The Butterfly Effect (adapted from Wikipedia): refers to the idea that a butterfly's wings might create tiny changes in the atmosphere that may ultimately alter the path of a tornado, say from an open corn field to the center of a crowded urban populace; or delay, accelerate or even prevent the occurrence of a tornado in a certain location. The flapping wing represents a small change in the initial condition of the system, which causes a chain of (oft unforeseen) events leading to large-scale alterations of said events. Had the butterfly not flapped its wings, the trajectory of the system might have been vastly different. Of course the butterfly cannot literally cause a tornado. The kinetic energy in a tornado is enormously larger than the energy in the turbulence of a butterfly. The kinetic energy of a tornado is ultimately provided by the sun and the butterfly can only influence certain details of weather events in a chaotic (and upnredictable) manner.

The moral to the story: Regulators should be quite cautious when playing with, capturing, aiding or killing butterflies. The resultant tornado could be devastating. Special "shout out" to SEC Commissioner Cox for banning short selling and guaranteeing a literal crash in financial stocks, Mr. Paulson and Bernanke for saving Bear Stearns and AIG but allowing Lehman Brothers to fail, central bankers worldwide led by Mr. Greenspan for keeping rates very low in an attempt to prevent a natural correction (thus causing an unnaturally violent correction ~ butterflies), and a whole host of other government butterfly afficionados ... Note: I realize that the role of Central Banker is not an easy one, but we must be cognizant of our errors if we wish not to repeat them!

Before we go on, I would like to mark our current location in the Asset Securitization series. I consider this a very useful roadmap that clearly illustrates how we got to where we are today. It is so much more than a subprime or credit crisis...

Listen closely and you can you hear the dominos falling...

Industrial/ manufacturing companies in for hard times

The severity of the credit crisis, which has brought down Wall Street stalwarts such as Lehman Brothers and Merrill Lynch (MER), is likely to be felt for a long time. The repercussions of the ongoing credit crunch and confidence crisis are more than likely to spill over to the real sector and impact industrial and manufacturing companies. The International Monetary Fund (IMF) downgraded its global GDP estimate for 2008 to 4.1% from 4.9% due to the credit crisis as well as worsening macroeconomic conditions such as rising inflation and unemployment rate.

As the credit situation deteriorates and economies slip into a recessionary phase, industrial and manufacturing companies may find themselves in distress. The industrial and commercial sectors face severe problems in the form of rising input costs, flagging consumer demand and confidence, and increasing cost of funding due to deteriorating credit conditions. Industrial/ manufacturing companies that depend heavily on debt are in for tougher times as credit becomes tight. Furthermore, as demand declines, they would find it difficult to service their loans.

The one-year-old credit crisis has spread across the globe, impacting banks/ financial institutions in Europe, Asia, and Japan. This in turn has affected credit growth in these regions. Moreover, the rising food and energy inflation is denting the growth prospects of these economies. Rising prices of essential commodities have inflated input costs across the globe, sending inflation north. The global food shortage is also contributing to the upward spiral in inflation. To curb the rising inflation, central banks are trying to suck excess liquidity by increasing the lending rates to lower demand. As a result, demand in the industrial sector is declining. This declining demand is promising to dampen inflation, but it is highly unlikely the inflation dampening factor will even come close to offsetting the damage done by the decreased demand. A mild global depression is imminent, with an absolutely best case scenario of a strong global recession.

The Global Macro Landscape

The United States of America

The industrial sector is beginning to show signs of a slowdown. Higher commodity prices, increased borrowing costs, decreasing sales and decline in consumer confidence have weighed on industrial companies.

The slowdown triggered by rising commodity prices has led to an increase in the cost of production. In the US, input prices of all commodities surged 19.1%, while those of industrial commodities increased 19.7% from January to July 2008. Rising input costs have far-reaching implications on industrial companies, which are now witnessing a decline in sales. The US Industrial Production Index has plunged over the last six months, falling 2.1% y-o-y in July 2008. Higher input costs pushed prices upward, reducing demand.

Currently, the US is witnessing a slowdown in retail sales as demand for goods is decreasing. Retail sales declined 0.3% m-o-m in August 2008. Furthermore, the unemployment rate in the US reached 6.1% in August 2008, the highest in the last five years. This factor is also affecting demand for industrial products. The rising cost of borrowing due to the decreasing availability of credit and hike in interest rates has tempered the growth prospects of industrial companies.

Source: Government Website

In the US, the installed industrial production capacity increased to 140% (Base: 2002) in July 2008 from 137.9% in August 2007. However, the decline in industrial production lowered capacity utilization to 79.9% from 81.2% over the same period. The decrease in capacity utilization indicates a slowdown in growth in industrial companies.

Source: Government Website

The European region

Rising inflation, slowdown in credit growth following the hike in interest rates, higher unemployment rate, and decreased industrial production have created a recessionary environment in several parts of Europe. The European Union (EU) GDP contracted 0.2% q-o-q in 2Q 08. Moreover, the EU lowered its GDP forecast for 2008 to 1.3% in September from 1.7% in April. The slowdown in Europe is likely to be led by major countries such as Germany, France, and Italy - these economies contracted 0.5%, 0.3%, and 0.3%, respectively, in 2Q 08.

According to the European Commission, recession would strike Germany, the UK, and Spain in 2H 08. The downward revision in GDP forecast was due to the global financial crisis, which is likely to impact industrial companies. Germany's GDP decreased 0.5% q-o-q in 2Q 08 (2% annualized) and is expected to fall 0.2% in 3Q 08. Consequently, the nation could slip into a recession. Orders for German engineering goods declined 5% y-o-y, while foreign orders fell 7% y-o-y in June 2008. With a few economies in Europe contracting and others growing at a slower pace, the EU GDP, which grew 2.6% in 2007, is likely to decline further.

Source: EU

The increase in commodity prices and interest rates has pushed inflation higher. On sequential basis, inflation in the Euro area rose from 3.3% in 1Q 08 to 3.8% in 2Q 08. The rise in input cost with inflation moving north has negatively impacted the margins of companies by increasing the cost of production. The EU raised its inflation forecast for 2008 to 3.6% in September from 3.1% in April. If inflation continues to remain high, the margins of manufacturing companies could shrink significantly. In addition, the decline in consumer demand-household spending fell 0.2% y-o-y in 2Q 08-is forcing companies to lower production.

Source: EU

The rise in unemployment rate in Europe to 7.3% in July 2008 from 7.2% in January 2008 has further weakened demand. Any further rise in unemployment would depress consumer demand even more, thereby dampening the growth prospects of manufacturing companies.

The decline in growth in industrial production in Europe since the start of the year is reflected in the movement of the region's industrial production index. In May 2008, the index declined 0.9% y-o-y, indicating tougher times for industrial companies. Factory orders in Germany have decreased over the last eight months, falling 1.7% m-o-m in July. The Purchasing Managers Index (PMI) for new orders slipped to 44.6 in August 2008 from 48.6 in April 2008, signaling a decline in demand. Similar trends were seen in other European nations as well.

Source: Government Website

United Kingdom

Rising inflation levels have adversely affected manufacturing companies in the UK. The Total Production Industries Index plunged 1.9% y-o-y to 99.3 in July 2008 from 101.2 in July 2007. This drop indicates the output of industrial/ manufacturing companies is decreasing.

Source: Government Website

The increased cost of commodities has pushed the cost of production higher, adversely affecting industrial companies. Although commodity prices have cooled down to a certain degree, they continue to remain high on a y-o-y basis. The index for input cost of iron and steel rose 16.1% y-o-y in August 2008, while the index for input cost of non-ferrous metals declined 8.5% to 176.5 in August 2008 from a high of 193.3 in March 2008. However, the cost was still 4.0% higher on a y-o-y basis.

Japan

Japan, the second-largest economy in the world in terms of nominal GDP, registered a 3% decline in GDP growth in 2Q 08, higher than the provisional contraction of 2.4%. Corporate spending fell 0.5% y-o-y, while exports decreased 2.5% in 2Q 08. The decline in overall demand, in line with expectations, prompted several companies to downgrade their production forecast. Tokyo Electron Ltd, the largest manufacturer of semiconductor equipment in Japan, lowered its profit forecast for 2008 by 40%. Kubota Corp, the world's biggest manufacturer of mini excavators, also hinted at a reduction in output due to decreasing demand.

After cutting down production in the US, Toyota Motor Corporation (TM) (the world's second-largest carmaker) plans to downsize production facilities in the UK and Poland. Lower sales in Europe-down 2.7% in 1H 08-compelled the company to undertake production-cuts. In addition, the slowdown in growth is driving many companies to abandon or delay their capital expenditure plans. This trend could severely affect the financial position of these companies. Machinery orders, an indicator of capital spending, decreased for the second consecutive month. On m-o-m basis, orders declined 3.9% in July after falling 2.6% in May 2008.

The Index for Industrial Production continues to slowdown, decreasing 1.6% q-o-q in 2Q 08. Lower orders, downward revision in production forecast, and the tight credit environment are likely to impact the industrial/ manufacturing sector. Moreover, the unemployment rate has been rising, leading to a further decrease in demand. Responding to the lower demand, companies are cutting down production.

Source: Government Website

China

A decline in commodity prices has brought down inflation levels in China. Although inflation fell from a high level to a new 14-month low of 4.9% in August 2008, manufacturing companies continue to face problems; the higher cost of borrowing is exerting pressure on margins. With the decline in inflation, the financial health of industrial companies has suffered, as reflected by the consumer confidence index. It fell 2.3% y-o-y in July 2008, indicating the worsening credit environment in China. In August 2008, industrial production increased at what was the lowest growth rate (12.8% y-o-y) during the last six years. The decline in industrial production indicates a slowdown in the economy.

The Chinese Purchasing Managers Index (PMI) for manufacturing stood at 48.4 in August, the lowest level since 2005; it has plunged 3.6 points since June 2008. The PMI for output and new orders also plummeted in August 2008. The fall in the PMI reflects slower growth of manufacturing companies in China. GDP growth declined 10.4% y-o-y in 2Q 08 from 10.6% in 1Q 08. Despite the decrease in GDP and declining consumer confidence, optimism seemed to prevail-retail sales grew 23.3% y-o-y in July 2008.

Source: Government Website

India

India, one of the fastest growing emerging markets, has seen a spectacular growth in industrial production during the last few years. On a q-o-q basis, the production index fell sharply in 2Q 08. The sectoral mining index dove 20.7% q-o-q in 2Q 08. In addition, other sectoral production indices, such as manufacturing, electric, and general, fell 11.6%, 4.4%, and 11.7% q-o-q, respectively, in 2Q 08. However, the Index of Industrial Production (IIP) increased 1.2% y-o-y in June 2008.

The lower rise in IIP and higher inflation prompted the Prime Minister's Economic Advisory Council (EAC) to revise its GDP forecast for 2008-09 to 7.5% from 7.7%. A rise in the Wholesale Price Index (CPI) from a low of 3.07% in the week ended October 10, 2007, to a high of 12.63% in the week ended August 9, 2008, forced the Reserve Bank of India (RBI) and government to take preventive measures to curb inflation. The RBI raised the repo rate by 125 basis points to 9% and the cash reserve ratio (CRR) by 200 basis points to 9% in September 2008.

Although the hike in prime lending rates was successful in mopping excess liquidity, it impeded credit growth, which declined to 21.6% in 2007-08 from 27.9% in 2006-07. Credit growth is expected to stay at around 20% in 2008. Tightening of the monetary policy in the form of interest rate increases has significantly affected the manufacturing sector-it expanded 5.8% in 2Q 08 compared to 10.9% in 2Q 07 (down 510 basis points). The sector is likely to witness even slower growth, going forward, as inflation continued to remain above the 12% mark as of August 29, 2008. Under the October policy, the RBI and the government plan to raise key interest rates further to rein in inflation. If the interest rates are increased, the growth of industrial companies could further slow down as the cost of borrowing would rise.

Source: Government Website