|Investments in major capital equipment are a reliable indicator of demand for and consumption of castings. As such, foundries are responsive to the market conditions that influence those investments. |
The U.S. economy typically consumes about 150 million tons of steel annually — much more than is produced domestically — and must import steel to meet domestic needs. Much of the steel needed goes into consumer products while a smaller portion goes into capital equipment and infrastructure. Included in this production total, steel foundries are a small but important constituency among component suppliers for large capital equipment.
About 12 million tons of iron castings are produced domestically each year, mainly for automobiles, household appliances and pipes for construction. Iron foundries service mainly the consumer market. Domestic foundries produce only about 1 million tons of steel castings for railroads and other capital equipment. Steel castings are specialty items, custom-made by pouring liquid steel into bonded sand molds to form the shape of the component desired.
Investments in capital equipment includes large machines like locomotives, bulldozers, mining excavators, etc., which feature lots of castings. Thus, steel foundries — as suppliers of components for capital equipment used to produce commodity materials — are subject to market conditions for commodities.
Figure 1. U.S. production of steel castings, 1899-2004.
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U.S. steel castings production over much of the past 100 years is shown in Figure 1. In this graph, three periods of time can be seen: the “Traditional” period until 1962; the “Classical” period from 1963 through 1980; and the most recent, or “Modern” period from 1980 to 2003. A similar trend can be seen in domestic steel production presented in Figure 2.
The most recent severe contraction in demand, from 2001 through 2003, followed by the strong improvements in conditions from 2004 until now, cannot be understood without the perspective offered by the policies and economic conditions for the past 40 years. Understanding the interaction of capital equipment investment, commodity prices, and public policy will allow us to react to our current situation appropriately.
Until 1962, during the Traditional period, U.S. monetary policy was tied (at least theoretically) to the gold standard. Fixing the monetary policy to a convertible currency tied to gold resulted in an ongoing volatile market. Government fiscal policy was less of a factor in economic decisions because the federal income tax was not established until 1913, with the adoptions of the 16th Amendment to the U.S. Constitution, and the role of the federal spending did not become a major factor until after 1935, with the establishment of the Social Security system.
|Figure 2. Total U.S. raw steel production, 1950-2005. |
This Traditonal period was characterized by high volatility, with swings in the demand for steel castings of over 50% in a typical three-to-five-year business cycle. This led to a boom-bust cycle that made business success difficult and stimulated the demand for capital equipment by the liquidation of the bust, followed by the new investment of the boom. In employment, workers anticipated regular layoffs of short duration during busts and significant overtime during booms. Wartime demands increased the volatility, creating excess capacity and often leading to inflation. The price of commodities remained relatively stable because the demand was principally local and abundant resources were readily available.
The volatility of these markets, the legacy of the Great Depression, and the expanding economic role of the federal government led to the Classical period of policy, from 1963 to 1980. Following significant tax cuts from 91% to 70% in 1963, the Great Society programs led to a dramatic increase in the influence of federal fiscal policy in economic conditions.
During this period capitalism ruled, as most people thought capital-equipment investment was the best way to create more wealth and better economic conditions. In terms of fiscal policy, this meant retaining relatively high marginal tax rates (70%) with significant tax advantages for capital-equipment investment.
By 1979, steel foundries were struggling to meet demand for the castings needed to build more than 90,000 railroad freight cars, many of which were the result of investments by wealthy individuals to reduce their tax liability.
In 1971, with the federal government’s decision to end the gold standard, it increasingly followed a Keynesian monetary policy and targeted low unemployment as a measure of success. As shown in Figure 1, these policies were successful for a time at limiting the historical volatility and sustaining the industry, as seen in steel casting production, at high levels of employment and production.
Figure 3. After 1979, U.S. monetary policy became consumer-focused.
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This monetary and fiscal policy shows up in increasing rates of inflation, as seen in Figure 3. Arthur Burns, the Federal Reserve Chief under President Nixon, is often blamed for the dramatic increase in the money supply. Following a period of stable inflation in the post-War years, inflation rose after 1963 and accelerated as accommodating monetary policy and higher inflation incentified additional accumulation of commodity assets.
These changes created significant distortions, because the tax policy encouraged unlimited investment in capital equipment and monetary policy sought to keep all these investments producing through liquidity. Inevitably, this combination led to the “stagflation” of high unemployment and inflation. The sharp increase in energy prices (a result of oil politics) exacerbated inflation and spurred added investment. The perceived shortage of raw materials led to marketdistorting investments. Between the disruption of oil supplies, the distortions of wage and price controls, accelerating inflation, and a general lack of economic growth, it became apparent that this mix of policies was flawed. If wealth is the accumulation of material resources, then the policy may have been successful, but at some point the marginal utility of more stuff is so low that demand dries up.
The appointment of Paul Volcker to head the Federal Reserve in 1979 marked the end of the Classical period and the establishment of a new guiding principle for Fed policy: controlling inflation, a more monetarist approach. As seen in Figure 3, inflation came down sharply after peaking in the early 1980s. This was initiated by sharp increases in interest rates to thwart inflationary pressures and lower expectations.
Interest rates are a more compelling signal of investment activity than inflation rates. Interest rates are influenced by policy decisions but must take into account market conditions. Corporate rates are set through market mechanisms that respond and balance the policy decisions on money supply and credit with the market demand. When fiscal policy and economic wisdom combined to encourage investment in capital goods and commodity production, interest rates naturally rose, as demand for capital increased more rapidly than economic growth would support.
Figure 4. Corporate interest rates demonstrate the Federal Reserve Bank’s anti-inflationary policies.
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As seen in Figure 4, corporate rates rose throughout the period from 1963 to the early 1980s. Federal Reserve policy drives up interest rates to mitigate inflation. Inflation, as seen in Figure 3, drops rapidly after 1980 but interest rates decline slowly as seen in Figure 4. The overcapacity installed in the prior years tames inflationary pressures while the financial community benefits from strong consumer activity.
The Modern period began with Ronald Reagan’s election in 1980. That spurred a simplification and reduction of marginal tax rates, which removed much of the incentive for capital-equipment investment. Fiscal policy was shifted away from the capitalist notion that wealth was created by capital investment, to the notion that the marketplace created wealth through the proper allocation of assets. There was little need for added capital investment because the overinvestment due to the prior policies created a significant overcapacity in many industries.
This overcapacity for commodity production was an essential component of the price stability and low inflation of the next 20 years. These unproductive capital investments were a target for the corporate raiders that were active in this period. Capital equipment in excess of market requirements with long production lives provided the systemic overcapacity that is characteristic of commodity production for the period of price stability up to 2003. Interest rates remained high, financing the real estate and market activity required by robust growth in the consumer economy.
By 1999, gradual reduction of capacity and the per-capita growth in demand due to improvements in the global economy made it seem that there would be a gentle and orderly transition to a balance of supply and demand that would restore some profitability needed for reinvestment, as equipment installed in the late 1970s required replacement. The correction of 1999 through 2001 became a severe recession in 2002-2003, as capital spending plummeted during the global uncertainty that followed September 11, 2001.
That recession led finally to elimination of much of the installed obsolete capacity from the 1980s. As global economic activity improved sharply in the end of 2003, the production of commodities could not keep up with global demand and prices for most materials, and energy rose sharply. The severe downturn exposed the limits of market-created wealth because while markets are efficient at global wealth enhancement, they will not necessarily create wealth domestically. The monetarist belief in limiting inflation through stable money supply was benefited by the installed overcapacity, but with its elimination monetary policy may not be able to prevent significant increases in prices.
Figure 5. Weak commodity prices encourage capital investment.
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There is a long-term trend for the relative price of commodities to decline, as shown in Figure 5. During the post-World War 2 period, commodity prices rose as the U.S. economy absorbed returning workers and the increased demands resulting from household formation during the baby boom. Prices were on trend in the 1960s, as the classical period began and rose sharply in the late 1970s. These high commodity prices supported by fiscal and monetary policy led to the large build up in capacity during this period. When policy changed and overcapacity existed, commodity prices fell sharply from well above the trend to well below the trend.
Overcapacity constrained the pricing in commodity production and led to the expectation that prices would continuously trend downward, even while low levels of inflation nevertheless eroded the real price further. This idea that prices would continue to fall is unrealistic because the sharp drop in commodity prices reduced any added investment or new capacity.
During the extremely poor conditions in 2002 and 2003 much of the installed but obsolete capacity was liquidated. Inevitably, the per-capita growth in demand and the poor financial returns limiting investment will lead periodically to a lack of installed capacity sufficient to meet the global demand. The lag in the imbalance of supply and demand and the liquidation or investment in capital equipment ensures volatility and leads to irrational public policy.
When there is inadequate capacity to meet demand, prices rise sharply and eventually create the added capital needed for expanding capacity. In fact, prices are the market’s signal of inadequate capacity. This situation is exacerbated by world population growth and the depletion of rich and easy sources of supply. If prices are stable and demand grows in a capital-intensive industry, especially one with large capital-equipment requirements, then at some point inadequate capacity will lead to price increases, signaling the need and providing the funds for investment. Price increases are sharp and large.
This is unexpected for most professionals today. Our expectations are formed by the stable conditions of overcapacity and price stability that have prevailed from 1980 through 2003. We consider this economic context as “normal.” As shown by Figures 1-4, that was a period of transition, liquidating excess capacity. These conditions of excess supply occur but are not predominant and are therefore not “normal” in a normative or frequency sense.
If we take the recent period as an example of a period of excess capital-equipment investment and characterize business conditions, they should look “typical” to us. For example, the expectation of price stability without the ability to realize even the change in value due to inflation is characteristic of excess capacity. Producers are unable to realize higher prices because prices are set by the last increment of capacity needed to meet market demand. Because there is excess capacity, bidding always drives the price below market value to some margin over the raw cost of production.
These prevailing low prices make “cost control” the dominant business strategy required to survive and profit in a period of excess capacity. Reducing costs leads to inventory and staffing reductions. Innovation is not vigorous, because it costs. The excess capacity puts some confusion into the system that allows all players to shop for lowest cost. If the low-cost supplier has quality, delivery, or performance that is inadequate, the excess capacity in the market allows players to “catch up” by employing unused capacity. Inventories can be low when prices are stable, suppliers are plentiful, and capacity is open.
Excess capacity is liquidated through substandard pricing. Because much of the excess capacity is in the form of plants and equipment with long life, and each plant tries to survive, liquidation is slow. The equipment exists and is capable of production. Private owners are unwilling to write down their personal investment and try to maintain their facility and outlive the bad times. Public or corporate owners sell off at auction prices or through bankruptcy and reorganization, they write down the capital value of the excess investment. But, in all these cases, the plant with its equipment survives and contributes to the excess capacity.
It’s only when the equipment is worn out or obsolete that liquidation finally will occur. Because the excess capacity is generally created in response to a capital boom, liquidation occurs during times of an economic bust.
During these periods of excess capacity, some plants are planning for liquidation rather than survival as a going enterprise. These plants lose their capabilities and minimize sustaining investments in order to minimize costs. They put tremendous price pressure on the industry as a whole. The unsustainably low prices set by these liquidating enterprises are selling the excess industry capacity to customers.
Customers get pricing that is stable and fails to keep pace with inflation, not only due to improvements in efficiency but because the excess capacity is being liquidated to their benefit. This liquidation of excess capacity is the opposite of investment, and so it frees up customers’ capital by lowering their costs. This lowers inflation rates, lead times, and interest rates, too. Poor rates of return on these segments with excess capacity lead to larger corporations eliminating their captive operations in favor of lower-cost outside vendors.
Purchasers are most powerful in times of excess capacity. Corporations eliminate captive operations and consolidate vendors. Inventories are reduced. Prices are expected to decline each year. Innovation is slow. Costs are the driving commercial concern. Capital investment is limited and capacity is retired.
In contrast, during times of limited supply many business conditions are reversed. For example in the period preceding the recent period of excess capacity, we experienced a time of limited supply. In a period of limited supply, prices rise because customers bid up the existing capacity based on the market value of the item. The price is not set by the last required increment of capacity utilized but by the bid received by the last available increment of capacity. Instead of the price reflecting the cost of production, it reflects the value added to the user. Profits are not limited by cost-control but by production output.
There is no time to catch up if quality or performance is inadequate so buyers pay premiums to ensure supply. Price signals occur early as users insist on shorter deliveries, larger production quantities, and preferential treatment, and are willing to pay for this service. The limited supply is signaled by increased prices that are inflationary. Inflation for the producer of commodities or capital equipment means that supply is limited and rising prices allow more profitable operations.
When there is a limited supply, inventory is recognized not as an undesirable cost but as a valued asset. Inventory protects users from supply disruption and limited supply leads to escalating prices, so inventories appreciate. Because the limit of profitability is production volume, not costs, added staff can be justified to increase production. The inability of producers to make or users to get products leads to a willingness to innovate.
Users are willing in chaotic and turbulent times to try other products in order to displace traditional suppliers or improve availability. Hiring staff and other incremental investments are used to maximize or increase capacity within the constraints of existing facilities. Competition for finance, stronger competition for workers with the accompanying higher wages, and rising inflation numbers lead to market and policy rises in interest rates.
In limited-supply environments, the salesmen are most powerful. Production and capacity requirements become keys to success. Users seek multiple sources and may invest in captive capacity. Prices increase regularly.
Figure 6. Oil prices demonstrate how commodity prices react to supply constraints and demand increases.
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Prices of commodities demonstrated a sharp and significant increase at the end of 2003. Most important and typical is the price of oil, seen in Figure 6. In the classical period of limited supply and high relative commodity prices, from 1963 to 1980, oil prices escalated to a peak around 1980. In recognition of added supply and production capability, prices fell. Adequate capacity for oil production caused relative price stability, even with significant global political and military uncertainties. Then as global growth and limited supply collided in 2003, prices rose dramatically.
Many analysts attribute this rise to added uncertainty and robust global demand. The inability of current oil supplies and refining capacity to meet the demand requirements was clear. At prices considerably higher than the older, stable price (around $20/barrel), there are many investment opportunities in alternative supply. Oil sands in Canada, deep wells in the Gulf, coal gasification projects, etc., can be justified at current oil prices. As long as supply is limited and oil prices rise based on market value rather than production costs, new investments will be justified.
The same type of pricing behavior can be seen in copper, shown in Figure 7. Copper prices remained well under a $1/ lb. until the end of 2003. This limited any investment in mining or production. At the end of 2003 the price began to rise and then rose sharply to well over $3/lb. At this pricing level, new mines and production equipment are justified.
Investment does not happen quickly. Higher prices may signal the need for added investment but decades of experience with excess capacity make the financial institutions and business decision-makers rightly cautious to invest in added capacity. Legacy pricing retards the full-value pricing. Existing capacity fills up with profitable work. Without a large disparity of demand and supply driving up prices further, the industry consolidates and incrementally responds.
Figure 7. The commodity price increase for copper demonstrates the inflationary effect of low levels of investment in new capacity.
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Capital-equipment investment for commodity production finally increases in response to pricing signals as economic activity increases and demand increases. As increases in production lead to increases in profits, capital flows into capital-equipment investment. Rising prices and increased employment develop political and financial support for the infrastructure of capital investment. At the end of the investment phase, many different players expand capacity.
This rapid expansion stimulates demand, systemic shortfalls of supply stimulate demand, and the strong economy stimulates demand. This results in a capital-equipment investment boom. At the end of an overcapacity phase, capital-equipment liquidation occurs for the same reasons. Underlying demand is tepid, obsolete excess capacity is no longer viable, and existing inventory and excess capacity limit production requirements.
These phases of capital-equipment investment in limited supply and liquidation in times of excess capacity do not occur quickly. It takes time for pricing signals and industry conditions to justify required actions. Liquidating excess capacity is painful and done reluctantly through the consumption of the investment in pricing. Because limited supply occurs after a period of liquidation and secular growth, there is a systemic resistance to investment. It requires time, durable pricing leverage and profitability, changes in public policy, and recognition of the fundamental change in market dynamics to make the needed investment. In the meantime, existing suppliers consolidate as they recognize the market opportunities and the lack of proper valuation of other suppliers for sale in the industry.
There is also the risk of marketplace shifts that must temper the willingness to invest. In the current market the risk of global suppliers being able to invest and displace domestic suppliers will limit the willingness to invest in needed capacity. This is exacerbated by public policies that tend to penalize fixed investments. Financial institutions have shifted to cash-flow lending practices that limit the ability to invest in capital-intensive industries. The long period of excess capacity made a generation of investors skittish about large, capital-intensive cyclical industries.
On the other hand, significant global economic growth is likely to lead to a prolonged period of limited supply with the resulting increases in prices and profits. The limits on natural resources and the need to expand commodity production are likely to sustain prices needed to invest.
This capital-equipment reinvestment cycle however is of limited economic impact. Most of the economy serves the consumer. Consumer goods are much more stable in supply and demand with underlying growth. This means that consumer goods experience higher material prices but are not as seriously affected by this boom-and-bust cycle. Changes in commercial practices, like outsourcing or globalization, may create capacity in some industries and eliminate the need for new investment. Technology shifts (e.g., integrated steelmaking to mini-mills) create efficient capacity and reduce the need for new replacement investments.
- Commodity production in many sectors cannot keep pace with the world demand, and will result in sustained higher prices and inflation.
- Investment in production will take time, and it will take a long time for their effects to be seen by the commodity producer, the capital-equipment supplier, and the component supply chain.
- Public policy should encourage domestic investment, to stimulate employment, promote energy efficiency, and minimize environmental impact.
- Investors should be able to identify segments that will continue to prosper from capacity shortfalls and barriers to investment.