The key ratio warning of trouble ahead for the US

The US is still the world’s largest economy. If it sneezes, the rest of the world gets a cold.

So how can we best predict what’s about to happen in America?

There are plenty of economic indicators around. But watching them all can end up giving confusing signals. So it’s a good idea to stick to the tried and tested measures.

One such measure has worked well for years. What’s more, as technology becomes an increasingly large part of our lives, its efficiency as a leading indicator is only improving.

And right now, it’s blaring out distress signals – which is bad news for investors on this side of the Atlantic too.

The warning from the book-to-bill ratio

I’m talking about the US semiconductor ‘book-to-bill’ ratio.

How is it calculated? You take the number of orders that the country’s microchip industry has received (ie that have been booked) from current customers. Then you compare it to the customer invoices that have already been filled (or billed).

In other words, it measures the balance of supply and demand in the US semiconductor equipment industry. A book-to-bill ratio of greater than one suggests that net chip demand is rising: tech companies have more orders than they can deliver. A reading below one implies that chip supplies exceed demand.

Though it’s a tech industry measure, it has far wider implications. It’s a key barometer of the health of the personal computer business. And as Philip Isherwood at Evolution Securities says, the ratio has particular significance right now.

“Semiconductors are always important for the global electronics supply chain. But seasonally, at this point in the year, they represent a key lead on the supply chain being filled for the Q4/Christmas consumer season”.

In other words, the ratio is a very good pointer as to the amount of stock that US shop-owners reckon they’ll be able to shift over the year-end holidays.

If the book-to-bill ratio is below one, this suggests that US electronics retailers aren’t very confident about their likely sales at such a crucial time for retailing.

 

How the US debt ceiling debate could hold back the economy

As you can imagine, in the midst of the Great Recession, the book-to-bill ratio took a bath. It plunged to a scary looking 0.5, which showed semiconductor demand was collapsing. Last year, as the US economy showed signs of recovering, it bounced back to more than 1.2.

But the bad news is that in recent months, the ratio has dropped back again to below one. That implies weak demand ahead. “If continued, today’s semiconductor weakness wouldn’t be encouraging”, says Isherwood. “It seems that the men in charge of the future direction of the global economy aren’t looking in the right places”.

This is where the current wrangle over America’s debt ceiling comes in. My colleague John Stepek mentioned this fight in a recent Money Morning. The short version is that if the nation’s politicians can’t agree to hike the legal limit on US government borrowing, the country will default by mid-August at the latest.

That matters for all kinds of reasons. One is that the US government has historically been a massive spender on IT equipment. If the debt ceiling argument isn’t resolved soon, it won’t be able to spend any more money on it.

This may seem minor compared to the consequences of a US default. But while a formal default is unlikely to happen, US state technology spending is likely to be cut, even if a deal is reached. That will result in the book-to-bill ratio falling even further as chip demand drops more.

In turn, many tech-related businesses will soon be feeling the pinch. Further, the adverse effects will be felt throughout the economy. As firms receive fewer orders, their profits will fall, or even evaporate. So workforces will be cut back. Any job losses will require extra welfare benefits from the already cash-strapped state.

What does this mean for UK investors?

As we’ve been saying for ages, the safest areas of the stock market are likely to be the defensive sectors, such as utilities, that don’t require economic expansion to make their money.

Further, there are some sectors that are likely to continue to do well because their markets are transforming – we look at one of these in today’s MoneyWeek magazine cover story.

Then there’s the dollar. Wouldn’t a lower book-to-bill ratio be bad for it? Actually, no – look at this chart.

US book to bill ratio

Source: Bloomberg

The currently falling book-to-bill ratio is shown in blue, while the international value of the buck is in red. Sure, in 2004-05, the two lines moved together. But since then they’ve largely diverged. In other words, investors have responded to a falling book-to-bill ratio by buying the dollar – as a safe-haven in troubled times.

And that could soon happen again.

Category: Economics

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