with Walter Kemmsies
It has been five years since the 2007-2009 recession ended, but only in the last few months have aggregate macroeconomic and freight movement industry data series indicated that activity has generally returned to pre-recession levels. As capacity utilization rises, negotiating power should shift from buyers, as has been the case in the last seven years, to sellers. Buyers may end up disappointed as sellers renege on deals they agreed to when their competitors had a lot of spare capacity that gave buyers many alternatives and therefore the upper-hand in negotiations. In the case of freight movement, shippers should be careful about trying to compress their providers’ profit margins too much, because demand is building up.
A practical way to think of business cycles is that they have two modes:
- During periods when economic activity is expanding, business is conducted on a “cost-plus pricing” basis. Sellers figure out the cost of delivering a good or service, add their desired profit margin or return on investment demanded by providers of capital and the sum of the two is then the offered price on a take-it-or-leave-it basis.
When economic activity is contracting and/or during a prolonged recovery period, transactions are executed on a “price-minus return” basis. The buyer tells the seller what they are willing to pay and, after deducting the return demanded by providers of capital, whatever is left of the price is the budget available for sellers to cover the cost of delivering the goods or services.
Perhaps even before the recession officially began in December 2007, the economy had been stuck in a “price-minus return” mode. After seven years of this most people probably think that it will last forever, just like they did after the 2001 to 2007 world trade boom period during which cost-plus pricing prevailed. However, the world’s population is growing and, according to OECD economists, during the 2010-2030 period 4.5 to 5 billion people are expected to join the middle classes, a status only enjoyed by 1 billion people (mostly in Europe, North America, Japan and Australia/New Zealand) in 2010. If another 5 billion are to enjoy anything near the standard of living that the current 1 billion people in the middle class have then capacity utilization will eventually be pushed to the limit and cost-plus pricing should once again become standard procedure.
The time for cost-plus pricing to return is therefore probably a lot sooner than most expect as capacity utilization in the economy and in most segments of the freight movement industry continues to increase.
Macro level: the Federal Reserve publishes a monthly estimate of manufacturing capacity utilization. The index read 79.1 in May. To put this in context, the reading in 2007 prior to the recession was 80.5 percent; it declined to the upper 60s in 2009 and has been rising steadily since. The consensus forecast for the June level is 79.3 percent. On Wall Street, listed companies report earnings every quarter. In the last few quarters earnings have been rising on revenue growth as opposed to cost reduction. Non-farm payrolls in June were reported at $138.6 million, exceeding the peak $138.4 million-level set in January 2008. In the last 12 months, employment has grown on average by 1.7 percent per month and has been accelerating. More jobs mean more demand for goods and services.
Freight movement industry: Intermodal (containers and trailers) railcars reached 2.96 million in 2013, well above the 2.8 million-level of 2007 and 2012, according to the American Association of Railroads. In the first half of 2014 volumes are up almost 4 percent. However, non-intermodal railcar volumes, 3.4 million in 2013, are still well below the 2007-level of 3.9 million. This is mostly due to lower coal shipments. In 2013 U.S. ports handled 40.5 million TEUs, according to American Association of Port Authorities data, less than 1 percent below the 2007 peak. Year-to-date volumes are growing at an annualized 3-5 percent pace, which indicates that in 2014 the 2007 peak-level will have been exceeded. American Trucking Associations’ truck tonnage index exceeded its 117 peak-level in January 2008 and currently stands at 129.7, as it steadily climbs in line with macroeconomic data such as employment and industrial activity.
These statistics paint a picture of an economy that’s generally back to pre-recession levels of activity, with some segments reaching historically high levels of activity and others still recovering. Some activities like coal railcar shipments may not recover to previous peak levels given an increasingly negative attitude towards this fuel source. However, energy still needs to be produced and shipments of alternative fuel sources will be needed.
The global economic picture indicates that U.S. economic trends are reflected elsewhere. Europe is clearly past the worst point of its self-imposed financial crisis and the continental economy is on the mend. Economic activity in Japan has also been expanding. China is reporting stronger export growth recently. Eventually, these trends will drive up demand from the resource-exporting economies like Canada, Australia, Brazil, South Africa, Russia and India.
With all the turmoil that the deep-winter freeze created in terms of delayed shipments and shippers diverting cargo from West Coast ports due to concerns over possible longshore labor disruption, it is easy to lose focus on the overall macroeconomic and industry trends. These trends indicate that cost-plus pricing is close to making a comeback and buyers would be prudent to bear that in mind going forward.
Kemmsies is chief economist at Moffatt & Nichol, an infrastructure engineering firm. He can be reached at (212) 768-7454 or by email.
This commentary was published in the August 2014 issue of American Shipper.