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January 1, 2010

THERE’S 2010 AND THEN THERE IS THE RECOVERY

The worst may be over, but industrial recovery will be a slow climb.

The recession is over, but what’s next? The issue of a U-, V- or W-shaped upturn will rage, but economic statistics lie and what will be reported as a strong economic recovery won’t be initially felt by the greater part of the industrial economy. We believe 2010 is likely a transition year for most industrial end markets with modest volume gains. However, most production increases will be stronger than sales gains and reflect the end of inventory liquidation rather than economic strength. Companies need to focus on 2011 to 2012, when the below-average, muted recovery of 2010 gains momentum and end-market demand begins to grow sharply, albeit from a depressed base. The new normal level of demand reached over the next several years will likely be below the recent 2006-2008 experience, but profitability should recover in what should be a lower interest rate, lower inflation environment. The risks to economic recovery stem from what government policies emanate from Washington.

Virtually every end market was under pressure in 2009. Housing has fallen an additional 40% from about 900,000 starts in 2009 to somewhat over 500,000 in 2009. Automotive production will likely come in between 8 million and 8.5 million units, down from 12.6 million in 2008, helped by the recent cash for clunkers stimulus program. Construction equipment production is down over 50% as export demand wanes, non-residential construction falls 5% to 15% in 2009 and likely a similar amount in 2010. NAFTA heavy truck production looks to be 44% lower in 2009 to about 115,000 units from 205,000 the previous year. Even markets like farm equipment, mining and oilfield machinery and electrical machinery, which were originally expected to hold up in the weak domestic economic environment, found themselves under pressure from the recession and financial meltdown.

Government programs have been successful in generating renewed economic growth in the second half of 2009, a profile that will likely continue in 2010 and beyond. No matter how strong the reported economic statistics get, the industrial reality is that we have dug ourselves a very deep hole to climb out of in 2010.

Manufacturing capacity utilization is now heading to the upper 60s (currently 67.6%) compared to a more normal 78% to 80%. Virtually every industrial sector is in an “over-capacity” position globally.

This will translate into a slow industrial recovery over the next six to 12 months. There is minimal need for any capital equipment expansion in 2010 as industry attempts to absorb the excess capacity. The only exception may be for new products. Production increases will mostly be related to the end of inventory liquidation as production levels more closely match end-market sales. Smaller, lighter equipment is likely to outperform heavy equipment, which could decline through at least the first half, if not all of 2010.

We believe 2010 industrial demand will favor energy efficiency and productivity. We foresee a faster recovery for technology, components for maintenance, repair, overhaul and inventory restocking, and consumables as industrial production rises from the ashes.

The key to the level of 2010 industrial activity may be inventory restocking. Our surveys suggest that there appears to be a developing consensus that the goal of industrial distributors is to start running leaner than they have previously. The inventory restocking process may actually be significantly slower as distributors establish a new, lower, normalized level of inventory. This also is an indication of caution in early 2010, as no distributor is taking any chances of renewed demand declines and distributors suggest that they will only keep certain parts in stock if specifically asked by a customer.

Assuming sustained economic growth, real growth in demand for equipment is likely to return in 2011 unless overwhelmed by mistakes in government policies. We foresee 2011 into 2012 to be a slow climb back towards a likely new normal demand helped by U.S. government programs that will likely play a greater role stimulating industrial markets in 2011-2012 and beyond than they did in 2009 and likely in 2010.

The new normal level of demand that we perceive is expected to be lower than the end market demand realized in 2006-2008.

  • Automotive demand will likely bounce 25% in 2010 to somewhat near or over 10 million units from our projected 8.2 million in 2009. Auto is unlikely to return quickly to the 15 million to 16 million units of NAFTA production that prevailed for most of the past decade to support what was 16 million to 17 million annual car sales. Perhaps 12 to 14 million unit production will be the new norm.
  • Housing starts will likely jump 50% in 2010 to perhaps 750,000 to 800,000 units or more and double in the next two to three years to over 1 million units. However, we believe housing is unlikely to return quickly to more than 2 million starts. The new norm may be 1.3 million to 1.6 million over the next few years with cautious lenders keeping the sector in restraint.
  • Non-residential construction markets will remain difficult well into, if not through, 2010 as financing institutions continue to be reluctant to provide capital to this sector. This is the one end market that may benefit from government stimulus money to help bring about stability over the next 12 to 18 months.
  • Heavy class 8 truck demand is likely to return toward a more normal level of around 200,000 units as early as 2011 with sustained economic growth as the impact of excess capacity and the new, tighter 2010 emission standard passes. However, prior level peak demand of well over 300,000 units is unlikely to be realized until we approach the next emissions cycle.
  • Construction equipment, engines and turbines, railcars, machine tools and other heavy equipment face a slow recovery through 2012 to levels that are likely below those seen in 2006 to 2008. Mining equipment may be the one heavy equipment market that begins to show recovery by 2011 as commodity prices begin to rebound helped by China led global growth and the weak U.S. dollar.
  • Farm equipment will have a weaker 2010 principally for larger equipment impacted by global bumper crops, lower commodity prices, and recent overbuying especially in North America. Growth could resume as early as 2011 with sustained economic growth and normal weather.
  • Electrical markets and alternative energy demand could resume in 2011 after a recession-induced pause in 2010 with renewed electrical demand growth and the development of any defined domestic energy policy.
  • Commercial aerospace will continue to feel the impact of the global recession for several years while the outlook for defense spending for 2011 and beyond is as uncertain as it’s ever been in history.

The worst is clearly over for now for Industrial America. Most companies will have to readjust to a lower level of activity over the next several years, but the opportunity for improving profitability is still excellent in what is likely a lower interest rate, lower inflation environment, at least for the foreseeable future.


Eli S. Lustgarten is senior vice president and senior research analyst at Longbow Securities for the Industrial Manufacturing and Technology sector. Mr. Lustgarten is also president of ESL Consultants Inc., a consulting firm dedicated to assisting trade associations and their members, as well as individual companies, to understand the global outlook for their end markets.