Capacity utilization ticks up in July, but inflation remains low
Must-know: Key industrial data for July (Part 1 of 5)
Higher utilization and inflation rates
Most people don’t think industrial data affects office real estate investment trusts (or REITs). However, it does influence the top-line growth of commercial REITs like SL Green Realty Corporation (SLG). Higher utilization rates can be an inflation driver because more expensive capacity is used. This can push rent higher.
Capacity utilization is a bellwether of economic activity
Capacity utilization is a good top-down macroeconomic indicator that helps forecast the labor market, final demand, consumption, and inflation. While manufacturing is no longer the primary driver of the U.S. economy, it still influences the economy to a large degree—particularly for unskilled workers.
Recently, U.S. manufacturing has been undergoing a bit of a renaissance because of cheap energy prices. There’s still a difference between wages overseas and wages here, but low natural gas prices are offsetting that difference. Also, as wages rise overseas, the cheap labor arbitrage—taking advantage of lower wages—is fading away. The Fukushima nuclear disaster also showed how long supply chains are vulnerable.
An increase in capacity utilization generally signals an increase in employment and capital spending. Lower-skilled workers have struggled since the financial crisis. It dampened demand and consumption. Things are finally starting to improve. Construction jobs are rebounding. More companies are starting to move toward onshore production. Increased capital spending is also a big economic driver. For a long time, corporations have been in a maintenance mode towards capital spending.
Capacity utilization rates are approaching long-term historical averages
Capacity utilization was 79.2% in July—slightly higher than June’s 79.1%. Capacity utilization has increased steadily since the economy bottomed in 2009. Over the past year, it has increased 130 basis points.
From 1972 to 2012, capacity utilization averaged 80.2%. It was highest in the early 1970s, peaking at around 89%. It bottomed at 66.9% in 2009. This suggests there’s a lot of room for production to expand before we start feeling inflation pressures. High capacity utilization levels in the 1970s were a big cause of inflation.
Impact on commercial REITs
Industrial production and capacity utilization are numbers that get a lot of focus from the Fed. These figures not only help forecast economic activity, but they also impact inflation. Once the Fed believes inflation is too low, the outlook will change. The Fed certainly will be happy to see capacity utilization approaching long-term historical averages.
While inflation is completely under control, the Fed will look at capacity utilization when forecasting future inflation. Right now, the Fed is worried about a weak labor market and inflation that is too low—not too high.
Interest rates are an important input for the commercial REIT sector. They tend to be leveraged. Interest rates are traded based on their dividend yields.
Increases in interest rates may not be welcome news for office REITs like Brookfield Office Properties (BPO), SL Green (SLG), Vornado Realty Trust (VNO), Kilroy Realty Corporation (KRC), and Highwoods Property (HIW). However, the reason for the increase is good news—higher capacity utilization signals stronger economic growth. This is an important driver of rental income and vacancy rates.
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