How Global Excess Capacity Can Determine Market Cycles

Using Capacity Utilization in Your Due Diligence

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There are many different tools that international investors can use to analyze economies around the world, but excess capacity is a valuable leading indicator that often goes underappreciated. By measuring how much is being produced and sold, investors can get a glimpse into future inflationary pressures that can be helpful when investing in the equity and bond markets that are heavily influenced by interest rate dynamics.

What Is Excess Capacity?

Excess capacity occurs when actual production is less than what is optimal for the economy. For example, the manufacturing sector may see strong demand when an economy is growing, but when demand starts to dry up, there can be a painful adjustment process. Manufacturing companies cannot immediately fire employees, shift capital investments, or cope with slower demand, which leaves them with excess capacity—or too much overhead.

The most common way to measure excess capacity in an economy is by looking at capacity utilization, which measures the extent to which a country is uses its installed productive capacity. While the metric can be calculated in many different ways, the capacity utilization rate is the ratio of actual output to potential output. The indicator is often surveyed at the plant level and presented as an average percentage rate by industry and economy.

If the market is growing, capacity utilization will rise as factories produce as much as possible with existing resources. If demand weakens, capacity utilization will fall as factories reduce production. Capacity utilization is also used as an indicator of production efficiency and chronic excess capacity is common in many capitalist countries. Uneven buying power means that about 20 percent of output isn’t produced and sold despite its potential.

Determining Market Cycles

Most investors watch capacity utilization for signs of inflationary pressure, since it’s directly related to supply and demand. In the United States, capacity utilization rates between 82 percent and 85 percent tend to lead to price inflation and lower utilization rates tend to lead to stagflation or deflation. These numbers tend to vary between country and international investors should compare historical capacity utilization to inflationary indicators.

Falling capacity utilization rates are better for bond yields since investors view strong utilization as a leading indicator of higher inflation. Higher inflation decreases bond prices and increases bond yields to compensate for higher interest rates. Stocks also tend to rise in response to stronger capacity utilization due to the possibility of higher profits for producers, as well as the prospect of higher inflation in the overall economy—which tends to boost stock valuations.

During an economic upswing, excess capacity and higher utilization rates can help support greater sales, but when the tides turn, the negative effects can be greatly amplified. Most investors take a long view when looking at the impact of capacity utilization during an economic decline. If the economy has stalled for just a quarter or half a year, reduced capital expenditures is less likely to result in future pricing power or substantially less revenue.

Looking at Specific Industries

Excess capacity and capacity utilization are great tools for analyzing a country’s economic health, but the same tools can be used to dive into specific sectors and companies. While many international investors prefer exchange-traded funds (ETFs) or mutual funds, those that invest in American Depositary Receipts (ADRs) or foreign stocks may want to consider using excess capacity metrics like capacity utilization in their due diligence.

The best past example of how capacity utilization can impact individual companies is the crude oil industry. The advent of hydraulic fracturing technologies led to higher capital expenditures that eventually created a supply glut. Investors in the most reputable companies were still impacted by these dynamics and suffered from lower prices in the long run. Capacity utilization could have helped investors exit these problematic companies earlier.

Many investors look at capital expenditures versus depreciation rates to see where investments are being made and where capacity could be constrained moving forward. These techniques work best in commoditized markets, such as energy or semiconductors. Value investors seek out industries where stocks are oversold, capacity utilization is declining, and product demand is nearing the low end of historical averages or cycles.