Factory orders show strength - but so does inflation

Global factory orders are increasing, but so are manufacturers' costs, highlighting the race between demand and inflation that will determine the strength of the world's economic recovery.

At the moment, demand is winning, which helps explain why central banks in the developed countries are content to leave benchmark interest rates low to encourage economic growth. As long as orders hold up, manufacturers will be able to absorb higher commodity prices without boosting the costs of consumer goods.

Surveys of purchasing managers from a range of countries released Tuesday showed global manufacturing continued to gather strength in January, including in the United States, where the Institute of Supply Management's monthly index jumped to its highest since 2004.

Similar gauges of factory activity rose to a record in Britain and the Czech Republic and to a nine-month high in the euro region of 17 countries. Manufacturing increased in China, India and Brazil, among others, according to surveys by Markit Economics, a London-based research firm.

Stock prices soared as investors took the factory data as evidence that the global recovery is becoming entrenched, reducing the risk that the economy can be knocked seriously off track by political uncertainty in the Middle East or Europe's struggles with sovereign debt. The Dow Jones industrial average closed above 12,000 for the first time since June, 2008, and bond prices fell.

But the reports hinted at what is emerging as the biggest threat to the world economy: Inflation.

In the United States, the Tempe, Ariz.-based ISM's index of prices that factories pay for inputs surged almost 10 points to 81.5 in January, the highest since 2008.

Input-price inflation rose in all the countries Markit covers in Europe, rising to records in Germany, Italy, Spain and Austria. Reports by Chinese companies showed the overall cost of their inputs rose at the slowest pace in four months, "but remained considerable in the context of historical data," according to HSBC, which collaborates with Markit on the China survey. "As a result, firms continued to pass on higher costs to clients through increased output charges."

The way companies respond to higher input costs will determine greatly the strength of the global economic recovery.

If demand is strong, they will be able to absorb higher costs of doing business through higher sales, and possibly rehire some of the millions of factory workers who lost their jobs during the recession.

That appears to be happening, based on the latest batch of factory data. The new orders component of the ISM purchasing managers report rose to a seven-year high in November and the employment index, an indicator of hiring intentions, surged to the highest since April, 1973.

The latest surveys of purchasing managers are "very encouraging," said Peter Newland, an economist at Barclays Capital in New York. "We're starting to see a drip, drip, drip of better-than-expected indicators."

The MSCI All-Country World Index of shares in 45 countries rose 1.7 per cent to 341.33 at the end of trading in New York Tuesday, the biggest increase in two months, according to Bloomberg News.

At the same time, copper touched a record $4.551 (U.S.) a pound and aluminum and nickel prices climbed to their highest in two years, as traders anticipated that stronger economic growth would cause increased demand for the widely used metals.

Higher commodity prices are squeezing companies' profit margins.

Emerson Electric Co., a St. Louis-based maker of automation equipment, reported earnings Tuesday that fell short of Wall Street expectations because of higher raw material costs, Reuters reported. Bellevue, Wash. -based Paccar Inc., which builds commercial trucks and diesel engines, warned that higher commodity prices would "moderate" its operating margins in the months ahead.

Developing countries are reluctant to lift benchmark interest rates even as energy and food prices put pressure on inflation. The Reserve Bank of Australia on Tuesday was the latest to leave interest rates unchanged, indicating the economy has lots of room to grow before inflation becomes a significant threat.

With unemployment in the United States and Europe is still well above 9 per cent, Mr. Newland at Barclays said he thinks factories have limited scope to ask consumers to pay more, suggesting consumer price inflation will remain constrained. Elevated unemployment also is restraining wages, which economists say represent about two-thirds of companies' overall costs.

"As long as wages are muted, overall inflation will be muted," said Jennifer Lee, an economist at BMO Nesbitt Burns in Toronto.