Seeking Alpha
Portfolio strategy, mutual funds, collective investment trusts, currencies
Profile| Send Message|
( followers)  

Over two years have passed since we introduced the U.S. Manufacturing Renaissance theme in our Outlook Series. At that time, we detailed initial signs of a pick-up in domestic manufacturing, driven by both a return of formerly outsourced production as well as an expansion in goods for export. This trend was being driven by a narrowing of U.S. labor cost differentials versus other nations, combined with several other competitive advantages (e.g., favorable energy prices, largest domestic market in the world, a culture of innovation, excellent universities, a well-trained workforce, strict intellectual property rights, and good infrastructure). We also noted the existence of meaningful headwinds to a resurgence of U.S. manufacturing, including a shortage of high-skilled workers, and policy risks. Our conclusion back in 2012 was that this phenomenon had the potential to be a positive contributor to economic growth in the U.S., but that it had not yet evolved far enough to alter our expectation for an ongoing period of slow growth.

The Manufacturing Renaissance theme and overall economic growth have largely tracked the expectations we established two years ago. However, there have been some welcome surprises to the upside in certain elements to this theme, including the energy sector. This month, we revisit our original work on this topic to provide an update on the progress of U.S. manufacturing and the implications for growth from here. In preview, slow growth remains our base case, although we continue to believe the Manufacturing Renaissance is a viable trend which still has the potential to evolve into a long-term engine of economic growth.

Checking Up on the Manufacturing Renaissance

Manufacturing activity as a share of U.S. GDP has been in steady decline for several decades. While manufacturing’s output and value-add has continued trending upward, its trajectory has been more gradual than other sectors, resulting in its falling share of output. Over the past two years, there have been signs that this downward trend is abating. In fact, this expansion was the first noteworthy increase in manufacturing’s value-add share of U.S. GDP since the 1980’s (the blip in 1997-1998 is due to a change in methodology) (Chart 1). Durables have recovered much more robustly than non-durables, especially in Computer and Electronics, Motor Vehicles, and Machinery, passing their pre-recession peak in the third quarter of 2011.

Manufacturing value Added

There are numerous recent examples of companies returning manufacturing activities to (or increasing manufacturing in) the U.S. The nation’s share of global manufacturing output has stabilized at around 20% after 30 years of decline. This increased interest in locating production in the U.S. is largely attributable to the fact that many companies are now accounting for more than just labor costs, and are increasingly using a total cost analysis when deciding where to manufacture (Table 1). Some of the major reasons for re-shoring include: high and increasing transportation costs, attractive domestic energy prices, increased real estate and land costs in China, and increased hidden costs. Hidden costs include: product quality control issues, complicated supply chains, logistics expenses, longer development times, inability to accurately forecast rising costs (such as labor) due to uncertainty, and stolen intellectual property. Referring to the accuracy of forecast of future expenditures, U.S. manufacturers are the most productive in the world, which has historically enabled unit labor costs (ULCs) to stay relatively stable domestically, while many other countries have volatile or increasing ULCs. These costs are not easily captured in wage and productivity data, but companies are increasingly trying to better account for them when making decisions on the best place to produce their products.

Favorable energy prices have provided an additional tailwind to the re-shoring theme (Chart 2). Companies in highly energy intensive industries are discovering that manufacturing in the United States has become increasingly attractive. Industries set to benefit most from these lower energy prices include: organic chemicals, resins, agricultural chemicals, petroleum refining, metals (i.e., iron and steel), and machinery. This unconventional oil and natural gas boom has also put more money in consumer’s pockets to spend on goods and services in the U.S.; some estimates have been as high as $324 billion in savings for the U.S. consumer in 2013.

As technology and automation drive an increasing share of the manufacturing process, labor costs share of the overall pie shrinks. Logistics and transportation costs can overpower labor advantages in some developing markets. The importance of simplifying the supply chain really came to the forefront in 2011 after the Japanese tsunami and the Thai floods, which made manufacturers rethink just-in-time inventory management. It also brought to light the vulnerability of complex supply chains where one or two small inputs from these countries delayed shipments of products made elsewhere. Another development is the demand for more customization by developed market consumers, resulting in manufacturers needing to produce in smaller order sizes. In China, high order minimums have made this difficult and it is a niche that U.S. manufacturers have been able to capitalize on. Intellectual property rights have also increased in importance as the Emerging Markets, particularly China, move up the value chain.

So what have been the impacts of these developments on labor thus far? Signs suggest that the U.S. labor market’s demand for manufacturing personnel today is stronger than it has been in some time. Average weekly hours worked per production and nonsupervisory worker are at the highest level since the 1940s, and overtime hours are at historically elevated levels (Chart 3). Wages are also beginning to show signs of life in the manufacturing sector (Chart 4), though some industries are seeing stronger wage growth than others.

Manufacturing’s unemployment rate hit the lowest level since 2008 in April at 5.2%, and durable goods manufacturing came in even lower at 4.6%. Some industries within manufacturing are seeing unemployment for those with prior industry work experience at rates below 3%. This data indicates that manufacturing companies are operating near full capacity on the labor front. This may lead to increased hiring activities assuming they can find people with the necessary skills to fill the job openings, and wages may begin to rise at a faster pace. Manufacturing jobs tend to be attractive from an earnings perspective, as the compensation per hour worked exceeds that of the average job.

As mentioned in our initial overview on the Manufacturing Renaissance, there are also multiplier effects when manufacturing and energy jobs are created. Chart 5 on the next page shows that manufacturing states have shown an overall strength in payroll growth not seen in non-manufacturing states.1 According to manufacturing.gov, the employment multiplier effect is 1.6 additional local service jobs for every 1 job created in manufacturing; however, this multiplier varies by industry, and in high-tech manufacturing, the multiplier can be as high as creating 5 local service jobs for every 1 manufacturing job. Furthermore, the amount of research & development will also increase as manufacturing comes back, as new research centers are set up like the General Electric global research center, which planned to hire 600 highly paid software engineers, data scientists, and user experience designers through the end of 2013.2 The multiplier also helps the economies of the states beyond simply employment growth. According to the Bureau of Economic Analysis (BEA), manufacturing contributes $1.35 in additional economic activity for every $1 it spends. This is the highest multiplier of any major economic activity based on the BEA’s methodology.

Where Do We Go From Here?

The improvement in American manufacturing appears to be sustainable and the potential for further growth from here remains a strong possibility. Favorable conditions which could foster further growth going forward are: stable/lower domestic energy prices, potential for increased demand for greater capital investment, volatility in international shipping costs, and rising or unpredictable ULCs in the Emerging Markets. However, nearly all of the threats and challenges that we identified back in 2012 remain true today.

Capacity utilization rates in both the manufacturing sector and the broader economy are running at post-recession highs and in line with 30 year historical averages. At the same time spare capacity has declined, the average age of plant and equipment has reached new highs (Chart 6). This will make these companies more likely to replace these older, and likely less efficient, machines to increase productivity. The Business Round Table CEO Survey showed a renewed strength in plans for capital spending in March, indicating some willingness to invest as demand increases (Chart 7). Increased appetite for capital spending should in turn lead to additional manufacturing activity to produce the needed equipment.

Another leg of the capital spending story is energy as a source of demand. Oil technological advances have helped bring new supply to market, but the reality is that global oil supply has been “running to stand still” for some time now. As oil wells age, their level of output generally declines, requiring additional wells and equipment in order to maintain the oil field’s output. This is good news for U.S. Manufacturing in terms of equipment demand. Capital spending has grown at double digits for most of the past 13 years, yet OPEC excess capacity has actually declined since 2000.

Although additional capital spending is likely, we caution against becoming too optimistic on this front. After all, in a slow growth world, how much capital spending is really necessary to keep up with demand growth? If companies are unsure about future economic growth, they are likely to continue squeezing as many years as they can out of their current equipment. Furthermore, although capacity utilization is nearing its 30 year historical average, prior to the 1980s, the economy ran at much tighter capacity on average, suggesting that there may still be further room to grow before greater capital spending is required.

Labor force dynamics remain one of the more significant headwinds to the Manufacturing Renaissance today. Tight manufacturing labor capacity has lead to increased wages and more overtime for workers. Although wage growth is a positive for the consumer, if wages rise too quickly, it may be sufficient to diminish the all-in attractiveness of manufacturing in the U.S. Equally important is the fact that the workforce continues to age in many industries such that there is a risk of net decline in workers as Baby Boomers continue to retire. Hundreds of thousands of jobs remain unfilled in manufacturing and other skilled labor industries because the current workforce doesn’t have the adequate skills to fill these positions. The upshot is that the U.S. has access to a more highly skilled workforce than many economies and the demographic backdrop looks to be a greater challenge for many developed nations outside the U.S. While this creates a relative advantage of sorts for the U.S., many European countries are further ahead in setting up apprenticeship programs to bridge this gap. According to the U.S. Labor Department, formal programs combining on-the-job learning with mentorships and classroom education have declined 40% over the past decade. The good news on this front is that recently these training programs have begun to expand once again.

Finally, there are many policy risks that could threaten the sustainability of the recent gains in domestic manufacturing. While protectionism has been a relatively benign concern of late, it does bear close monitoring. Any moves towards greater protectionist policies and trade restrictions will likely have negative repercussions on the manufacturing sector. Additionally, tax policy is another factor that can influence decisions as to where a company will locate various business activities. The individual tax rate is also very important to manufacturers, as two-thirds of manufacturers are flow-through entities and pay taxes at individual tax rates. Rather than trying to predict policy changes, it is more important to monitor risks such as these and update our outlook accordingly.

Conclusion

The title of our 2012 exploration of the Manufacturing Renaissance – Silver Lining, Not Silver Bullet – continues to describe our view on the topic. The outlook for U.S. manufacturing continues to improve, and for the past two years it has been a positive contributor to overall economic activity. The resurgence of domestic energy production, rising labor costs in the developing world, increased transportation costs, and the emergence of more training programs for skilled workers are all positives for this theme. However, headwinds such as rising U.S. labor costs, the skills gap, government and regulatory hurdles, and lackluster global growth are sufficient to dictate restraint when forming expectations for future growth. At present, we believe that the ongoing evolution of this theme will create opportunities for select companies and industries, but it is not a big enough tailwind yet to change our overall slow growth outlook. We will continue to closely monitor this topic and provide additional updates as conditions warrant.

Analysis: Manning & Napier Advisors, LLC (Manning & Napier).

Manning & Napier is governed under the Securities and Exchange Commission as an Investment Advisor under the Investment Advisers Act of 1940.

1Manufacturing States are defined here as all states which derived 20% or more of their GDP from private-goods producing industries

2http://business.time.com/made-in-the-u-s-a/

Sources: FactSet, International Energy Agency, Financial Times, National Association of Manufacturers, Economic & Statistics Administration, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, U.S. Energy Information Administration, Deloitte, Federation of American Scientists, U.S. Department of Commerce Bureau of Economic Analysis.

All investments contain risk and may lose value. This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

This newsletter may contain factual business information concerning Manning & Napier, Inc. and is not intended for the use of investors or potential investors in Manning & Napier, Inc. It is not an offer to sell securities and it is not soliciting an offer to buy any securities of Manning & Napier, Inc.

Source: Revisiting The U.S. Manufacturing Renaissance