Vehicles Drive Rebound in Production
Surprising strength in aerospace and autos will be unable to support industrial production overall.
Overall industrial production grew by 0.6% in July, double the consensus expectation for a 0.3% increase. The rebound was driven by a surge in the production of vehicles and durable goods and was welcome news to the industrial sector, which started the summer off with two consecutive monthly contractions in activity. Part of the strength in July, particularly in automobile production, was likely attributable to some uncoiling in supply chain bottlenecks. While that is good news after two and a half years of significant disruption, more will need to unwind before inventories are rebuilt and supply and demand equilibrate.
The strong headline number in July hid unevenness across industry and market groups. Easing supply chain constraints and falling energy prices helped production in some sectors, while cooling economic conditions and tightening financial conditions weighed on others. The Fed is expected to continue to raise borrowing costs through the end of the year, which will drive down demand, and ultimately, production of both durable and nondurable consumer goods.
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Production of manufactured goods jumped in July by 0.7%, beating consensus expectations for an increase of 0.3%. Across industries, the picture was more mixed. Durable manufacturing jumped by 1.3%—the fastest monthly pace for growth since February—while production of nondurable goods only edged up by 0.1%. The fall in nondurables was driven in part by a large decline in the production of energy goods.
Production of business equipment rebounded in July. This strength suggests that economy-wide investment got off to a solid start in the third quarter. Capital costs are expected to rise appreciably in the coming months, which will likely slow investment as the year progresses, particularly for larger projects, or those that are financed. Production of goods like fabricated metals and machinery should moderate in coming months.
Another bright spot in the July report was the rebound in aerospace. The pandemic and a temporary grounding of some planes hit the industry hard in recent years, but orders picked up measurably at the Farnborough Air Show in July. Demand for leisure and business travel is up from pandemic lows. Production in the aerospace sector should remain in the black in the second half of the year.
Vehicle shortages mean continued production, despite easing demand
Production of motor vehicles and parts surged by 6.6% in July. The sector remains supply constrained; disruptions to global supply chains persist, but demand for new vehicles has so far held up despite surging inflation and tightening credit conditions.
The domestic inventory-to-sales ratio continues to hover around its lowest point since the series started in 1967, suggesting that supply is, at best, just able to keep up with demand. However, rising rates are already having an impact in some market segments. Demand for units at lower price points and from borrowers utilizing subprime lending is cooling. Used vehicles have returned to being a depreciating asset. Sales are expected to cool in the second half as the Federal Reserve continues to push borrowing costs higher and inflation further erodes household spending power. Even with those hurdles, record-low inventories suggest that production of motor vehicles and parts should continue to expand, albeit at a slower pace, over the next couple of months.
July was a surprisingly strong month for industrial production, with the growth in the headline index doubling market expectations. However, pockets of strength obscured some areas of weakness. Cooling economic conditions suggest moderating activity in the months ahead. The slowdown will likely be uneven with the same external forces impacting sectors differently. For instance, geopolitical tensions are expected to continue to drive demand for defense goods but will weigh on manufacturing exports as global growth slows. Similarly, falling energy prices will help downstream industries like chemical and plastic manufacturers but will create headwinds for energy producers. How these micro trade-offs play out will define the monthly trajectory of the industrial sector. Still, a cooling economy, deteriorating housing market and tightening financial conditions together suggest that the headwinds will overtake tailwinds by year-end.