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March 1, 2011

When the Turtle Gallops

On balance, the medium-term economic outlook is just OK, with some significant negative factors that remain unresolved.

From time to time, it can be useful to stand back from the daily pressures of business life to consider whether the longer-term reality has changed.

This recovery is one of those times.

On the one hand, the factors that suggest healthy, short- to medium-term economic growth are plentiful. GDP is recovering, slowly perhaps but steadily. In mid-February, the Federal Reserve Board went so far as to increase its forecast for economic growth in 2011 to a range of 3.4% to 3.9% from its earlier estimate of 3.0% to 3.6%.

But that's not all. By way of quick summary:

Manufacturing, for the time being, leads the way, as output rose 0.3% in January after having increased 0.9% in December, the Federal Reserve says. The level of output in January was 5.5% above its year-earlier level.

Productivity, measured by the U.S. Department of Labor, was up 2.6% in last year's fourth quarter, up 0.3% from the quarter before and exceeded economists' predictions for the period.

Commercial and industrial loans were up 5.2% in January, the Fed said, following an 8.8% increase in December, the first substantial increase since 2008. The Fed's January survey of senior loan officers across the country showed demand up and a 12.3% easing of lending standards to firms with sales of at least $50 million. Cash for expansion, they say, will become more available as the decade progresses.

Some businesses are hiring again, and a study commissioned by the Wall Street Journal showed that job postings on the Internet hit 4.7 million in December, up from 2.7 million the year before. The hiring trend, too, will only strengthen. A fourth quarter poll of 84 companies by the National Association for Business Economics showed 42% expecting to increase their payrolls in the following six months.

Some consumers are spending again, although they are more often the wealthier among us. The U.S. Department of Commerce reported that total retail sales for November 2010 through January 2011 were up 7.8% from the same period a year ago.

Sounds great, even robust. But now we come to those factors that slow or deter growth. Huge holes remain in the economy, and they threaten longer-term financial health and growth. It is these that are the most unpredictable, but significantly drag our economy.

They include a potentially seismic shift in the housing market, which remains near its all-time low. Private housing building permits for January, for example, were 10.4% below December, according to the Commerce Department, and 10.7% below year earlier levels. There is a load of ominously toxic bank assets, an estimated $13.8 billion sitting in the top 10 U.S.-owned banks alone, and 23 bank closures just in the year's first two months. There are the functional if not legal bankruptcies at state and local governments, which erode the prospects for government employees and for significant public works programs to bolster construction. There are consumers who remain fitful and unpredictable in their spending. And then there is the elephant in the room: Although new jobs are being added to the economy, unemployment remains above 9% at this writing. The unsettling new realities of being out of work in America look to be a serious drag on the economy for the foreseeable future.

If that weren't enough hard news, there is a growing realization among industry leaders, educators and politicians that schools, despite two decades of determined efforts to make them better, may actually still be losing ground to our competitors overseas. Our high school graduates do not read and write at functional levels; 68% of eighth graders, for example, cannot read at grade level, said the Eli and Edythe Broad Foundation, which studies American schools. The United States has all but lost much of its global competitive edge in science, math and technology. American students rank 25th in math and 21st in science compared to students in 30 industrialized countries, the foundation says. Many manufacturers already report difficulty finding competent operators for their now computerized machinery. In the years ahead, persuasive studies show that this country is in dire danger of losing its ability to innovate on the world stage.

Growth for Now

For now, we are recovering from recession at the slowest rate in post-war history. Slow but steady is the mantra. “People feel we are moving forward and gaining momentum,” says Karen Kurek, partner and manufacturing lead at RSM McGladrey, which studies the manufacturing sector, among others. “But the biggest thing about this recovery is how unemployment has lagged, and that is a serious
negative on consumer confidence and consumer spending. The economy, you'd have to say, is recovering at a turtle's gallop.”

“Last year growth was at 2.8% year-to-year, so we are slogging our way through growth right now,” echoes William A. Strauss, senior economist at the Chicago Federal Reserve. Fourth quarter GDP growth last year was an encouraging 2.8%, up from 2.6% the quarter before, but as Strauss notes, few expect that rate to continue. Those fourth-quarter gains brought U.S. output back to pre-recession levels, but it took three years. It took just eight quarters, by contrast, for the economy to come back from the deep recession of the early 1970s.

Still, for manufacturing there is relief if not outright smiles. The widely watched Institute for Supply Management's Purchasing Managers Index grew for the 19th straight month in March. Its 61.4% level was at its highest level since May of 2004. Readings above 50% indicate expansion. The index also showed the economy in general expanding for the 20th consecutive month. Of the 18 measures used by the ISM to evaluate manufacturing, 14 grew, led by petroleum and coal products, primary metals, apparel leather and allied products, wood, and computer and electronic products.

It is somewhat the same in Canada. “We tend to be looking at improved growth for the year, just like the United States,” says Ron Watkins, president of the Canadian Steel Producers Association. He says federal and provincial programs have kept general construction going to some extent. But steel producers and construction contractors among others are watching the new federal budget, due out this month, which will signal whether the government's pre-recession C$33 billion commitment to infrastructure spending will be resuscitated. That would signal an increase in public works projects for the next five years at least. “We have
significant infrastructure needs in Canada,” Watkins says. “One study put the infrastructure gap at C$200 billion and that was in 2008. Yours in the U.S. is like $2 trillion. Everything is times 10 for you. And we watch your economy carefully, of course.”

Interesting then, that the U.S. Commerce Department shows Canada falling to second place behind China last year as the top source for U.S. imports. Canada retained its position as the top destination for American exports. China was third, behind Mexico.

“My clients who are selling into Canada are doing well,” says Kurek at RSM McGladrey. “Canada can be a good first step for manufacturers wanting to expand their export businesses.

“Exporters in general are recovering faster,” she says. “And if not exporting, those that are selling to customers with global markets are doing better. They have got to be looking for new avenues for their products to do well now.”

The View From the Shop Floor: Optimistic

True enough, but some are doing well by keeping a tough eye on costs, riding the sluggish momentum of the economy and having the good fortune to live in the right place. Certified Steel, a service center in Hamilton, New Jersey, remains tied to commercial construction and real estate, for example.

“We made money last year and will again this year,” says Dante Germano, chief financial officer at Certified. “It was mostly on price increases though, not volume.” He says that real estate problems such as the huge excess inventories and vacancy rates in places like Las Vegas and Florida are a lesser problem in his area. That is relatively good news as Certified looks at the next several years. “We have a real estate development division,” he explains. “We don't have the giant overbuilding and huge vacancy rates of other places. So we will recover more quickly.”

“Business has certainly recovered and then some,” says J.J. Fischer, president of Fischer Tool and Die in Temperance, Michigan. “And the outlook for the year and beyond is very positive. We are just completing a 35,000-square-foot doubling of our manufacturing here in Temperance. We have loyal, and now broader-based customers. Some are on the automotive side, but we've also branched out so they are coming from our small engine side and our energy, oil and gas side as well.”

The steady uptick in oil and gas prices, which aggravates consumers at the pump and hurts so many transport-based businesses, allows the folks at Fischer to expand operations into new business lines and geographic areas.

“Our energy business is directly correlated to the price of a barrel,” says Fischer. “When oil is in the $60 to $80 range, our potential is stronger.” Brent Crude, a significant oil contract, hit $100 a barrel earlier this year. “Some of our competitors did not survive the downturn, so this puts us in a fabulous position to take on bigger programs than we previously had,” Fischer says.

The company has been hiring, including 24 new employees at its Tennessee plant, and a dozen or so workers at its Michigan facility in 2010. “That makes 140 total in both plants. And we are still hiring,” Fischer says.

There is also oil and gas action, and a lot of it, to be had as well, no surprise, in Texas. “Business is good, across the board there is definitely an increase in demand,” says Ryan Letz, vice president and co-owner of Willbanks Metals Inc. in Ft. Worth. “We have a lot of energy related customers that are now doing extra drilling. There are some solar jobs, mostly government funded. But any time oil is over $80, on the drilling side, we do well.

“I expect oil to be at $110 a barrel this summer,” says Letz, and you can almost hear him smiling. “We love it, but everyone else gets hammered.”

With unrest in the Middle East growing, energy prices will continue to be volatile to the higher side. There are plenty of signs of life outside the oil patch and its vendors that also are longer-term positives for the economy. Technology spending, from telecom equipment to computer software, is expected to increase slightly more than 5% this year, says market research from Gartner Inc. And a Wall Street Journal analysis of Standard & Poor's 500 companies at the beginning of the year found companies packed with cash, relatively debt free and beginning to expand and spend again. Corning, Cummins and General Electric, among others, say they are planning to hire and expand capacity this year. The Journal looked at corporate cash, debt and profits at the end of 2010's third quarter. It found that “cash held by 419 companies in the Standard &Poor's 500 list was up 49% from three years ago — before the start of the recession — while total debt was up a more modest 14% — and total corporate profits rose 26% from a year earlier.”

The View From Other Sectors: Not So Rosy

Certainly the consumer spending numbers, reflecting as much as 70% of what drives the economy, are problematic. Most projections see steady, slow growth. Gallup measures what it calls self-reported consumer spending and found it down sharply in January from an understandable December holiday high. But January also is traditionally a big sale month, so it was a bit disconcerting to see that “consumer spending in stores, restaurants, gas stations and online averaged $55 per day in the week ending Jan. 9 — down as expected from the $75 average for the month of December, but also well below the $68 average for the same week in 2010.” The Conference Board is slightly more illuminating, noting that the real growth is among those of us with money, or at least those with annual incomes of $50,000 and above. Stores like Nordstrom and Neiman Marcus have been reporting the bigger gains. For lower-income households, with food and fuel prices rising, the outlook is not so jolly.

The Elephants in the Room

After all, unemployment had been at or near 9% for 20 consecutive months in March and is expected to continue in that range for the rest of the year. Yes, it seems to be improving slightly. But the Bureau of Labor Statistics numbers remain sobering. In January, 8.5 million Americans were out of work, nearly half a million fewer than the month before. But that did not include another 6.2 million who have been out of work for more than 27 weeks. Nor did it include the 2.8 million so-called “discouraged” unemployed who did not even look for work in the four weeks before the Bureau's count. And it also did not include 8.4 million who are working part time “involuntarily,” as the Bureau puts it, because they cannot find full-time jobs. The total is 17.5 million out of work and another 8.4 million working only partially; nearly 26 million Americans with partial or no wages.

For large numbers of them, things will not get better. “We have returned to prerecession levels of production with millions of fewer workers,” says Michael J. Hicks, director of the Bureau of Business Research at Indiana's Ball State University. “With few exceptions, most of the laid off workers are in manufacturing and the industrial Midwest, and they have no future employment prospects that are better than ones they've left.” That means that if they do find work again, they will almost certainly be earning less — estimates run from 20% to 40% less — than they were.

Worse than that, Hicks explains, “the average age of these workers is older, which puts them in a group that is less mobile. If you are in your 60s in the Midwest and have lost your job, you are not going to go to Alabama for a new one. Chances are you can't, even if you wanted to, because you can't sell your house. And the longer they remain unemployed, the less qualified they are for new work and the less their job prospects are, and the lower become the expected wages they would get.”

And this, Hicks says is not the only major structural drag on putting people back to work. He and others who study the job market say, in fact, that we will likely not return to prerecession low levels of 4.7% unemployment. They are looking for a “new normal,” as he puts it, of between 6% and 7% unemployment. At present job replacement rates, “We will get a lot of those jobs back,” says Strauss at the Chicago Fed, “but it may take seven or eight years.”

Back of the Class

Hicks says the “new normal” also includes extremely low job prospects for a younger generation that either only finished high school, or dropped out. “The job growth we are seeing is in health care, financial services and other sectors heavily dominated by four-year and advanced degrees,” he says. “A high school diploma today is pretty much evidence that you cannot read at an acceptable level. Americans with a high school diploma now represent the highest investment in education with the lowest return on the globe. These are kids who got $100,000 worth of education over 13 years, and will be lucky to get jobs paying $8 to $10 an hour. We are looking at the need for real education reform in this country to improve our employment picture.”

There is a growing and persuasive consensus, in fact, that the deteriorated U.S. education system is now our most serious obstacle to long-term prosperity and competitiveness.

In the middle of last year, Paul Otellini, president and CEO of Intel Corporation, told the Technology Policy Institute's Aspen Forum, “We are not taking the right steps as a nation to ensure that our economy is on a long-term trajectory of growth and leadership. The United States now faces a world with much tougher competitors. Many of them are accelerating their investment in the future faster than we are. Unless government and business take firm actions to improve education, create a culture of investment and job creation in this country, the next Intel or the next big thing will not be invented here.”

At one time, Otellini says, the United States had the best students in math, science and engineering, studying and working at “research centers without peer.” We seemed a generation ahead of the rest of the world in information technology. Now, he says, competitors have caught up. The United States, he says, has dropped to 12th among the nations for people aged 25 to 34 who have college degrees.

Otellini is worth listening to because his worries match those of the savviest business, academic and consulting research that examines major threats to America's competitiveness.

Consider, for example, the observations and conclusions of a prestigious report last year titled Rising Above the Gathering Storm, Revisited: Rapidly Approaching Category 5. This was an update of a report done five years ago to assess the long-term competitiveness of the country. The report was prepared by a group of 20 distinguished Americans, including then-current or former corporate CEOs, university presidents, scientists, including three Nobel laureates, philanthropists, former government officials and education leaders. Norman R. Augustine, retired CEO of Lockheed Martin and former undersecretary of the Army, chaired the committee in cooperation with the presidents of the National Academies of Sciences, Engineering, and the Institute of Medicine. Their conclusions five years ago sound eerily like Paul Otellini's just last year: “Market forces are already at work moving jobs to countries with less costly, often better-educated and highly motivated work forces.”

The 2010 update found that “overall, the United States' long-term competitiveness outlook (read “jobs”) has further deteriorated since the publication of the Gathering Storm report.” It describes a country that over the last five years has neglected its education system at its extreme peril. “In the United States, six million more youths dropped out of high school to join a cadre of similarly situated youths—over half of whom under 25 years of age are currently without jobs. During the above-mentioned interval, another $2 trillion was spent on K-12 public education while K-12 students remained mired near the bottom of the developed-world class. . China continued to graduate more English-trained engineers than the United States. Similarly, the number of first university degrees received in the natural sciences and engineering in China increased at a rate of 42% per year whereas the production of such degrees in the United States has increased just 3% per year—with part of the increase attributable to growth in the number of non-citizen students receiving degrees.”

Equally disturbing, the report says, “as a result of the recent financial reversal many U.S. universities are in greater jeopardy than at any time in nearly a century. As tax revenues have declined, state support of public higher education has been curtailed — in some cases severely.”

 “Perhaps the most disconcerting assessment,” the report says, “comes from a United States Conference of State Legislatures report: Transforming Higher Education, which concludes, 'The American higher education system (overall) is no longer the best in the world. Other countries outrank and outperform us.'”

And the Baby Elephant: Housing

Unless you live in Beverly Hills or Manhattan, home prices are bottoming out or continue to fall across the United States. Too few buyers are chasing too many homes, and though foreclosures have slowed, they continue. Mortgage applications are at a 15-year low. Buyers need excellent credit to even get through a bank's doors. The National Association of Realtors says sales grew slightly toward the end of last year, but were still an average 20% or so below the previous year. This short-term situation is bound to improve slowly over the next few years. With prices at the bottom of the cliff, sales will increase. But it is unlikely that banks will return any time soon to the bad old days of throwing mortgages at any warm body that appears.

In addition, it is not at all clear that the construction industry has yet understood another important shift in the housing sector. “We are under investing relative to trends in housing right now,” says Strauss. “There is a real question whether future households will want to be home owners. And if the answer is yes, we will certainly see a demand for more modest houses. Consumers, having seen home prices fall by 25%, will see a house as a place to live and not as an investment.”

Strauss says this situation will lead, in all likelihood, to improvement in multifamily housing. But slowly.

“Until we get this inventory of homes off the market, construction is going to have a hard time,” says Kurek at RSM McGladrey. “The construction industry is starting to move forward and build homes. It was absolutely dead last year, but now we are seeing companies with contracts with rental home buildings and some improvement in plumbing and electrical products.”

Another Growth Engine

So the turtle will keep galloping. But it will continue to do so primarily because of people like J.J. Fischer and Ryan Letz and Dante Germano — people who do their jobs with persistence, imagination and regard for the people who work with them and for them. If we are going to have a “new normal” economy that includes predictable growth, it will depend on businesses that are adaptable and flexible and improving continuously.

“The big thing we are seeing in manufacturing is innovation,” says Kurek. “Ninety five percent of the companies that are growing are doing something that extends them, from Six Sigma and lean manufacturing to new product and market development. The organizations that get it, those that embed it in their culture and take it to the next level, will be fine.”

“Twenty four years ago, when this company was founded, everything we worked on could be carried around in someone's hands,” says Fischer at Fischer Tool and Die. “Now we have 40- and 50-ton cranes. We modified our business model to larger die cast tooling and machining for the energy business. We do a lot of cross training so a single employee can do different things and work on
different machines.

“We need to help our customers be more competitive,” Fischer says. “We are taking weeks and days out of our lead times. We are cutting 20, 30 and 40% of machining times and processes and product delivery. We have to.”

At Willbanks Metals, Letz is making money, expanding and finding ways to nurture good workers at the same time. “We always pay above the market because we don't like to rehire,” he says. And when his health care premiums began climbing, Letz began making a conscious effort to improve his employees' health. Among other steps, he hired a full-time dietitian and may hire a chef to feed his employees healthier food. Fruits and vegetables are now provided in break areas. “We have pulled Coke from our vending machines and substituted it with water and juices,” says Letz. “It doesn't just reduce our health insurance utilization, it's the right thing to do to get them healthy and keep them that way.”

Still, others like Germano at Certified Steel in New Jersey, see structural and psychological positives in this new economy. “Corporate profits are up and that's a sign that we are in the upswing and that eventually there will be expansion. I am big on perception. And I think people are becoming more positive. I see more and more planning for projects in real estate and construction. People are dwelling less on how bad it is and thinking differently, and that feeds on itself. I think things are looking good.”

Certainly, things are a lot better than they were. And for the next one to three to maybe five years, things are looking good, if good means steady but generally unspectacular growth. Beyond that, the country will need to address its chronic unemployment and increasingly inadequate education systems if we are to remain a global economic, political and intellectual power.