Our look back and our look forward…
It’s that time of year; time to look forward and plan for the year. In order to have a better idea of where the economy and industry are headed, we always like to look back and review from where we came and what happened. Then, assess where we are now. Only then are we equipped to make our predictions about 2019.
First, though, let’s start with a history lesson. The 2009 through 2014 timeframe was the first industrial-led recovery in the U.S. since 1961. This industrial activity was driven in large part by fracking (see Industrial Economy section below). The success of that industry resulted in the dramatic expansion in the infrastructure and earnings of railroads, the chemical industry, the plastic industry, pumps and cranes, and domestic machine tool and die companies, to name a few. In the fall of 2014, this activity came to a crashing halt as the price of oil fell dramatically below the marginal cost of its production via fracking. As oil (WTI) climbed back above $45 a barrel in the fall of 2016, fracking activity resumed and the industrial ‘mini-recession’ ended. Coincidentally and concurrently, equity markets began to reflate and millennials finally began to form households in meaningful volumes (see Consumer Economy section below). As a result, we are currently in an environment in which the U.S. industrial and consumer economies are both growing.
Industrial Economy – The advent of fracking and the substantial supplies of natural gas and crude oil that have been developed in the U.S. since 2009 have lowered the global price of oil, made natural gas incredibly inexpensive, and made the U.S. the world’s largest producer of crude oil. Fracking and all of the industrial activity that it spawned were a powerful economic boom to our country. In the 2010-2015 timeframe, eight new chemical refineries, and 22 new plastic resin production plants were built. Feedstock for these facilities has become plentiful and as the energy cost for the entire economy has dropped dramatically, the U.S. has become the least expensive place in the world to make most plastic products. As we described earlier, as long as the price for WTI oil stays above the marginal cost of its production via fracking, the industrial activity created by fracking will continue to thrive.
Consumer economy – To be fair and accurate, there really wasn’t a consumer recovery after 2009. Consumer income and consumer spending growth was anemic coming out of the 2008–2009 recession. From 2008 through 2013, the total average annual expenditures per person in the U.S. grew by only 1.2 percent. That’s a CAGR (Compound Annual Growth Rate) of 0.24 percent, and the worst rate of growth in consumer spending coming out of a recession in the post WWII period. Spending finally started to grow at a CAGR of 3.9 percent in the 2014–2016 period. Then the stock market began to rally in the fall of 2016, with the Dow Jones rising almost 45% (from about 18,000 to 26,000) in 15 months. Although the stock market was volatile in 2018, it is still greater than 30% above the valuations it was at in 3Q ’16 before the rally started. Higher stock market valuations increased the confidence (and spending) throughout the baby boomer demographic as it watched the value of 401k’s and other investments grow. The millennial generation also began to grow its spending. After being long derided for “never going to start household formation,” it has begun to prove the critics wrong as it “MOOBed” (Moved Out Of Basement). We aren’t surprised and attribute the delay to simple sociological and demographic factors. Just as has been true for almost 100 years, each generation has waited a little longer to get married (driven by longer life expectancies and higher levels of education) and longer to buy that first house (nothing drives household formation like getting married). The millennials are no exception. That said, there are more millennials than boomers. Millennials have started to form households and have started the goods accumulation phase of their lives that accompanies it. Consumer spending is poised to be strong for the foreseeable future, and the recent appearance of some wage inflation only emboldens our view on this.
Where are we in the cycle?
Obviously, this isn’t the beginning of the recovery with the economy just starting to climb out of the recession as it was in 2010 and 2011, but with the ‘mini-recession’ of the industrial economy just ending in the fall of 2016, we are only 26 months into the expansion of the industrial cycle. Since the consumer really didn’t recover from the 2009 recession and spent almost 6 years in a ‘slow-growth, no-growth mode,’ we are only 24 months into the expansion of the consumer cycle. Dissecting the U.S. economy in this manner leaves us dismissive of those whose predictions of “Imminent Recession in 2019” because we are “so long in this cycle,” as we see no factual basis for this assertion and even less academic merit to the argument. We acknowledge that there is a limit to the lifespan of economic expansions, but would assert that recessions are the marketplace’s method of cleaning up the excesses created by growth, not the duration of economic growth. Following this logic, with which we are comfortable, also proposes that the severity of the recession is determined by the magnitude of the excesses that led up to it. Bottom line – we are in the first approximately two years of the cycle and there aren’t any massively glaring or broad excesses in the private sector of the U.S. industrial or consumer economies right now, so the probability of a recession created by internal market dynamics in 2019 is rather low.
On the freight side, the history books will say many things about 2018, but whatever else is recorded, it will go down as the strongest year on record for spot and contract pricing increases in the history of trucking in the U.S. After spot market rate increases of over 30 percent in dry van and reefer, and spot market rate increases of over 25 percent in flatbed; which were followed by contract rate increases of over 15 percent in all three modes – the logical question becomes, “Can rates in 2019 actually increase over the rates of 2018?” For many in trucking, who over the last several decades grew accustomed to thinking of pricing increases of more than 5 percent as “very high,” achieving price increases in 2019 on top of the levels achieved in 2018 seems difficult to imagine.
Obviously, the eventual outcome will depend on whether economic demand continues to grow (and at what rate it grows), and how whether capacity continues to expand (and at what rate it expands). The simple marketplace certainty is:
the degree to which demand growth exceeds capacity expansion raises the amount by which rates can rise,
while the degree to which capacity expands faster than demand grows (or demand contracts faster than capacity shrinks) lowers the amount by which rates can rise, and if severe enough pushes rates down.
What created the extraordinary pricing power for trucking in 2018?
Capacity Constraint - The December 2017 imposition of the rule requiring ELDs in almost all for-hire trucks constrained capacity. Capacity was constrained to varying rates in each mode (dry van, reefer, and flatbed) and to varying degrees in fleets of different sizes. The ability to learn how to use them and regain some or all of the lost productivity also varied and evolved throughout the year. We will discuss many of the details later in this report, but the constraint of capacity created by ELDs reached its peak in the first half of 2018.
Surging Demand – The December passage of the “2017 Tax Cuts and Job Act” (TCJA) lowered the federal corporate tax rate to 21%, allowed for bonus depreciation on a wide range of new capital investment, and provided significantly lower cost to repatriation of overseas earnings. As a result:
More than 450 large companies announced pay raises, bonuses, and better benefits;
Most publicly traded companies increased earnings guidance as a result of the lower tax rate, which in turn buoyed their marketplace equity values;
As result of the increased after-tax cash earnings expectations and in order to capture the bonus depreciation, most companies increased their capital expenditure budgets for 2018;
More overseas earnings were repatriated in the first six months of 2018, than in the entire years of 2015, 2016, and 2017 combined.
All this served to drive healthy increases in consumer income and the value of retirement plans, which in turn helped drive the willingness of both boomers and millennials to increase their spending. With WTI oil above $60 a barrel, the TCJA, and equity market rally, the U.S. saw pronounced accelerations in the industrial economy, the consumer economy, the financial markets, and the technology economy (which the U.S. still dominates globally), especially in the first half of 2018.
The surging demand in both the industrial and consumer economies collided with a trucking marketplace that was struggling with capacity constraints before the ELD rule was imposed. Predictably, pricing power exploded, first in the spot market and in time in the contract market. Just as any good cyclical market participant should, truckers used the increased pricing power to grow capacity.
Capacity in trucking increased in 2018. How and where?
During 2018, capacity was added to the trucking industry for several reasons and to varying degrees in each mode. Demand has continued to grow as we’ve already outlined but is growing at a pace slower than it did in the first half of 2018. The DAT Trucking Freight Barometers are indicating a marketplace in which demand continues to exceed capacity in all three modes, perhaps not to the extreme extent it reached early in 2018, but overall there are still more loads than trucks. ELDs played a significant role, first in the constraint of capacity, and then in its growth. How?
Carriers in all modes (dry van, reefer, flatbed) and carriers with fleets of all sizes, on an ever-increasing basis are learning how to better utilize the available hours of service for each driver while still remaining compliant using ELDs. All modes are using improved equipment visibility, better shipper and receiver selection, and more drop and hook to offset some of the loss of flexibility in productivity that ELDs have imposed, with dry van doing so better than reefer and reefer better than flatbed. Remember, we believe that the vast preponderance of log book “cheating” was not driving over 11 hours in a 24-hour period, but instead it was not completing the driving (often 7 to 9 hours) portion of a driver’s work day within the 14 hours allowed by the FMCSA. Throughout the first six months of 2018, ELDs presented some significant challenges especially to fleets that were late adopters of the technology and those with low trailer to tractor ratios, low density of freight lanes (no matter what size the fleet was), poor management of loading and unloading execution by consignors and consignees, and equipment that did not lend itself to drop and hook/unattended loading or unloading (i.e., flatbed and reefer). As those carriers have better learned how to maximize utilization while still remaining ELD compliant, we argue that much of the capacity initially lost has been restored. The capacity of the marketplace has improved. We continue to argue that the visibility of equipment available in the marketplace has also improved, but we will save further elaboration about that aspect for a future article.
Strong pricing power was first achieved, then collected, and then used to significantly increase driver pay. Higher driver pay means more people willing and able to be truck drivers instead of turning to competing jobs. Steady increases in driver pay throughout the industry have resulted in dramatically lower unseated truck counts, which have effectively increased capacity for the industry.
The focus on the loading and unloading times of shippers and receivers that was necessary to recover lost utilization post ELD adoption has provided dispatchers and fleet managers with the data needed to provide the added benefit of improving the driver’s quality of life. Whether it was directly penalizing shippers and receivers who abused drivers’ hours through higher rates and detention charges; indirectly penalizing them through decreased access to equipment; or simply managing the equation through increased drop and hook – drivers are spending less time than ever waiting to be loaded and unloaded.
More trucks have been built and purchased, and with higher pay and better working conditions, enough additional drivers have been brought into and retained in the industry to increase the number of trucks on the road.
The average age of trucks in service has declined. A new truck is seldom in the shop, while a five-year old truck may spend a day a month in the shop. We’d point out that a trucking company, whose trucks averaged 20 days a month on the road, would increase available capacity by five percent by running new trucks versus running five-year old trucks. We understand that most truckers spend a few more than 20 days on the road in any given month (so maybe the capacity improvement is closer to four percent in the real world, but we wanted to keep the math simple). We also understand that there is always a varied age of trucks throughout any fleet’s population, but the point remains – newer trucks have more useable capacity per month.
An important side note - Despite the continued growth of demand, one of the age-old challenges facing the trucking industry is being emphasized: when demand exceeds capacity to the extent necessary to create pricing power, and that pricing power is sufficient to grow trucking capacity, it still faces further challenges. Where the loads are is seldom where the trucks are. Even in that perfect moment in time in which all the trucks are where the loads are, they pick up those loads, take them to destination and then are out of place again.
Where Are We Going?
Our Prediction: Perhaps not as dramatic, but sustained.
Continued economic growth - We just completed the first two years of the expansion in both the industrial and consumer economies, and there aren’t broad or large excesses which need to be addressed. Failing a prolonged trade war with China, or other unpredictable external force, another year of economic growth in the U.S. in the 2.5% to 3.0% range seems achievable. Growth at the rate achieved in 2018, especially the rate achieved in the first half of 2018, seems unrealistic, but sustained growth is the most likely scenario. The longer freight flows in all the various modes continue to grow, the more our confidence in this outlook grows.
Demand exceeds capacity – Not to the extent it did in the first half of 2018, but there are still more loads than trucks throughout most of the trucking industry. The current DAT Dry Van Trucking Freight Weekly Barometer (55.0 in the week ending Dec. 29) has been highly correlated with spot market price increasing by more than 10 percent in the coming year. The ultra-high spikes in spot market pricing in early 2018 may put this prediction to the test, but the point remains, “if there are more loads than trucks, then rates can still rise.” If spot rates rise in 2019 over the ultra-high spikes achieved in 2108, then the possibility of contract rates going up on top of the rate increases achieved in 2018 seems more imaginable. Contract rates increasing on a full-year basis for 2019 by 3% to 5% seems achievable.
Continued capacity growth – If our outlook on pricing proves to be correct, then the industry will find ways of adding capacity.
Continued consolidation – Inflation and interest rates will stay subdued, and the capital to fund acquisitions will remain accessible for most credit-worthy transportation companies. Larger, more successful players will continue to buy direct competitors and expand into other service offerings and geographies.
Only time will tell, but 2019 promises to be another very interesting year in the trucking marketplace.
Donald Broughton – chief market strategist