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Monday, January 2, 2017

Auto Industry Book of Note!

Mike Smitka

Up on Amazon as a New Year's surprise for me:

Here is the Table of Contents:
  • Chapter 1 Introduction: The Global Auto Industry Through the Lens of Technology
  • Chapter 2 History 1: The Rise of Oligopoly
  • Chapter 3 History 2: The Collapse of Oligopoly
  • Chapter 4 Changing Economic Geography
  • Chapter 4 Changing Economic Geography
  • Chapter 5 China and the Rise of New Producers
  • Chapter 6 Automotive Innovation Model and the Supply Chain: PACE Awards
  • Chapter 7 How Companies Innovate: Intellectual Property and Roadmaps
  • Chapter 8 CAFE Standards and Materials Competition
  • Chapter 9 The Rise of Digital Manufacturing and the Boundaries of the Firm
  • Chapter 10 New Technologies: Productions Systems, Management, and Labor
  • Chapter 11 New Technologies: Disruptive or Evolutionary?

Some chapters were drafted by Peter, some by myself. We each edited the whole thing more than once, cutting out each other's material to keep within the strict page limits set by the publisher (150 pages, minimal footnotes/references). It is truly a joint work.

Wednesday, December 28, 2016

Trump, Jobs and Growth

Mike Smitka, Washington and Lee University

Since it is in the news, let me point to three posts from this blog on growth and jobs. I've read many blog posts on this issues. While others note that labor force growth is slow, they don't provide concrete numbers. I do.

What Trump can hope for is (i) employing entrants to the labor force due to population growth, which will total about 2 million over the next four years, net of those who retire plus (ii) pulling the employment level of prime-age and 20-somethings back to the pre-2007 level, which was stable over the five years 2002-2006. In particular, as a share of the population about 2% fewer prime-age workers are employed today than in the period before the Great Recession, as per the graph on the right.

Now as the graph indicates, the employment share has been recovering for the past five years. So all Trump has to do is to not mess things up, and for us all not to be the unlucky victim of external circumstances. If in fact we add 6 million jobs, I will let him claim credit, even though policy initiatives under the new presidency aren't likely to make it through Congress and take effect so as to have much impact before his 4 years are out.

Tuesday, December 20, 2016

Mexican Tariffs and the Auto Industry

Michael Smitka
Economics, Washington and Lee University

During the election campaign Trump promised to levy a 35% tariff on trade with Mexico. Under both Section 201 and Section 301 of US trade law the President has power to impose unilateral trade measures without going through Congress. So he could, if he chose, impose tariffs on January 21st. He's also promised to tighten up the border. What would those two policies do to the industry?

...there's a silver lining in Wilbur Ross as Commerce Secretary...

Automotive trade within NAFTA is huge. During January-September 2016, the US exported $2.6 billion in vehicles and $21.7 billion in parts to Mexico, a total of about $25 billion. At the same time, it imported $41.7 billion in parts and $17.1 billion in vehicles, for a total of over $80 billion. Trade with Mexico is thus double the $39 billion in cars and parts imported from Japan during the same period, and 40% more than the $48 billion of the light trucks, cars and parts the US imported from Canada. Those US exports represent a lot of jobs, and those imports support a lot of jobs.

What does this trade consist of? Some reflects the logic of comparative advantage. A modern car may have two miles of wiring, assembled into harnesses by a factory full of workers standing at pegboards, laying out wire according to pattern and then bundling them together with special tape and fasteners. This process has proved immune to automation, and so is labor intensive, but is relatively unskilled work. A higher wage leads directly to higher costs. But doing it right is critical. Fixing wiring problems has long been one of the most costly and most intractable source of new car warranty claims. Skills may not matter, but experience does, and having a plant with management systems and maintenance personnel and knowledgeable foremen in place is critical. Moving factories thus risks skyrocketing warranty costs and much higher labor costs. In addition, it's not clear where in the US you would find sites with thousands of unemployed yet highly motivated workers. Worse, at present there is almost no harness production in the US – or similarly in Japan. (I don't know about Europe.) You have to build a whole new plant, not just scale up an existing one. Doing that, and ramping up production gradually to keep quality in line, means that any shift would require at least two years, and moving the whole sector would require several more years, to train new managers and maintenance staff – unless Trump grants the current factory teams in Mexico work visas. So a higher tariff would result in higher costs, not more jobs.

But how much higher? Let's do a sample calculation using round numbers for a part that costs ₱320. In early 2016, when the Mexican peso was at ₱16 per dollar, that part would thus cost US$20. But because of worries about protectionism, among other factors, the peso has since depreciated to under ₱20 per dollar. (Again, I keep numbers round, the actual rate at 4:24 EST on 20 Dec 2016 was 20.4562.) So today it costs only US$16. Add a 35% tariff and the net cost jumps to $21.60. That's 8% more than the start of the year, painful when repeated across many parts (and wire harnesses are one of the most expensive purchases a car company makes, only seats run more). But it is not an immediate disaster.

This however is an underestimate. For Delphi, the wire is imported from a highly automated plant in Warren Ohio that draws wire from copper bars, twists them into a bundle (even the smallest gauge automotive wire is multi-strand, for flexibility and robustness to defects) and then adds insulation. Automotive sheet steel comes from US mills. Many other specialized components come from a single factory – that economies of scale thing – and many parts include elements that have crossed the US-Mexican border more than once. Indeed, on average imports comprise 40% of the cost of what Mexico exports.

So let's revisit the tariff calculation, using 50% imported content for clarity. So initially we have the same ₱320 part, where US$10 (₱160) was imported from the US and ₱160 consists of Mexican value added (wages, overhead, profits). Now we still have ₱160 in local costs, but the imported portion now runs ₱200. So total cost is ₱360, and at ₱20/dollar the pre-tariff cost is now $18. Add the 35% and it now runs $24.30. That's 21% price hike, and no longer trivial. Furthermore, the more the Mexican peso depreciates, the worse the impact, because half the tariff is on the unchanging cost of Made in USA content. Of course this increase in the costs of imported parts will make automotive exports from the US less competitive. The bigger bottom line is that it will be a big tax on American consumers: car prices will go up, but very few jobs will return.

...car prices will go up, but few jobs move...

How about cars themselves? Ford will build the Fiesta in Mexico, not the US. Audi will make the Q-series there, too. The reason is Mexico's FTAs (free trade agreements) with 45 countries, far more than the US has, and including Europe, Japan and China. Cars exported from the US to Europe incur a 10% tariff; cars exported from Mexico enter free. And many of Mexico's trading partners – absent their FTA with Mexico – have automotive tariffs far above 10%. That's a big deal, and is what drives assembly plants to locate to our south. Labor may be a little cheaper, but that's not the driver, because even in developed countries it's less than 10% of the ex-factory cost of a car. Cheaper labor saves a few percent. Lower tariffs save 10% or more.

Furthermore, boutique firms such as Audi aside, Mexico makes small cars. Now much of the Fiesta output will be exported, but only some of that will be to the US. We don't buy small cars, so if production were moved to the US midwest, much of output would still need to be exported. But add a 10% tariff and it can't be sold in Europe. Add higher tariffs, and it can't be sold in South America. Moving production to the US would make it impossible for the Fiesta to be profitable, not because of expensive labor, but because Ford wouldn't be able to run the plant at capacity without the FTAs in place that enable exports. (In this particular case, Ford doesn't in fact have idle capacity. Building a new assembly plant would take years, and mean that the Fiesta would lose even more money.)

But there's another issue that lies in the background: logistics. Trump has promised to tighten things at the border. Because of NAFTA, however, we don't collect a lot of tariffs and so have no need for a large customs staff in Laredo and at the other major crossings. But the automotive supply chain operates on a just-in-time basis. There's only 3-5 days inventory in the pipeline, and even less for Toyota's plant in Texas, which is remote from the midwest supply base and so relies more heavily than most on parts plants in Mexico. Close the border for a week, and every assembly plant in the US and Canada will be forced to shut down, and parts plants with them. That's hundreds of thousands of jobs, a disaster for the economy and something even Trump would have a hard time spinning positively – plus layoffs would be concentrated in the region that gave him his electoral college victory.

There is a silver lining in Trump's naming of Wilbur Ross as his Commerce Secretary. Ross owns International Automotive Components (IAC), which concentrates on making interior parts, door panels, headliners and the like. Many of the components in IAC's portfolio are labor intensive, and it's a competitive segment with thin margins. So since Ross put together IAC in 2005 from a group of failing and bankrupt parts companies, IAC has opened numerous plants in Mexico and in China as a matter of strategic survival. Ross understands very well what tariffs would do to the industry. Furthermore, Trump trusts him – Ross was instrumental to Trump surviving the bankruptcy of his Atlantic City casinos. But it's the silver lining to a dark cloud: Trump may not bother turning to Ross for advice.

Wednesday, November 23, 2016

Why BEVs Won't Be Disruptive

Mike Smitka, Torino Italy

In 2030 I expect that Toyota, VW and GM will remain the top 3 global automotive producers (though not necessarily in that order). The flip side is that neither vehicle electrification nor autonomy nor Mobility 2.0 businesses will prove disruptive.

...Disruptive Technologies? Not in Automotive!...

Each of these purported threats have their own challenges as technologies and businesses. That is for other blog posts. All three however have a common feature: new technologies roll out slowly, and in the auto industry they roll out very slowly. Even with rapid commercialization, in 2030 only 1 in 10 vehicles on the road will be BEVs (battery electric vehicles).

New technology adoption and diffusion follows a logistics process: slow early on, then accelerating, and slow again towards peak. That is true in theory: few are willing to chance adopting a technology when no one they know has done so. Similarly, towards the peak those who have yet to adopt a technology have refrained not because (or not only because) they are obstinate but due to idiosyncratic circumstances. This is a robust empirical finding, dating back to Zvi Griliches' classic 1957 study of hybrid corn. Commercial hybrids were first developed in 1923. While half of Iowa farmers used such seeds by 1938, farmers in regions where corn was less widely planted continued to sow non-hybrid cultivars until the 1960s.

Automotive technologies are no different. Initial costs of a new technology will be high, while performance will still have room to improve. Historically many technologies appeared first as an option on luxury cars. If the uptake was good, one or more firms might make it a standard feature. As the volume rose, suppliers would reduce the price point, and OEMs would migrate it to high-volume products.

Feasible BEV Rollout Scenario


Global new vehicle output

BEV share

BEV share vehicles on road





































This process is thus constrained by the commercialization process, by the standard "learning curve" and economies of scale effects, and by the time needed for the supply chain to add new capacity. It is also constrained by the new model development process, because it is highly unusual for a feature to be introduced in the middle of a model year. So the use of new technologies can only expand as models are redesigned, which for standard sedans is done a rolling 4-year cycle. That puts a limit on the pace of adoption. Furthermore, it may only be possible to introduce a radical technology with a new platform; those are developed on a rolling 6-10 year cycle. Drivetrains are also redesigned less often. And heavy trucks may not be fundamentally redesigned for as much as 20-30 years. (One major brand uses an H-frame first introduced in the 1960s, before the advent of the steel and aluminum alloys that are widespread in the passenger car market.)

[The bulk of the engineering for a standard passenger vehicle model takes place over roughly a 12-month period, with a smaller advance team working on model specifications at the front end of the process, and at the tail end a smaller team seeing the design through to SOP (the start of production). The full process thus spans 18-24s months. The rolling development cycle is thus due to staffing constraints in the development process, and the desire of the marketing and dealership end to have a steady stream of new models, but not a flood of them.]

In the past, even rapid rollouts of technology in the automotive space, such as when there is a "hard" regulatory deadline, has required over a decade. The fastest example of which I'm aware is the replacement of carburetors by technically superior fuel injectors, the latter necessary to meet emissions requirements. They had been used intermittently in racing from the 1950s, and began to appear on low-volume luxury cars in Europe in the 1970s. However, they were complex and costly mechanical contraptions. That changed with the introduction of microprocessor engine control units (ECUs), which also made fuel injectors much more effective. The first Motorola ECU was launched in 1980, and by 1990 GM had converted the last of its engines to the new technology. At the firm level, the rollout was over one decade, but for the industry as a whole it follows a logistics curve. Pulling off this fast introduction required huge investment. To facilitate the fast pace and not be hostage to Motorola, GM invested in its own semiconductor manufacturing operation; for a time it was the fourth largest chip maker in the world.

...15 years from now BEVs will still account for less than half of production. That's hardly disruptive!...

So what does it look like if you combine industry specifics with a logistics curve? First, by 2020 global production will be 100 million vehicles, and slowly increasing. Globally there will be perhaps 1 billion vehicles in operation, with 8% scrapped in a given year (at which rate the average vehicle on the road will be 11.5 years old). Finally, because large vehicles are unlikely to be BEVs, it's sensible to assume diffusion peaks at 80% of the market. You can read the numbers for yourself.

This is an excerpt from one section of a paper on new vehicle technologies that I presented this will at the "Toronto-Torino Conference" organized by the Munk School of Global Affairs at the University of Toronto, Collegio Carlo Alberto, and Politecnico di Torino. Along with wonderful food and wine, the conference also included a tour of the Torino assembly plant of Maserati.

Wednesday, November 16, 2016

Premature Panic over Bonds

It's anyone's guess at this point what the incoming Administration will do. [I'm guilty, having indulged in speculation on trade policy and the auto industry in my previous post.] So why should each and every change in the economy be viewed as a reaction to Trump? Well, I suppose it's easier than thinking.

...don't blame Trump – yet...

According to headlines, bond prices have crashed over the past couple days. First, is that really the case? Second, there are many reasons for interest rates to change that have nothing to do with the election. If we look at the first graph, we do see a spike in yields over the past week. But rates constantly bump around, and remain within the range we've see over the past 12 months. Second, if we look at what the slope of the yield curve implies for what 1-year Treasuries will look like down the road, we're almost exactly where we were a year ago. That in turn is very little different from where we were two years ago.

We should remember that employment data suggest the economy continues to improve. At 152 million [Oct 2016] the level is 13 million higher than the 139 million of November 2010. In addition, the number working involuntary short hours fell by 2 million, and now is back to more-or-less normal numbers. That's 15 million new or improved jobs. Slack remains, but since monetary policy can take 18 months to have an impact – and a 25 basis point hike to 0.50% won't have much! – we should expect rates to rise sooner rather than later.

So don't blame Trump. Yet.

Monday, November 14, 2016

Autos, Trade and Jobs: Chaos Looms

One of the things that appears to motivate Trump supporters is a desire for better jobs. They will be disappointed: trading part-time work at Walmart for sewing garments in a sweatshop is not what they have in mind. If he really does clamp down on trade – one of the few economic tools he has without going to Congress – the results will be counterproductive. The impact on the auto industry could be worse.

...campaign nostrums do not good automotive policy make...

Creating jobs is not easy. Getting legislation through Congress takes time, and hiring isn't immediate. If Trump wants quick action before midterm elections, then it's to trade policy that he will turn, as he can impose emergency trade restrictions without waiting for Congress. That will be yuuuge, it will be decisive. It will give the U.S. an upper hand in negotiations. Or at least that's been Trump's historic mindset.

...we would lose the jobs for our $45 billion in annual automotive exports to Mexico and China...

That would also be in accord with his campaign rhetoric, with its focus on manufacturing and trade. But in fact trade isn't the issue, it's productivity. The gradual increase in the efficiency of our factories over the past half century means that we are turning out more goods with fewer workers. Indeed, some estimates suggest global manufacturing jobs are in decline. Manufacturing jobs are in any case a small slice of our economy. A small number tweaked remains a small number. As a politician though Trump's experience is limited to the virtual Twitter universe, not the real world. So such facts aren't likely to matter to him.

Back to trade. There are sectors where automation is limited, with productivity is little higher than a century ago. Garment production is one; in the automotive sector, wire harnesses are another. Those are the jobs that have moved overseas, in line with the analytic approach developed two centuries ago by another wheeler-and-dealer turned politician, David Ricardo. Anyway, higher tariffs can indeed lead to more of those sorts of jobs, albeit only as a response to rises in prices for clothing sufficient to make production here profitable. Being priced out of shopping for clothing at Walmart is not part of the the mythical golden age of the 1950s and 1960s that his supporters have in mind. Nor, to repeat my opening claim, is sweatshop labor.

For the auto industry, however, low-wage labor is not central, it is intraindustry trade. Ricardo's view of specialization based on wages is not the main story. If it was, the rich world would not be engaging in trade with itself. In fact finished vehicle trade with the rich world – Australia, Europe, Japan and South Korea – is 72% of the US total, while 74% of parts exports – $45 billion in Jan-Sep 2016 – are to Canada and Mexico. Much specialization is within product niches, rather than in labor-intensive versus capital-intensive goods. We value variety, while production still benefits from economics of scale. As an example, BMW turns out the X-series in South Carolina, exporting 70% of output, while the other models for the US market are imported from Germany. Without such efficiency-enhancing specialization and associated intraindustry trade, consumers in the US and Europe would face a smaller and more expensive array of product choices. Indeed, that was the motivation behind the formation of the US-Canada Auto Pact of 1965, our first free trade arrangement with Canada, which paved the way for the 1988 Canada-US Free Trade Agreement, and in turn to NAFTA in 1994.

Back to Trump. If he wants quick action on "jobs," then trade policy it is. Trump is not one for nuance, and developing fine-grained policy also takes time. We are looking at broad-brush, across-the-board tariff increases. In a globally integrated auto industry, that would prove highly disruptive.

On the intraindustry trade front, we already have tariffs of 25% on trucks, which has proven sufficient to effectively eliminate imports of such products from outside NAFTA. Tariffs of 35% would be prohibitive, starving dealerships of product in a scattershot manner, and killing the jobs associated with our $35 billion in automotive exports to Mexico and China. [Again, Jan-Sep 2016 data.]

Not all parts production is intraindustry in nature; about half of our imports are from Mexico, China and other lower-wage countries. Of course a 35% tariff would lead to sharply higher prices for items such as wire harnesses, for which there is virtually no production capacity inside the US. (The cost of adds up: a “loaded” vehicle can have 2 miles of copper to power and control 10 airbags, seats, infotainment systems, and computer-controlled drivetrains.) But tariffs will hit the parts sector in a scattershot manner, driving up costs and throwing investment and sourcing plans into disarray. Car companies operate on a 4-year product cycle and an 8-10 planning cycle. Managing sharp changes will be a nightmare.

Border policy also matters to the industry, and that has remained part of Trump's post-election rhetoric. Just-in-time production means assembly plants are critically dependent on the uninterrupted the physical movement of goods across the Canadian and Mexican borders. It is easy to paint a scenario under which the auto industry incurs major collateral damage from quick-draw, shoot-from-the-hip policy.

...whatever the putative long-run regulatory and tax benefits of a Trump administration, the immediately impact will be harmful and chaotic...

There is one gray lining in these black clouds: we live in a world of flexible exchange rates. The dollar has already strengthened significantly agains the Mexican peso, which is down from ₱18.5 to (as I write) ₱21, a 12% drop in a few days (and 21% from November 2015). This will offset some of the financial impact of higher tariffs, but in an uneven manner.

Campaign nostrums do not good policy make. The net impact of higher tariffs will be higher prices, and lower real wages for the working class, and less consumption across the US as a whole. Lower consumption means it will be a job-destroying policy, not a job-creating one. Whatever the putative long-run benefits to the auto industry from relaxed regulation and lower taxes, the immediate impact will be both harmful and chaotic.

Thursday, November 3, 2016

The Problem with Electric Vehicles: They're Cannibals

Mike Smitka

I'm working on a paper for a conference in Torino on disrupters in the auto industry. Contrary to most, I'm not convinced that battery electric vehicles (BEVs), autonomous vehicles or "Mobility 2.0" business models will be disrupters. That's not because I believe these technologies are unworkable. Indeed, I expect BEVs will one day dominate. I define "disrupter" narrowly. I argue (but not here) that existing car companies will dominate, so that the transition will only be disruptive for the portion of the supply chain devoted to fuel delivery and engine components. That's not a small footprint. Even there the impact won't be disruptive, because BEVs will diffuse slowly.

we should look to 2030 for BEVs to go mainstream

The market for hybrids is an example to which we need to pay heed. None of the full hybrids has sold well – with the exception of the Toyota Prius, to which I return below. That is true whether they are in the form of a Chevy Volt with a range extender, or a "traditional" hybrid such as the Honda Accord. As the name suggests, hybrids have two complete drivetrains that must be made to work together. That's not clean engineering, and it adds cost – hybrid vehicles are inevitably priced $3,000 or more higher than comparable regular vehicles. If someone drives 15,000 miles a year, then at $4 per gallon the fuel savings come to only about 125-150 gallons or $500-$600 per year. So unless they are subsidized, either by the government or through rebates by the manufacturer, then for most people a hybrid is not a good value proposition.

Subsidies aren't hypothetical, but in NAFTA, the EU or China, each with 20+ million sales, it's easy to exaggerate their potential. Initial pilot projects have largely run out – those in China, only just expanded to cover hybrids and not just BEVs, are set to expire in 2020. Governments (Congress in the US) rationally aren't eager to spend money to make hybrids a competitive option: at $2000 per vehicle (not $3,000 – lower fuel costs have some benefit!) and 10% of the NAFTA fleet, the requisite subsidies would come to $4 billion per year. That's not going to happen, not in the U.S., not in China.

The key point is that not only did hybrids not succeed, they will not succeed because the cost differential is fundamental to the technology: a downsized internal combustion engine (ICE) costs almost as much as a larger one, while batteries, power controls and electric motor can only add cost. The bottom line is that we have good evidence that when it comes to fuel efficiency, consumers won't buy vehicles unless there's a value proposition.

The exception is the Prius. After a slow couple years, it became the car for the Academy Awards. Was it an economy car that someone would buy because of the savings? No, as per above, there were none. And it was not an economy car; when I last checked it came in 5 trim levels, but don't try to find a base Level I vehicle! Instead it was a trendy statement of environmental concerns, bought at the fully loaded Level V. For that a Honda Accord Hybrid provides no benefits, as it's visually indistinguishable from the regular gas-guzzling version. [I have notes in my office and will fill in names/dates later.]

BEVs face the same challenge as hybrids. They also face a moving target. Over the past 20 years carmakers have added turbochargers, electric steering and other motor-driven functions that eliminate the cost, weight and parasitic losses of always-on hydraulic systems. Start/stop alternators are now diffusing, vastly improving the efficiency penalty of in-city and rush-hour driving. As 42V systems roll out, alternator-motors will be beefed up to provide power boosts at cruising speed and capture power through regenerative braking. Add in better combustion control, and ICEs have another 15 years of efficiency gains ahead of them, and likely more. Even though batteries are falling in price, BEVs will remain niche products.

BEVs are helped today by direct subsidies in China and elsewhere (a $7500 tax benefit in the U.S.). Those face the political-budgetary limits noted above. More important are indirect subsidies as "compliance vehicles," most obvious under California's zero-emission mandate. (The California Air Resources Board is a de facto global standard setter, as the state's 2.1 million unit market is too large to ignore.) That indirect subsidy may expand: as the US moves closer to implementing its 54.5 mpg fuel standard – with parallel measures in other major markets, including China – it may be in the interest of OEMs to expand the number of BEVs they sell, to offset the sales of larger non-compliant vehicles, even if consumers are not immediately interested.

Every BEV sold will mean an ICE that is not sold. How will this cannibalization play out? With the easing of the fleet-wide US fuel economy standards of the original CAFE mandate, companies no longer need to offset fat-margin light trucks with sales of small cars. That is, the latter can now be sold – or not sold! – on a stand-alone commercial basis, as long as each vehicle doesn't overflow it's footprint-based bucket. Money-losing BEVs will thus replace the sales of positive-margin vehicles. The larger the BEV, the bigger the gap: margins in general increase with vehicle size, but the bigger the battery pack, the greater the cost penalty of BEVs.

In other words, until battery prices fall enough to make them cost-competitive with comparable ICE vehicles, each BEV sold will lower OEM profits. That is, as stand-alone products BEVs have to be able to generate the same gross margin as the vehicles that they replace in consumers' garages. My educated guess is that batteries won't reach that break-even point for a full decade. Worse, if those battery systems involve new chemistries, instead of representing incremental improvements on today's lithium-ion cells, the validation and vehicle redesign process could easily add another 5 years. By then the global market may approach 140 million units, so a lot of battery capacity has to be added.

Diffusion will be speeded if driving habits co-evolve: small commuter vehicles with modest range incur a smaller cost penalty at any battery price. They don't sell today. I believe that too will change, but I expect that to be a function of cumulative exposure – it will be an "experience good" in economic terms. Hence my choice above of the term "co-evolve." So my expectation is that we should look to 2030 for BEVs to go mainstream. Only then will a car company* dare to offer at least one core model with only electric drivetrain as options.

* Boutique players such as Tesla are irrelevant to the industry as whole. New entrants must hurdle barriers that today's big players have already overcome, and face little or no advantages in technology. However attractive their product, they simply can't grow fast enough to make a dent in the global market.

Monday, October 24, 2016

Is Brexit a Risk to US Growth?

mike smitka

I made a short presentation as a component of board education for a local bank. The president was curious about Brexit, so I used that as a point of departure. What follows are thumbnails of slides; I add several at the end that (as expected) I did not get to during my talk.

First, I began by emphasizing that there is no business cycle, as emphasized in a previous posting on this blog. By chance in the immediate aftermath of WWII the US had 3 recessions with similar timing, but that's not happened since. Just because we've gone 7 years without a recession doesn't mean that one is more likely in the next year. Furthermore, the apparent causes vary, so predicting on the basis of past recessions is pointless. Now once a recession has begun, then certain changes occur – but those can also arise without a recession being underway. So it is possible to calculate recession probabilities, but those are weak and at best provide information on the next several quarters.

Still, we can think about potential threats. Is Brexit one? A quick look at recent data suggest "no". The pound has depreciated by about 25% and because the UK is relatively "open" – trade is about 1/3rd of GDP – that will result in some uptick in consumer prices. But so far that's been modest (from 0% inflation to 1% inflation). Meanwhile, unemployment is falling, not rising, and there's no evidence so far of a slump in GDP growth. Meanwhile, interest rates remain at zero. No surprise there, that's been true of the developed world thanks to the Great Recession, and the stalwart refusal of most countries to use fiscal policy.

Even if British growth does slow, that has only a modest impact on us, the US, because the UK is a modest part of the global economy, at a bit under 3%. Now if problems there hurt the remainder of the EU, then that starts to change – the EU is bigger than the US, but it's still only about 1/6th of the world economy. If we are worried about flash points, then we really need to look at the rest of the world because growth in the developed has been slower than elsewhere. NAFTA comes to only about 20% of the world economy; add in the EU and Japan and the developed countries are now less than half of the global economy. That's good news, the more the better for everyone. But we need to pay attention to China. No more on that here

Meanwhile NAFTA as a whole is doing relatively well, with the IMF projecting 2017 growth in all three member countries at over 2%, higher than the UK or any of the larger continental economies.

We do however need to set concerns about the future in context. Due to demographics, growth in the US will not hit 4%, no matter what politicians do. The baby boomers are retiring, and so we have very low labor force growth. While we still have slack, we are now – at long last – approaching historic levels of labor utilization. Indeed, I'm slightly hopeful that with the numbers of those working involuntary short hours is now close to historic levels more of demand will serve to pull those prime-aged Americans who dropped out in 2008-9 back into the labor force. So we can continue to grow at 2% for a couple years, but then things will slow, independent of whether the Fed raises interest rates.

The graphs below present several snippets. The first is the "broad" measure of unemployment (the black line, U-6) relative to the "headline" level in green. It's still high, but at least close to the level of the better time periods since 1994. (Consistent data aren't available before then.) Second, we can see the loss and now addition of jobs, all relative to my calculation of the number of additional jobs needed to keep up with population growth, net of "boomer" retirement. The third graph is a variant on the second one, looking at jobs relative to my attempt to calculation a "normal" baseline. Finally, there's age-specific participation, which continues to be well below normal – if we extend back before 2007, these curves are all flat. (That does hide other dynamics, such as a drop male participation prior to 2007 that is offset by a rise in female participation.) This graph suggests that we have further to go until full recovery – I'm hopeful of end-2017, but project participation and it's 2019.

Now the Rockbridge Virginia region is not average; we depend more on retirement and tourism, and construction. The bad news is that for the nation as a whole housing starts have been falling relative to the population for the past 50 years. We may not see an uptick at the national level. But the good news is that the CoreLogic data on mortgages shows the share with negative or near-negative equity has fallen from almost half of all homes to a quarter. Most of that has been due to the drop of those with negative equity, either because over time the combination of higher housing prices and the repayment of loan principle has pulled them into the 80%-100% loan-to-value bracket, or because due to foreclosures there are now new owners. Since as a small bank you do hold some mortgages on your books, that is reassuring, and it's even better that net homeowner equity has risen by over $4 trillion since the start of 2013.

What happens locally is however more a function of whether retirees in nearby urban areas can sell their houses and buy a new one here. House prices in the mid-Atlantic region aren't uniformly above the bubble peak of late 2006, but Charlotte and Atlanta are close or positive, and the Washington DC area looks pretty good relative to much of the country. You can find all that data on FRED. Finally, my work is on the auto industry, and car (or more accurately) light truck sales are strong, but that does imply you should not expect much upside. With only one dealership left in the county car loans may not be a big part of your portfolio, but don't look at them to grow except as you increase market share. Production is strong, too, despite the bad-mouthing of NAFTA. The plants of Lear and Dana are long gone, so that's less relevant, but it is consistent with the picture of sales near their peak, reinforced by sales per person working back around 0.14 (scaled by 1,000).

Finally, what of interest rates? We should not expect the Fed to raise them quickly, or far. For the past 25 years interest rates have been falling. Some is that for the US as a whole inflation has fallen, and expectations seem to have gradually factored that in as a permanent change. Ditto in the major trading partners with whom we're linked financially, several of whom are actually experiencing mild deflation. In addition, it seems that despite all the hype around Silicon Valley, investors aren't expecting growth to pick up, either. Long-term interest rates are at 3.5%. We should take that with a dose of salt, as they've seldom been a good predictor of things 20 years hence. But if we return to 2% inflation, that means those in the bond market are factoring in growth of at most 1.5% (we surely need to deduct a risk premium, in which case growth and/or inflation must be lower).

Now I didn't include yield differentials. Those are quite volatile – the yield curve moves around a lot – and are neither high nor low today. So if the profits of a bank come from using short-term borrowing (including deposits) to fund longer-term loans, there's nothing to indicate conditions today are unusual. Have me back in a year and I can likely talk about the empirical evidence of interest rate normalization...

October 20, 2016

Friday, October 7, 2016

Jobs Update in 3 Graphs

The long, slow recovery continues. First, participation by prime-age workers continues its increase, as does that of those aged 20-24. These demographics bore almost all of the job losses in the Great Recession – I don't include it, but older worker employment actually rose, the "boomers" didn't retire the way their parents did. The same story shows up if we look at the gap between my calculation of expected levels of employment, given boomer retirement, and current levels. Indeed, the number of workers on short hours is now back to historic levels, good news as any strengthening on the demand side will be more likely to turn into new jobs rather than an increase in hours for those currently working.

Now the main focus of this blog is on the automotive industry. While it should not be surprising, given the likely peak in new vehicle sales, the rise in manufacturing employment has slowed if not stopped. But manufacturing jobs are affected by the continuing increase in productivity over the past 20 years. Fifteen years ago automotive manufacturing accounted for a full 1.0% of all jobs in the US. Now that level is peaking at 0.6%. Now the industry has added many software jobs, and will continue to do so to support new safety technologies and infotainment functions.

These data do not capture such employment. Our statistical systems were set up when manufacturing and construction were keys areas of employment, while healthcare and other services accounted for relatively modest shares. Bringing our data systems into the 21st century will require boosting the budgets of our statistical agencies. From the standpoint of the overall budget that expenditure would not even constitute spare change. However crucial such data are to business planning, there is no "business" lobby on Capitol Hill that can speak to such issues, and instead these agencies face budget cuts. It is not just physical infrastructure that is deteriorating, it is also some of the other hidden areas that our economy depends upon that need to be improved.

Monday, October 3, 2016

Domestic Automotive Jobs: NOT the Sept Monthly Sales Report!

Domestic Vehicle Production
Domestic Industry Revenue

The domestic US auto industry has by two metrics finally recovered from the Great Recession. The first two graphs present total industry output in unit terms and in revenue (deflated by the producer price index for motor vehicles and parts). Both are at the highest in 40 years. The industry has never surpassed the boom that immediately preceded the First Oil Crisis.

I remember that era well. As a college student in the summer of 1973 I worked at Chrysler Mack Stamping. Monday-Friday I worked 10 hour days, and to that added two 12-hour shifts on the weekends. For my 74 hours, between "regular" overtime and double time on Sundays I earned 96 hours pay. Anyway, it may be just as well that we've yet to repeat that level, as the boom (which coincided with booms in Japan and Europe) helped give rise to high inflation and the First Oil Crisis.

However, the level of manufacturing employment remains well below peak, as shown in the graph below. But that reflects productivity improvements: relative to 40 years ago, we need 40% few workers to produce the same number of vehicles. That's the graph at the bottom.

In every industry with which I'm familiar [the possible exception is garment production], over time manufacturing labor productivity consistently outstrips demand. Auto manufacturing jobs aren't going to return, ever. But the same is true for manufacturing jobs more generally. Now this shouldn't be surprising. Our population has more than doubled since 1945, but we today need only 30% as many farmers to feed us whiling generating a substantial surplus for export.

Oh, and China is undergoing the same transition: farmers are increasingly redundant, while factories are shedding workers as the economy moves away from labor-intensive goods.

Domestic Industry Employment
Domestic Auto Manufacturing Labor Productivity