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Picking Winners in a Semiconductor World

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We know full well by now that the global economy of the 21st century can be effectively summed up by the prowess of the semiconductor and smartphone markets. Semiconductors are the modern equivalent of oil or steel.

With that in mind, we can begin to pick out who the winners and losers of the near future will be:

  • iPhone sales make 3Q macro economic data look weak but will push up 4Q
  • China, as an iPhone manufacturer, will benefit
  • Semiconductor sales show more German and overall EU weakness
  • US is still chugging along but signs of slower growth are appearing

Regional Economic Distress and the Smartphone Economy

The smartphone frenzy unleashed by the iPhone 6 will boost China and Taiwan in 4Q on a macro level. In fact, the anticipation contributed to 3Q economic softness as sales of older models dipped. Markets may feel a bit reassured if they see some uptick from China.

Given that (1) German Industrial Production is contracting, (2) Sony reported a $2B profit loss and (3) Samsung announced plans to build a $15B semiconductor plant; you can start to see who is and who isn’t a player in the digital economy.

It’s a good time to be a semiconductor maker. Sales are entering the longest period of growth since 2010, and are on target to hit the longest streak since the dotcom boom. Smartphone imports into the US will breach $100B.

Semiconductor Billings

However Germany and Japan (Sony) won’t benefit because they are non-players in the 21st century digital economy. Conversely, Korea (Samsung) is a dominant player in the smartphone world.

Rewarding the Smartphone Players

If you want to predict the future of the global economy, pick out the major players:

  • US Designs: Most of the hardware and software is designed by US companies. Qualcomm, nVidia, Google and Apple to name a few.
  • Taiwan Manufactures: Almost 50% of smartphone semiconductors come from Taiwanese companies such as TSMC and UMC.
  • China Assembles: Apple could not sell 10M iPhone 6’s in one week without the formidable assembly strength of Chinese companies.

The impact can be quite impressive. Tiny Vietnam exported $38B in electronics last year (source: International Trade Council). They rank as the 12th largest export country. The reason? Samsung assembles in Vietnam. Just a few years ago they were best known for exporting sneakers.

The key point in all of this is that the iPhone 6 will boost China’s macro, which should reassure the markets a bit. However conditions are ripe for widespread currency intervention, leading to a strong dollar.

EU Suffering From a China Slowdown

The SouthBay Shipping Index has contracted for the first time in a year. Back in April, SouthBay began sounding the alarm that the EU would see a recession sometime in 4Q 2014 or 1Q 2015.

The primary signal was the SouthBay EU Shipping Index, which leads the EU economy by ~6 months. (The EU economy relies on goods shipments and the Index measures specific data that is especially sensitive to early shifts in demand for goods.)

The Index first began to slow in 2Q and then it tipped over.

EU Shipping

Auto production is getting hit. Semiconductors reflect the same slowdown trend.

Germany is a big consumer of semiconductors, especially in cars where semiconductor penetration continues to grow thanks to ever more safety and entertainment features.

Germany also depends on Chinese auto sales. Per the China Association of Automobile Manufacturers, China auto sales have been slowing from 14% Y/Y in May to 10% in July and 8.5% in August. With 24% of the Chinese auto market, Germany is suffering.

Semiconductor Europe

Not to mention the US auto market has peaked. Factor in the Russia/Ukraine geopolitical saga, and it’s time for monetary action again. Inflation? What Inflation? August inflation hit 0.4% (vs -0.3% in July). Europe is seeing the lowest annualized inflation since October 2009. With that in mind, a cheaper Euro is easily allowed.

China’s Much Needed iPhone 6 Boost

China’s exports are not doing very well. The country’s credit bubble is bursting and pulling down the domestic economy. Efforts to prop up the all-critical real estate market include lowering down payments and easier credit terms, but a slowdown is inevitable.

This makes exports more critical than ever.

As the chart below shows, Hong Kong exports are slowing down at a bad time.

Hong Kong Exports

Echoing the slower trend, US imports from China in August grew a mere 1.7% Y/Y.

That’s partly the law of big numbers. The US imports ~$450B from China, about 25% of total US imports (ex autos, petroleum). Squeezing another 5% would be the equivalent of adding Russia’s entire exports to the US.

US Imports

A slowdown has been in the cards for a while. In 2010 YTD, China’s exports to the US grew $45B Y/Y. In 2011, $26B. In 2014 it is down to just $13B Y/Y.

China is hugely dependent on smartphone exports and the iPhone 6 is driving recent export stagnation. This means China’s 2H macro story should improve.

From an export and industrial production perspective, not all smartphones are equal.

On one side is Samsung. A Samsung sale is good for Korea (where the chips are manufactured) and for Vietnam (where the phones get assembled).

On the other side is everyone else, including Apple. Chips get made in Taiwan and China, and products get assembled in China.

From a Chinese perspective, a Samsung win is a China loss. An Apple or Xiaomi win is a China win (Xiaomi is a Chinese maker of Qualcomm phones). Over the past year Samsung gained market share at Apple’s expense largely because Apple’s iPhone 5s was behind the curve in terms of features, functionality and price. More recently, Samsung has been knocked out of the Chinese market by lower priced Xiaomi, a local product.

Then there’s Apple. Apple sales typically stagnate before a new release, and then they jump. The iPhone 5s was a placeholder, a less innovative release, and the unit sales reflect disappointment.

The much awaited iPhone 6 set sales unit records of 4M in the first 24 hours and 10M unit in the first week.

iPhone Sales

Bullish expectations will be a welcome boost for Chinese manufacturers like Foxconn. The Apple release schedule effectively pushed out sales from 1H 2014 into 2H 2014. Suppliers report that Apple has ordered 68M units, a 27% Y/Y jump. It would double 3Q’s iPhone exports from China. An extra 35M units means $6B+ in Chinese exports. Add in some economic multipliers, and it will boost China’s GDP by at least 0.5%.

The impact of smartphones on China’s exports is seen here.

Impact of Smartphones on China

In August, US phone imports shrank (-3.6%) Y/Y and China imports stalled at 1.7%.

Smartphones are the third largest US import, after gas and cars. At least $110B+ of phones will be imported this year, mostly from China.

A slowdown in smartphones immediately translates into a slowdown in imports from China. Until another growth engine appears, China’s marginal growth depends on this market.

China is Positioned Well for 4Q

First, the latest macro data reflects the world before the iPhone launched in September. Expect China-US trade to rebound accordingly.

Second, China is taking the lead for low-end smartphones, and that’s where the growth is. Samsung just reported $3.8B in profit, down 60% from last year because they have lost the China market to Xiaomi.

Although we’re still just talking about a 0.5% boost to GDP. That’s nice, and it could make the markets think that China has recovered growth, but a cheaper yuan will do more.

Like Europe, inflation has moderated: 2% and well below Beijing’s desired 3.5%.

With China positioned well, US companies reaping some of the benefit and Janet Yellen firmly in place as the Fed leader, look for Central Bank coordination that allows for a stronger dollar.

Semiconductor Companies: Cautious Today, Hopeful Tomorrow

Semiconductor companies are a proxy for the private sector in general.

The Great Recession is alive and well in the minds of producers today. Fear of excess inventory dominates every investment decision.

Consider the Semiconductor Equipment Book-to-Bill ratio. For decades demand hurtled between shortage and excess, but for the last two years, the ratio has hugged the 1.05 level. Forward demand has remained cautious and risk-averse.

Semi Equipment

Producers have reason to be cautious. Based on silicon wafer consumption, chip unit production has been pretty flat Q/Q.

Silicon is to semiconductors as iron is to autos. Semiconductors are built like layer cakes, using silicon wafers as the bottom layer. 2Q wafer shipments surged in preparation for the September/October phone and tablet releases, but demand ex-smartphones is mild.

Silicon Wafer

Capital Intensity measures CAPEX divided by revenue. This metric has held steady at ~$20 because there is an oligopoly managing supply. Prices are high and stable, and producers don’t want to disrupt the situation.

Capital Intensity

This makes Samsung’s decision to build a $15B plant very interesting. It means that they see enough future demand to absorb massive new supply. In dollar terms, Samsung is expecting at least $150B+ in future demand growth at $10 Capital Intensity and $300B at current levels of semiconductor billing.

For context, total global semiconductor sales hit $305B last year. That’s a big commitment and the Matrix-like smartphone ecosystem is the main reason for the expectation.

The Internet of Things (IOT)

Every new consumer product goes through an evolution where the complexity gets hidden.

The first cars had unbelievable failure rates and the original chauffers were more garage mechanics than limo drivers. Over time, the complexity got hidden and ease of use increased. Goodbye manual transmissions, hello automatics.

The smartphone is a runaway hit because it eliminates the PC complexities. Focusing on ease of use, it turned the PC into a consumer device.

The IoT is about connecting everything to the Internet. It’s a grand plan. And the starting point is the smartphone because everyone already has one. It is essentially a computer in your pocket that can talk to big computers in the Cloud and small computers around you, all while you are on the go.

A lot of money is getting poured into the IoT. If you take every smartphone user and convince them to buy a network-connected pair of glasses and a watch, that’s a lot of silicon being sold.

The problem is that the devices don’t deliver to expectation. The Apple Watch can last a day without charging. People don’t want yet another gadget that could fail if it doesn’t get powered up daily. (It’s like some bad episode if Ultraman – will he make it to the Sun to power up just in time?) That’s just one example of the gap between what today’s hardware can support and what the consumer market needs.

The other problem is typical of Silicon Valley. There’s new technology in search of a need. Just because I can have shoes that monitor my daily walking, why should I? Well, apparently a few million people found a reason.

So investments are being pumped into new batteries and chips that consume power differently. Also into security since so many devices are interacting and listening in.

Enable the technology and eventually the applications will emerge.

What About 4Q?

4Q had the chance to be a massive event. Strong smartphone sales coupled with strong peripheral sales (wearable devices). Instead, suppliers have to make due with just smartphone sales. That means excess inventory in late 4Q.

Will wearable devices be more fizzle than sizzle? These are the early days. When Apple released the iPhone, it took years to break 10M units of sales.

Early this year, IDC forecast wearable device sales would hit 19.5M units in 2014. Recently, Canalys announced that YTD sales have been only 6M.

What’s missing might be the big product release. Apple pushed out their Watch release to February. HTC just announced the same. Google Glasses still are not widely available. More options will emerge over the next few months, but the shortfall is a problem for producers.

Also missing is a value proposition. What do you get for $300? Most smartwatch offerings boil down to reading text messages on your wrist. Lots of gadget-hungry people will buy the latest thing indiscriminately, especially for <$100. Yet expectations rise at a $300 price point. Samsung had to re-launch their product line-up because, to put it plainly, the products themselves sucked.

It’s really easy to create a wearable device. It’s a lot harder to find the killer application.

Apple is Winning, Others Are Losing

Apple suppliers are much happier than others.

  • Samsung phone sales are disappointing. They lost on the high-end (Apple) and on the low-end (Xiaomi).
  • Amazon Kindle Fire is disappointing as well. Amazon expected to sell a few million units. Instead, the market yawned. Prices have been cut from $200 to $99.

Samsung is now sitting on a mountain of excess capacity. Amazon’s suppliers have lots of excess chips as well.

Add to this excess the miss in wearable devices, and suppliers will face pricing pressure and inventory corrections in December and into 1Q 2015.

Yet strength remains apparent for China and Taiwan in 4Q macro, as they are the clear winners to emerge from the smartphone battle arena.

Signs Of A Market Top

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It’s not just that Saudi Arabia recently announced plans to dump money into the laps of invest with Silicon Valley’s venture capital community.

It’s that silly investments are again attracting money, exactly like the dotcom boom heyday.

Spot the Fake Investment

a) Yo: A smartphone app that sends a one-word message (Yo) to your smartphone contacts

b) An app for booking a fishing trip. Airbnb for fishing enthusiasts

c) Vurb: An app that chooses the best app for whatever you need to do. Let Vurb do your app surfing for you!

d) A one-stop destination for the multi-billion dollar global pine furniture market

Answer: is fake. (Unless you want to underwrite me, in which case it’s very real. Let’s do lunch and talk about it, and you should hurry before I go big and take the whole idea to Kickstarter.)

Yo received $1.5M in funding and is currently valued at $10M.

FishingBooker won the Audience Choice award at TechCrunch Disrupt SF. The judges were a who’s-who of Silicon Valley elite: CEO Benioff, Yahoo’s Mayer and more.

Vurb received $8M in funding. Actually, with thousands and thousands of apps, an app to find an app might not be a bad idea.

Let the Good Times Roll for Venture Capitalists

Venture capitalists (VCs) are hustlers of the highest order. They used to provide excellent and much needed guidance. I have worked with many start-ups and wannabes and most of them were a bunch of engineers who wanted to leave a company. They had been shielded from the demands of the full product lifecycle and the demands of running a company. They could write code but had no concept of getting the product done and into users’ hands.

So VCs used to provide missing ingredients. They groomed the company for success and brought them to the attention of established players.

If you watched the hit show Entourage, then VCs played the role of agent. They spot talent, build a team around them, find the right opportunities and hustle to get them signed.

Naturally this takes money, which the venture capital firm provides. Except it really isn’t their money. They operate like a hedge fund and use other people’s money (OPM). Then they charge a management fee, like a hedge fund.

However VCs have evolved to be less like Entourage and more like a real estate show about flipping homes. The typical deal isn’t about creating a long-lasting company that will eventually go public. No, most VCs have a three-year window in which they want the product developed and then employ an exit strategy that is typically selling to another, bigger company. Get in, get it up, get out.

Today, venture capital is flipping ideas and companies like real estate ‘investors’ were in 2006, or maybe 2007.

There’s Always a Customer

An example may help clarify things. A friend of mine at a top VC is seriously being wooed by a start-up.

The Premise: Large companies are bleeding money because vendors are overcharging. Specifically, companies agree to terms with vendors but the policing of those contracts is either non-existent or disconnected because companies are too big. So a supplier might charge $120 for a hammer that should have been $100 per the contract.

The Solution: Software that tracks billing and contract terms, paid annually.

My Response: The problem is behavioral and organizational. If a company has decided that the time has come to manage the problem, why not just spend a few thousand to create a single data warehouse? Why spend tens of thousands annually?

Her Response: Companies are stupid and if they are stupid enough to have this problem they will pay money to outsource their solution (not an exact quote, but close).

Sign of a Market Top

There is a lot of money out there, and it has a very big risk appetite. It bears the hallmarks of previous market tops when everyone had money and were chasing yield. Fast money is driving up valuations and taking on investments that lack a certain quality. We’ve been here before, in 2000 and 2006.

History has a funny, sometimes cruel way of repeating itself.

Japan’s Economic Death Spiral Continues

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The Sun Also Sets

I used to be a Japan hand. I spent my junior year in college in 1985 as an exchange student at Kansai Gaidai in Osaka. Upon graduating college in 1986, I worked for JETRO (Japan External Trade Organization), the Japanese government’s trade group. I then spent two years working in the Kagoshima State government’s international division. After this, I spent a year as a Research Fellow studying consumer trends at Kyoto University’s Economic Research Institute.

Japan was in its prime in the 1980s, and I was there. I ended my five-year focus on Japan when I read 1989’s The Sun Also Sets: The Limits To Japan’s Economic Power by Bill Emmott, editor of The Economist. The book lays out several points, among them was that Japan’s advantages were not sustainable and were easily copied. In fact, Japan was following a very basic mercantilist approach to becoming a major exporter. They made high-quality products, manipulated the currency to fuel exports and erode competition, and maintained a positive trade balance by blocking imports through trade barriers. Emmott predicted an end to each of these advantages, and he was right.

Once the cheap yen advantage was removed, Japan began a downward spiral from which it has not recovered, and I don’t think they ever will. Japan has the UK disease; a once great island empire fighting to stay relevant on the economic stage.

Japan won’t recover from its downward spiral.

Japan: A Bystander on the Digital Highway

In the world of bytes and bits, Japan has become a bit-player.

Japan’s fading economic might can be summed up in its share of global semiconductor sales, which has collapsed from 40%+ to barely double digits.

Japan Share Global Semiconductor

At the same time – and very much related – Japan’s share of Global GDP (per the OECD) has fallen from 10% in 1990, to 7% in 2004 and 5% today.

As the Semiconductor market has marched up an impressive 9.2% CAGR, Japan has actually shrunk.

Japan and Global Semiconductor

The latest smartphones come from Korea (Samsung) and America (Apple) and are manufactured in Korea, Taiwan and China. The software comes from America. The latest camera, the GoPro, is American. The electric car that everyone wants is American (Tesla). The consumer electronics that everyone buys come from Korea. Telecommunications and computer products come from American or elsewhere, but definitely not Japan.

A simple snapshot of Japan’s fading importance is evident in US imports as seen below:

US Imports Through August ($B):

                        2013     2014     Gain/Loss     

China            $281     $294     +$13

Germany      $74       $81       $+7

Korea            $42       $45       +3

Japan            $93       $89      -$4B

Other Countries See Exports to the US Growing while Japan’s are Shrinking

Participation in the Digital Economy Matters

Japanese companies have lost the lead in their traditional markets because they don’t make products for the 21st Century digital economy.

In 2013, out of $2.3T in imported goods, the top US imports were:

  • Oil $390B
  • Machinery $311B
  • Electronic and Medical Equipment (ex Smartphones) $300B
  • Vehicles $253B
  • Smartphones $100B
  • Pharmaceuticals $63B

Of the $2T non-oil imports, Japan’s share was $142B (7%).

China’s electronic equipment exports to the US ($120B) almost equaled Japan’s total exports to the US.

Production is Contracting

Semiconductors reflect the shift in Japan’s economic relevance. When Japan led the consumer electronics world, semiconductor sales led industrial production:

Industrial Production

Today semiconductors lag overall industrial production.

Make Stuff People Want, Make It Cheaper

The central problem, as noted above, is that Japan doesn’t really make stuff people want. That’s a long-term problem without an easy solution.

In the short-term, the only means to boost exports will be for major monetary stimulus to crush the yen, and not a little bit. It needs to contract at least 15%. That would boost exports.Going back to semiconductors, a lot of production would shift to Japan if the yen drops.

Yen Devaluation

Back in November 2012, I predicted that Japan would have to go nuclear on the yen; drive it to 100. The BOJ did exactly this, forcing the yen up from ¥80 to ¥100. It worked as production surged, but it has run its course.

More Yen Devaluation Please, Mr. Abe

In early August of this year, I called for yet another gutting of the yen, and of sizable degree. I estimated at least 10% or companies won’t change their behaviors.

A cheap yen only goes so far. It works in commodity products where price is the issue (consumer electronics, cars, etc.). The long-term problem is that the products desired by global consumers are not the products Japan makes, which means exports will slow and production will contract. Eventually the yen will reach 140 yen/dollar.

¥115 is coming, but it still won’t stop Japan’s death spiral. Japan’s economy continues to shrink and the game plan is boost exports by crushing the Yen, but don’t expect it to work.

Why Europe is Recession-Bound

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Europe is Already Rolling Over

The Association of European Automobile Manufacturers just reported that new car registrations (a proxy for auto sales) are up 6% over last year. Echoing that report, Ford just announced that 3rd quarter unit sales in Europe jumped 6%. After six years of contraction, European car registrations clocked their 13th month of growth.

Sounds great, until you look closely.

It’s a 1.2M unit market. 6% growth is 70,000 vehicles and getting there took a lot of incentives. Of the 70K in extra cars, 20%+ were in Spain (the highest performing market with a 26% jump in sales). Borrowing an idea from the US, the Spanish government introduced a cash-for-clunkers scheme which is turbo-charging sales (Spain is one of Europe’s major auto producing centers). As for the rest of the jump in sales, producers are offering ever-higher discounts; an average 12% (14% in France!) versus 8% last year.

Plus, the pace of registrations is slowing. It was up 13% year-over-year in March. Now it’s half of that.

In reality, European auto sales are bouncing along the bottom. The market has shrunk every year until this year, tumbling from ~16M in 2007 to 12.3M today.

Europe’s auto market is simply a microcosm of the entire EU economy. Many look at the recent growth in the auto industry as a sign that things are improving and can only get better. Unfortunately that is not the case. Europe is sliding into a recession

Stagnating Now, Rolling Over Tomorrow

The EU economy is more manufacturing-driven than the US (US GDP is 80% service vs. 67% for the EU).

Tracking goods shipments to predict the economy makes more sense for the EU, and not just any shipments. The SouthBay Index tracks a specific subset of shipping that is particularly sensitive to shifts in the economic winds. It reflects those changes quickly and early.

At the moment, the the SouthBay EU Shipping Index shows contraction has begun. This will be reflected in the broader economy by the 1st quarter of 2015.

Shipping Index

Cheaper Euro, Stronger Dollar

Looking again at autos as a proxy for broader economics, at the recent Paris Auto Show, the President of Renault reiterated the desirability of more stimulus. Or, as Peugeot’s President Carlos Tavares pointedly said, “The weaker the euro will be, the more profitable we can be.”

A stronger dollar is actually a mixed bag for the US stock markets. It reduces US exports and cuts the value of European profits. Most big US companies are vulnerable and would see a hit to profits.

At the same time, a stronger dollar brings the good kind of deflation. Cheaper imports expand US consumer discretionary income. Restaurant chains would be the big winners here, especially ones concentrated in North America because they get the benefits of lower food costs without the risk of overseas sales exposure.

Are Central Banks Already Coordinating Their Moves?

With regional economies slowing again, Central Banks must surely be thinking stimulus, but are they going to take unilateral action or will they coordinate? Consider the following:

  • Japan’s (-6.8%) GDP and an export sector that has yet to enjoy the benefits of a weak yen
  • EU is suffering from Russia/Ukarine sanctions at a time when things are slowing down (latest PMI is 52.8)
  • China PMI is barely above 50

The temptation must be strong to cut rates or to take further action. Is another round of currency skirmishes about to take place?

Strong Dollar and Low Yields

Overt moves may not be necessary.

Supply is tapering and driving down rates due to bond scarcity. Demand is rising as the relative strength of the US is driving up treasury demand (the “cleanest shirt syndrome”). The dollar has been firming up and there’s more to come. The yen at 120 and a Euro at 1.20 is inevitable within a year.

As you may know by now, Moneyball Economics doesn’t just take the global economy at its surface. When you really delve in and listen to what the data is telling you, it’s clear that the European Union has punched their ticket to Recession. Knowing what that means to the rest of the world could make a huge difference to your own bottom line.

Why Consensus Is Wrong About 2015

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US GDP Forecasts: Mainstream Economists Will Be Wrong Again

You can’t fault positive thinking, but in economic and investment terms realistic expectations are the most valuable.

Back in January, I estimated that 2014 US GDP would be ~2.2%, far below Consensus which was thinking 3%+. Consensus has caught up and is now predicting 2.2% (down from 2.5% in May).

Turning to 2015, Consensus is again pie-in-the-sky hopeful at 3%.

Sluggish Inflation Today, Sluggish Inflation Tomorrow

The traditional and conventional view is that inflation drives economic growth by forcing producers to buy today before prices get more expensive. Inventory stockpiling boosts the economy.

Looking around, is there inflation and are producers stockpiling? The answer to both is a whopping no.

Some amount of wage inflation is creeping in as minimum wages grow and as labor continues to tighten. Businesses will sometimes bump prices opportunistically. Paul Krugman recently pointed out something that is actually useful and relevant to the 21st century economy. He said businesses that are local and don’t face competitive pressures are raising prices, like airlines and restaurants.

However most producers do face competition and they are not raising prices. Producer Price Inflation (PPI) for goods has been negative two months in a row. On a year-over-year basis, PPI is up a tepid 1.6%. What little inflation we’ve seen comes from food price hikes in the face of drought.

Low inflation has been the trend for over a year, stemming from less pressure to raise prices because margin pressures have eased in the face of low energy prices (thank you cheaper oil) and a stronger dollar. The strong dollar is lowering inflation expectations since the US has emerged at the cleanest shirt in the global economy.

Global Oversupply: The Real Reasons for Low Inflation

Producers are struggling for pricing power. The economy may be on better feet than at any time since the recession ended, but there is still a major supply glut. Chinese supply has overwhelmed demand, leading producers like Alcoa to close factories and steel makers to walk away from purchases. Many commodity prices are in free fall. So much for the super-cycle in commodities.

Manufacturing Capacity Utilization is a great way to evaluate slack on the production side of life. The Federal Reserve Board measures capacity utilization by considering how much production is possible and sustainable and how much is actually being utilized. It considers available labor and equipment, among other things.

Supply constraints point to inflationary pressures as well as demand trends. Buyers bid up prices when supplies are tight.

Capacity Utilization

The good news is that capacity utilization is at a cyclical high, indicating solid demand and some price strength.

The bad news is that capacity utilization remains below the peaks of the previous cycles. We are almost four months into the sixth year of recovery and still lagging the previous cycle.

This business cycle is continuing for a while and with it capacity will get tighter, which is good for producers. Although the primary reason for higher capacity utilization is that producers are expanding slower than the pace of demand growth.

This undermines the entire conventional expectation that inventory stockpiling should be happening – right now – and pulling GDP up with it. Listen to earnings calls and you’ll hear producers in the supply-chain complaining that their customers’ inventories are too lean.

It’s not true that inventories are lean, though. They are leaner than the 1990s but right about where they were in the previous cycle and higher than ever this cycle. Business inventory-to-sales are actually rising.

Business Inventory to Sales

If anything, inventories have grown too much. They have grown while sales have been flat. Some form of inventory cutbacks is likely in the 4Q as businesses right-size their capital.

Business Inventory to Sales Year to Year

The key point in all of this? Producers have sufficient capacity to meet end-user demand, which itself looks likely to soften a bit. Against this background, prices are not likely to rise much and growth will probably weaken a bit.

Semiconductor Sales: The Crystal Ball for 2015 Growth

Consider semiconductor equipment spending. Everything being manufactured either includes semiconductor chips or uses machines that require semiconductor chips. As such, expansion in production of any kind automatically translates into more semiconductor chips.

Semiconductor sales today are tomorrow’s industrial production. Right now, semiconductor producers are looking out and expecting minimal increase in demand.

Look at semiconductor factory expansion. While they are spending more on re-tooling capacity expansion is barely above 0%, about the same as this year.

Fab Equipment Spending vs Change of Installed Capacity

Semiconductor makers are migrating to a new technology and that’s causing massive spending. Despite significant growth in the auto and mobility (smartphone) spaces as well as general global demand for stuff, semiconductor companies see no reason to greatly expand supply.

All that follows other fundamental data points. Consumer spending is steady but relatively mild. Most new jobs in 2013 and 2014 have gone to secretaries and bartenders. Retailers expect organic growth only, and without Y/Y increases.

With demand cruising along at organic levels (low single digits), of course producers will expand cautiously.

Fed Actions Will Slow Growth

Retailers and producers are positioning for low growth in 2015. Earlier this year there was talk about an escape velocity, meaning weather had caused some near-term sluggishness from which the economy was poised to surge and get back to some higher level of growth.

This idea of some mean reversion to higher growth made no sense. Growth is mild because demand is mild. US consumers spend what they earn, and no more. The wage picture doesn’t reflect a surge. Global demand is slowing. Producers expect prolonged subdued demand and are keeping a lid on expansion plans.

Into a low-growth environment, now add in rate hikes. David Shulman, Senior Economist at UCLA’s Anderson School, recently reflected the consensus view when he said that rates will go up for good reasons; because of a strong economy.

That’s not exactly true. One could argue that a stronger economy is what’s enabling both the end of QE and the reduction in treasury borrowing. The absence of pressure to keep rates low is far from being the presence of pressure to boost rates.

It’s an important distinction. If the economy is actually poised to slow and real interest rates rise, GDP will drop fast.

Household Wealth Will be Hit

The first blow will be felt in the housing market. Housing has already entered a slower stage. July home sales fell 4.3% Y/Y. During the most recent earnings calls, homebuilders reported a drop in unit sales and banks aren’t stepping in to chase the marginal buyer and create some type of escape velocity. Wells Fargo CEO John Stumpf recently said, regarding loans to low-income borrowers and poor credit holders, “We’re just not going to make those loans.”

Prices will come under some pressure as inventory grows. More owners are above water and can sell. Into this slower growth market, add higher mortgage rates.

Beyond the housing market, the stock market won’t like the impact of higher rates on leverage. A hit to stock prices is a hit to household wealth, contributing to further slowdown in spending.

We are likely entering a period of disinflation where prices don’t rise. That’s great for consumers; not so great for producers.

Prologue to Recession

Without inflation and pricing power, without growth in demand, companies stop hiring and start firing. A rate hike hastens the advent of a recession.

Right now, jobless claims are at 14-year lows. That’s actually a sign that a recession is coming within 12 months because once claims hit bottom, they can only rise. A rise in claims is the turn in the wheel for the economic cycle as it begins to slow and then contract.

So take economic indicators, conventional wisdom and consensus estimates with a grain of salt. Realistic expectations are far more valuable than overly positive ones.