Volume 79 | Number 8
A chain is only as strong as its weakest link – but if the weakest link presents little chance of failure you can expect the chain to last much longer. Expansions are similar, in that recessions are almost always the result of problems in a single sector generating a cascading effect through the economy. Overactive homebuilding colliding with tightening Fed policy is a classic issue. The impact of spikes in oil prices on inflation, and through interest rates on durables is another. Today, much of the focus is on weakness in the manufacturing sector, but the evidence suggests this sector is not only holding its own, but strengthening as industry leaders adjust to a world of slower growth and less trade. While the soundness of the weakest link holds no promise of future strength, it does suggest that the chances of recession remain low and that this is a time to increase risk taking, not shy away.
When looking for problems in the manufacturing sector, it is best to look in the Rustbelt, as lower cost Sunbelt competitors will offset their own weakness by stealing market share from even shakier firms. In today’s global economy, the Rustbelt is Europe and Japan, where the legacy costs of aging fully developed societies put them at a disadvantageous relative to Asia’s (and mostly China’s) newer infrastructure and rapid productivity growth as it walks up the skills ladder. Yet, the Rustbelt is looking OK – especially in the first quarter as the lagged effects of a stronger dollar allowed them to take market share from the one economy still above them. Japan reported 1.7% annualized growth in the first quarter of 2016, rebounding from a decline in the fourth quarter. For both the past six months and the past year, Japanese real growth has been unchanged – which doesn’t sound like much, but matches admittedly tepid US growth when adjusted for trend labor force additions. Similarly, Europe reported 2.4% growth for the quarter, and has run 1.8% for the past six months and 1.6% for the year. This uptrend produces far better results than for the US (or Japan) when adjusted for demographics. Even within Europe, it was Spain and France that exceeded expectations, suggesting the Romance nations are finally reaping some rewards from policy moves – including the devaluation of the euro — in response to the 2015 global slowdown.
China’s data has also been trending higher despite an ongoing correction in its manufacturing sector. Both better rail traffic and higher electricity use point to a stabilization in heavy industry, which is a major user of both products. Data on credit expansion – including newly issued provincial bonds – indicate that China is aggressively using monetary policy to augment the already aggressive fiscal policy. Front page discussion of China’s policy in recent days had an anonymous – but senior – official criticizing the debt-fueled expansion binge, and then Chairman Xi himself advocating for a commitment to long-term reform and immediate addressing of structural industrial problems. We see the messages as multi-pronged, but what should reverberate most clearly is that cadres who feel they will advance by pumping up their local numbers via debt without taking the hard medicine of clearing out the obvious deadwood should not expect good things to happen to their careers in the upcoming Party reshuffle in 2017. As no one in China expects Xi not to be in charge for at least (yes, at least) another five-year term, provincial leaders who simply paper over past problems do so at their own peril. Note that while debt issuance was criticized, there was no sign it was curtailed. We read this as do what you must do in the near term – but do what you must do by 2017 or reap the consequences.
China bears should note that the end of apparently heavy outflows of Chinese capital and the rapid rise of the Chinese local bond issuance were virtually simultaneous. While foreign investors may not buy the Chinese restructuring story, the rates and security offered in new provincial paper is attracting plenty of domestic interest. The game is to have provinces issue debt, which they use to pay down bad bank debts, and the securities are purchased most heavily by the same banks that are losing provincial loans from their asset portfolio. The difference is that various bonds can now be rated (by admittedly newly hired and inexperienced raters) and traded in a market. This allows the central government better market-driven information on who to bail out and who to let fail. Many analysts are agape at the fact that defaults have doubled in China this year – from near zero to almost never. Still any defaults are a step in the right direction. For those who dismiss the bad loan for risky bond swap, and the even more audacious bad loan for equity swap, we suggest reviewing how the First Bank of the United States was funded in precisely this way as proposed by Alexander Hamilton. Bottom line, we see China as solving the problem of excess capacity in older heavy industries slowly, while still gaining share on competitors in the Rustbelt in new higher technology sectors.
Finally, signals from various US purchasing manager indexes showing that manufacturing is recovering less quickly than the rest of the economy are to be expected. After all, it is the shift of the US manufacturing sector abroad that is the fuel for the global economic expansion. Note there is virtually no factory output in New York City or Washington DC. Nor will there be in a decade in Beijing or Shanghai. These are centers of government, management and finance – far more productive industries than manufacturing – as is reflected in the higher real estate values supported by the superior earning power of local workers and investors. Indeed, even the increased chatter among FOMC participants for higher interest rates is less of a threat to the US economy than elsewhere as more of US employment and income is based on financial intermediation and investment in industries abroad. Higher oil prices don’t hurt OPEC and higher interest rates are less restrictive to the US economy as it earns a widening spread while it serves as the financier of the world. Note that the two strongest quarters in this expansion came in mid-2014, a year’s lag to the announcement that the Federal Reserve would stop distorting financial markets. Since then the threat and reality of higher US rates has hurt the rest of the world far more than the US – despite a stronger dollar due to an inflow of investment.
Like the rest of the world, a strong dollar did effect manufacturing. Industrial production is the weakest link in the US economy – as reflected in the virtual dearth of new capital investment as it continues to shift abroad. Yet, for even this weakest link productivity and profits are improving — slowly. Recent data on output growth looks much like the long sideways patterns seen from 1992 through 2000 and 2002 through 2008 – albeit at a far lower level. This reflects the declining importance of manufacturing as a driver of the US economy. Factory recessions have been deeper and subsequent peak growth lower. Yet, the US has recovered to full employment with strength in new areas like medical care, leisure and hospitality and management.
Most notably, as in the late 1990s, productivity is now rising for the manufacturing sector despite a slowdown in an already slow growth rate. Even at a meager 1% growth rate, factory output per man hour is near the cycle high and well in excess of the pace for the broader economy. This is typical for manufacturing as the old school productivity measure determined by dividing output by hours worked ignores the contributions of more capital per worker, better capital per worker due to research and development, cheaper capital due to financial intermediation, greater efficiencies due to better management, and a host of other forces. As the other drivers of US growth make it possible for the US to survive and thrive with less domestic production, the productivity of remaining industries are naturally better. Despite the shakeout in America’s new manufacturing superstar, fracking, which slowed output factory growth from 2.8% to near zero after oil prices broke – productivity has still been climbing since 2013. If losing the acclaimed best industry in your weakest economic sector cannot shake productivity – the core driver of profits – we believe the expansion is both currently sound and due to last a good deal longer. The pace of growth may be unexceptional by historical standards, but good investing is about making money when the sun shines and avoiding recessions. The skies may cloudy, but we see no heavy weather ahead – even with interest rates slowly on the rise.