Durable goods orders plummeted 4% in June after falling a downwardly revised 2.8% in May. An outsized drop (58.8%) in aircraft orders, which have long lead times and are extremely volatile, exacerbated the declines. The only sectors to show strength were those tied to the consumer: motor vehicles and parts and electronic equipment including appliances. Core durable goods, which strip out defense and aircraft orders and more closely track overall business investment plans, edged up a negligible 0.2% in June; that failed to offset the weakness we saw in May and April.
Core durable goods shipments were still in the red for the month, which confirms that businesses remain hesitant to invest. Some of the weakness can be traced to lower oil prices and the energy sector, which had been the primary driver of business investment when oil prices were high. The weakness in investment relative to profits and cash flow during this cycle raises concerns about our competitiveness and productivity growth going forward.
Moreover, the breakdown we are witnessing appears to have begun prior to the financial crisis. The housing boom diverted funds from more productive investment.
Members of the Federal Reserve have begun to flag the lackluster investment have seen; they are clearly troubled by the role it could play in holding back our growth potential. We have seen firms use their cash to fund stock repurchases and dividends. The result boosts current equity prices at the expense of equity valuations down the road.
Bottom Line: The consumer has stepped up to carry the economy while firms cut back on their spending. This is a conundrum for the Federal Open Market Committee (FOMC), whose members see the need to normalize interest rates at a time when “normal” seems no longer to exist. Look for the FOMC to upgrade its assessment of the economy in the statement today, but temper those comments with concerns about the business sector, which remains hesitant to place a bet on the future.
Does this mean that the Fed should raise rates or hold off longer? The data on the labor market and inflation to date largely meet the Fed’s criteria to raise rates. We have seen, however, that data are not enough. FOMC members are also assessing risks, which remain to the downside. Doves will want to see more broad-based gains in business as well as consumer spending before raising rates again. Rate hikes in the context of additional easing abroad could place more upward pressure on the dollar and further injure the manufacturing sector. That will likely keep the Fed on the sidelines until the turn of the year.