A decline in manufacturing causes industrial production to fall

Industrial production is an important indicator of economic activity

Industrial production 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. U.S. manufacturing has been undergoing a bit of a renaissance lately due to cheap energy prices. While there’s still a difference between wages overseas and wages here, 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.

Increases in industrial production generally signal increases in employment. Lower-skilled workers have struggled since the financial crisis, which has dampened aggregate demand and consumption. Things are finally starting to improve as construction jobs rebound and more companies start to move towards onshore production.

A drop in January after a strong December

After an increase in December, when production rose 0.3%, industrial production decreased 0.3% in January. Construction fell the most, undoubtedly driven by poor weather, but all major market groups fell as well. The only industry group that rose was the utility sector, which was again weather-driven. Up until January, industrial production and manufacturing production had been accelerating, so it is premature to draw any major conclusions from one disappointing report.

Implications for homebuilders

Homebuilders are highly sensitive to the economy. Any sort of slowdown can leave them with excess inventory, and if home prices don’t rise, builders are stuck with depreciating inventory that costs them to maintain and finance. They will look at the production numbers and conclude that the economy is still expanding moderately. If anything, increasing production portends an increase in hiring, which is definitely bullish (positive) for the economy.

Recovery in the homebuilding market will be driven primarily by first-time homebuyers. They’re still struggling to find jobs, and until we see employment growth back to normalcy, it may be difficult to see the 1.5 million housing starts that are typical of an expansion. We recently broke 1 million, which historically has been a very depressed level.

Homebuilders have noted that the increases in interest rates and home prices have begun to hit demand, particularly at the lower price points. This is the first-time homebuyer market. Although the cost of renting is way higher than the cost of owning, the first-time homebuyer is still not comfortable enough with the labor market to purchase a home. Increases in manufacturing employment will go a long way toward settling this problem. Specific homebuilder stocks that will be positively affected by changes in consumer sentiment include D.R. Horton (DHI), Lennar (LEN), PulteGroup (PHM), and Toll Brothers (TOL). An alternate way to invest in the sector would be via the S&P SPDR Homebuilder ETF (XHB).