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Manufacturing is the workhorse of the US economy. It made America great in the 20th century. It pulled the US out of the Great Depression, was a critical advantage in the fight for Europe during World War II, is an engine of innovation, science and R&D, and it currently employs 11.8 million Americans. While down from its historic level on a relative basis, manufacturing still contributed 12.8% to 2010 GDP.

There is a certain fundamental in manufacturing that carries through to all other sectors of the economy: Start with materials. Change them into a more usable form. Create value for yourself and your neighbor in the process. The world is a dynamic marketplace, highly competitive and more interconnected than ever. And as the world has changed American manufacturing has lost some footing-jobs lost, market share diminished. Sometimes though conditions realign and breathe new life into tired lungs.

This week we posit that such conditions have aligned for US manufacturing. Today's combination of favorable monetary policy, decoupled global and domestic growth rates, and low inflation expectations for the foreseeable future have US manufacturing poised for growth

US Manufacturing - A Traditional Powerhouse Poised For Growth

Since the Great Depression, American manufacturing has been a primary driver of GDP growth. Misconceptions about manufacturing permeate the media, driven recently by political rhetoric. This week's Wall Street Flaneur argues that US manufacturing remains strong contra to what you hear on the evening news and current global economic and monetary conditions provide a tremendous opportunity for growth in the next 3-5 years.

First, US Manufacturing remains a critical and strong component of the US economy. Since World War II, US manufacturing has grown in sync with GDP, increasing sevenfold. In the ten years ending in 2008, manufacturing value added has increased 22%, demonstrating that growth has been steady historically and also recently. The US has the largest manufacturing base in the world, with international market share of 20% remaining steady over the past 30 years. By comparison, US manufacturing would by itself be the 8th largest economy in the world at $1.6 trillion, larger than the economies of Brazil, India, Spain, and Canada, among others.

Charts sourced from The Manufacturing Institute.

Establishing that US manufacturing is indeed alive and kicking, the next issue is growth - why and from where?

The Federal Reserve and Congress have taken unprecedented measures to intervene in the economy in the fallout of the financial crisis. The multiple stimulus bills, TARP, Quantitative Easing 1 and 2, and Operation Twist have all served to increase the number of dollars circulating in the world economy. This has diluted the dollars' worth relative to other currencies, thereby creating competitive pricing worldwide for US exports. In other words, with a "weak dollar policy" the Federal Reserve has created conditions such that it would take fewer Brazilian Reals to buy a tractor manufactured in the US by John Deere, even though the cost and pricing in dollar terms remains the same.

However, international competition is fierce, and the emerging economies in Asia are gaining market share. This is reflected in the US Trade Deficit, an economic statistic representing the difference between American imports of foreign goods versus American exports to foreign economies. Generally, the US imports more goods and services from foreign nations (primarily China and Japan) than we export. This gap represents lost market share and also an opportunity for growth.

US Exports are comprised of a variety of industries-services, agriculture, and others-but at 57%, manufacturing is the primary driver. The May 2012 US Trade Deficit was $49 billion, which approximates an annualized deficit of $588 billion. The manufacturing industry currently has a unique opportunity to close that trade gap, increase international market share of exports, and grow their businesses and shareholder value. The key is the weak dollar policy from the Federal Reserve.

This weak dollar environment spurred a rapid rise in US exports immediately following the Financial Crisis, but then quickly abated as interest rates declined worldwide and the recession eased. Currently the dollar is in a relatively strong position, driven by the problems in Europe and the moderated growth in the Chinese economy.

We believe these conditions are short term and that over the next 3 to 5 years the dollar will weaken, US exports will gain market share, and US manufacturing will be the primary beneficiary. US interest rates will remain low (as stated by the Federal Reserve), inflation will remain low due to continued corporate and personal deleveraging in the US, and the economic issues in Europe and China will be corrected through further government intervention.

The greatest risk to this hypothesis is a reversal of the weak dollar policy caused by raised US interest rates. There are two principal reasons that rates would rise, both of which are sufficiently mitigated to justify our expectations.

First, a rapid rise in US GDP and employment could force the central bank to raise rates to moderate growth. This is an unlikely scenario. Unemployment is persistently high, there are structural issues in the economy precluding a quick solution, and the economic situation overseas in Europe and China is such to moderate any potential for growth at home. As long as unemployment is high and GDP growth is in the 2-4% range, it is highly unlikely the Fed will raise rates.

Second, and more significantly, is the risk of inflation in the US economy. With the massive increase in the US monetary base from the stimulus and quantitative easing programs (money supply has nearly tripled from 2008 to the present supply of $2.6 trillion), intuitively one would expect the value of the dollar to depreciate and ultimately lead to higher inflation. This is a logical expectation based on the Classical Theory of Inflation supported by Milton Friedman. However, this picture is incomplete. To understand why inflation is still moderate to low, you must consider an economic phenomenon in the banking system called the money multiplier.

Say for example, that a small business takes out a $1,000 loan to purchase new equipment used in their manufacturing process. After the purchase, the equipment vendor would have $1,000 cash that they can put into a bank as a deposit. This deposit now provides the bank with sufficient reserves to make another loan. If the bank must keep 10% in reserve, they would be able to make a new loan to another business for $900. And the cycle continues on from there. At this point, the original $1,000 loan has now been transformed into $1,000 cash in the equipment vendor's deposit account and a new loan to another business in the amount of $900. Without printing any new dollar bills, the economy now has $1,900 circulating instead of the original $1,000. This dynamic is the money multiplier.

Since the Financial Crisis, banks have reduced their lending substantially. Corporations and individuals have reduced their debt without taking on more loans, banks have tightened their credit standards, and regulators have raised capital requirements. All together these factors have significantly reduced the normal money multiplier in the economy. So while the Federal Reserve has increased the money supply tremendously, this has been offset by the reduction in the money multiplier and thereby keeping inflation in check. Given the continued trouble in the housing market, high unemployment, slow growth at home, and the economic environments currently in Europe and the emerging markets, it is unlikely that banks will increase their lending substantially in the medium term to change the current inflation expectation.

These conditions paint a picture for a gradual weakening of the dollar in the medium to long term which will give American manufacturers new pricing advantages and opportunities to grow market share against their Asian and European competition. We recommend playing the industry broadly with these funds, conglomerates, and specific companies that supply broad based manufacturers:

  1. Guggenheim S&P 500 Equal Weight Industrials ETF (NYSEARCA:RGI)
  2. Vanguard Industrials ETF (NYSEARCA:VIS)
  3. General Electric (NYSE:GE)
  4. Danaher Corporation (NYSE:DHR)
  5. Roper Industries (NYSE:ROP)

Disclosure: The author and WSF currently do not hold any positions in these funds.

Disclaimer: As with any investment, we insist you consult with your personal financial advisor before taking any position.

Source: Weak Dollar Environment Affords U.S. Manufacturing Opportunity