Also the previous rise in food and energy prices has eaten into consumers' pockets while adverse weather seems to have had a meaningful impact as well. However, the importance of one additional factor was revealed by this week's release of the Beige Book (which covers the mid April to end May period) as well as by yesterday's trade data for April: supply disruptions in the wake of the Japanese triple catastrophe (earthquake, tsunami and nuclear crisis). Given that the effects of these supply disruptions should be temporary and slowly start to revert, my view that economic data covering the June-August will likely surprise on the positive side again remains unchanged.

To quote from the Beige Book: "Auto sales were mixed but fairly robust in most of the country, though some slowing was noted in the Northeastern regions. Widespread supply disruptions--primarily related to the disaster in Japan--were reported to have substantially reduced the flow of new automobiles into dealers' inventories, which in turn held down sales in some Districts. Widespread shortages of used cars were also reported to be driving up prices....Supply disruptions related to the earthquake in Japan led to reduced production of automobiles and auto parts in several Districts. The Cleveland District noted a sharp drop in auto production, the Atlanta and St. Louis Districts also saw production fall, and auto deliveries were reported as having declined in the Richmond District. The Atlanta District said lost production in its region would be made up later in the year. Contacts in the Chicago District said that contingency plans to deal with supply disruptions were helpful in mitigating the effects. High-tech firms in the Boston and Dallas Districts reported that shortages of parts, due to disruptions in Japan, had adverse effects on business."
Essentially, the Beige Book suggests that there was a significant negative supply shock occuring, especially in the auto industry but also ini IT manufacturing. The implications are significant, for one, cars manufactured in Japan can not be shipped (as they are not produced), furthermore, cars manufactured in the US cannot be produced as important parts are missing. But also the production of complementary parts should be affected significantly given that less production in cars means less demand for these parts. Furthermore, whereas a negative demand shock should result in lower production and lower prices, a negative supply shock should result in lower production but higher prices. This is exactly what we have been seeing over the past months. The chart below shows the Mannheim Used Vehicle Value Index. This index reached a new high in May.
Used Vehicle Prices reaching a record high
Source: Mannheim Consulting

But also price indications for new cars suggest the same: lower volumes but higher prices. Usually prices for new cars are not changed frequently (normally this is done when new models are being released). Instead of changing official prices, discounts are being adjusted and a higher discount is the same as a price reduction whereas a lower discount equals a price rise. The chart below shows the development of the industry wide discount percentage for the last 13 months. As can be seen, discounts have been reduced (from 12.9% in March, i.e. ahead of the supply disruptions to 11.4% in May).
Industry average discount percentSource: edmunds Auto Observer

Additionally, according to the April US trade data released yesterday, US imports of automotive vehicles, parts and engines dropped by 13% from March! This seems to be entirley due to reduced imports from Japan. Overall Japanese imports dropped by 25% (passenger cars - dropped by 70%, auto parts by 21% and technology imports by 14%).

In turn, the weakness in auto production and auto sales should not be down to a worrisome drop off in demand but rather to a temporary negative supply shock. Given that these supply disruptions should also be felt in complimentary parts used in the auto manufacturing process as well as in the technology sector, it can explain a substantial part of the weakness in the US manufacturing sector over the past two months. However, once the supply disruptions ease, the situation in the US manufacturing sector should improve again. As this article published yesterday suggests, the situation in the Japanese semiconductor industry has been improving significantly: "Following the devasting earthquake, tsunami and electrical power crisis that severly impaired both the Japan and world semiconductor industry, many supply chain players now report that production has reached pre-earthquake levels with minimal risk to future shipments. In addition, the Japanese government has excluded semiconductor fabs and many chemical plants from the 15% power cuts planned for this summer."
However, reports from some auto parts manufacturers suggest that in this sector it might take a bit longer before production has been fully restored.
Overall, though, the negative supply shock should slowly ease over the next few months. Coupled with a turn in the seasonal factors used to adjust economic data, the US economic reports covering the June-August period should increasingly paint a friendlier picture again.

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