Electrical manufacturers and electrical distributors are enjoying a continuation of the strong growth that began in 2004 after a three-year downturn. As the electrical market winds up 2006's third-quarter, industry sales are still robust but not as strong as the beginning of the year. The tally for the first half of 2006 shows overall industry gains of approximately 9 percent, compared with the performance tallied in first-half 2005.
Industry growth is now led by double-digit gains in the distributor-served industrial segment. In the first half of 2006, the distributor-served industrial market surged ahead by approximately 12 percent over the same period in 2005. At the same time, the distributor-served contractor market was up close to 10 percent. Meanwhile, the combined utility and institutional markets are up better than 7.5 percent.
When DISC Corp., Orange, Conn., pulls all the numbers together, I expect to see a change of pace in the second half of 2006. I am not suggesting a change in direction, only a change in the rate of growth as the industry moves through this year and into 2007.
Some observers in the electrical wholesaling industry think inflationary pressures could curtail industry growth because rising prices reduce demand. That's not the case in the current scenario. Rising commodity prices aren't dampening demand for electrical supplies because the demand is not directly for electrical products. It's for where these products are being installed — shopping centers and stores, health-care facilities and commercial buildings, manufacturing plants and other commercial/industrial construction projects. The demand for electrical products in these applications is currently very strong. Because good substitutes don't exist for the electrical products sold by distributors in the face of strength in the business sector of the economy, rising commodity prices are sticking and being passed on to the end customer.
The only force restraining rising prices at the distributor level is competition among electrical distributors. But because the prices for some of these metals are rising so rapidly and these metals are important components for a number of major commodity products in the electrical market, distributors are virtually compelled to pass along these price increases to end users. Shaving prices for some products to gain share doesn't make a lot of sense for electrical distributors because of the relatively strong final demand in some sectors. Moreover, I haven't heard any distributors complaining about the high cost of products from their vendors simply because they can easily pass along the price increases to their customers.
It's important to recognize that not all commodities in the overall distributor price index are increasing anywhere near the magnitude of copper and zinc, with copper up approximately 75 percent and zinc up more than 100 percent. The overall price index of distributor products increased nearly 8.5 percent in the first quarter of 2006 after a 10-percent gain in the fourth quarter of 2005.
Meanwhile, rising prices for commodities will eventually run their course as the Federal Reserve Board applies the brakes. I expect copper and zinc prices to fall in 2007. The biggest threat to the economic recovery is if the Federal Reserve Board's actions are too vigorous and too extensive. In July, the Fed took a welcome breather from its string of interest-rate hikes, but I believe another increase may be in store at the Fed's meeting this month.
If the Fed decides to continue increasing interest rates, it will, of course, dampen the overall economic recovery and take industry growth with it. There is no such thing as “fine tuning” the economy. The operational word here is “fine.” The Fed could easily err on the side of “too many hikes for too long.”
But we are not yet near the tipping point — not this year and not until the second half of next year. The cycle most important to electrical distributors — nonresidential construction — tends to lag the overall economic cycle. So while the overall economic expansion may be slowing, sales for electrical distributors are still robust. The downturn in the residential sector is apparent at this point, but nonresidential construction is just now beginning to join the overall economic recovery.
Residential construction is very important to the electrical wholesaling industry, but let's put it into perspective in relation to other key market drivers. In 2003, residential construction spending in deflated dollars was up almost 8.5 percent and housing starts were up 8.4 percent from the 2002 level. At the same time, the electrical industry's sales in current dollars were down 3.5 percent, and in deflated dollars were down more than 8 percent. The drag on the electrical industry's sales was nonresidential construction being down more than 4 percent in deflated dollars, while investment in important components of machinery and equipment was flat.
Although residential construction is starting to decline, distributor sales are still growing. If DISC is to hit its forecast of electrical industry's sales rising close to 6.5 percent in 2007, then nonresidential construction needs to grow between 6.5 percent and 7 percent. This forecast takes into account my estimate that 2007 residential construction spending will be down 8 percent and that housing starts will be off 9 percent in 2007 from this year's levels.
Even though residential construction is currently weakening, other indicators show strength. Industrial production in July was up 4.9 percent. Output of business equipment was up 12.2 percent, and output of construction materials was up 6 percent. These are strong increases, considering they measure pure physical volume. Moreover, capacity of utilization in manufacturing was at 81 percent, compared with 78.6 percent a year ago.
The current overall economic expansion is showing signs of aging, mainly due to the housing market and the consumer sector. But the sector of the economy most important to electrical distributors and vendors — nonresidential construction — is still growing strong. The 15 percent to 20 percent and higher growth rates experienced by some distributors and vendors is not explained by the aggregate indicators driving the electrical distribution industry.
The overall price level is expected to be up around 6 percent, nonresidential construction is expected to be up 7.5 percent, and investment in equipment is expected to increase 9 percent. Because of the mid-range increases on a national basis of these key market drivers, it's tough to see how overall industry sales can advance 15 percent or more this year. Increases of this magnitude are explained by sharp gains in some metals prices and by very strong increases in some sub-segments, but not the major segments.
Here's the bottom line: I expect electrical distributors to increase their sales by close to 9 percent this year and add another 6 percent next year. The following year, 2008, is another subject altogether.
Herm Isenstein is president of DISC Corp., Orange, Conn., a provider of market forecast data for the electrical industry. Contact Isenstein at [email protected] or at (203) 799-3673.