Tuesday, August 20, 2013

Capital goods are the first derivative of consumer goods

When analyzing product demand, a distinction should be made between consumption goods,  like toys and clothes and capital goods, like machines and trucks.  Capital goods can be defined as goods that are used to manufacture consumption goods.  Demand for capital goods can again be split in demand for growth and demand for replacement. Demand for replacement of Capital Goods is not the issue here: we focus on Demand for Growth. Demand for growth means the production capacity needs expansion.  If the production capacity grows at a constant rate, growth-demand for capital goods is stable. If production capacity is constant, growth-demand of capital goods is zero. If there is overcapacity, growth-demand of capital goods is negative, and because you cannot return machinery, it is zero. This relation is equivalent to the mathematical expression that growth-demand for capital goods is “the first derivative”  of demand for consumption goods. This 4th Law of Flostock may seem trivial or overly mathematical, but it has important implications.

Growth demand for capital goods goes through a peak when the demand for consumer goods merely goes through its inflection point (i.e. the point where the curve goes from stronger and stronger growth to weaker and weaker growth). Since the inflection point is much earlier in the economic cycle than the peak of consumer goods, capital goods peak much earlier. So all companies that produce capital goods go through an earlier cycle than all companies that produce consumer goods.

Labor in this comparison is also a Capital Good and there is supply of labor (hiring) for Growth and supply of labor (hiring) for Replacement. When consumer goods go through their deflection point, supply of labor for growth goes through its peak and starts going down. Supply of labor for replacement continues to take place untill the consumer goods go through their peak, then becomes negative and people are fired. Temporary labor suppliers like Randstad always remind us that they are early-cyclic, therefore they are a leading indicator. This is true, but they are only a good indicator because it is easier to see a peak than to see an inflection point. For the rest temp labor is just the first derivative of the main cycle. 

China is another implication of the 4th law : China has grown strongly over the last 25 years, but mainly in capital goods for the own industry and export of consumer goods. When the export growth slows down (so it is still growing, only slower), Chinese production of capital goods will decline.  If China does not manage to get its population to increase their consumption fast, and it is unlikely that they will, the Chinese industry will decline. This has already started. If the export of consumer goods will reach its peak, so when export markets become saturated, growth demand for capital products will be zero (or negative). In addition, the Chinese industry is young, so there is not yet much demand for replacement. This means that both types of capital goods production will stop.

On the other hand (because I don't want to stop with the word 'stop'), if demand for consumer products starts growing again, as it may be doing in the USA, Japan and Europe, growth demand for capital goods will once again see a strong growth indeed.