Ed Yardeni had an interesting post out last week discussing the long awaited manufacturing renaissance in America. To wit:
“Over the past few years, there has been lots of buzz about the coming manufacturing renaissance in the US. The central concept is that plentiful and cheap natural gas will convince manufacturers to expand or to move production to the US to cut their energy costs. Labor is still cheaper overseas, but it isn’t as expensive as it once was in the US. Besides, the IT revolution has increased factory productivity with more automation, including robots and the ‘Internet of Things.’ The recent strength in the dollar could be a spoiler if it continues since it reduces the global competitiveness of US exporters and provides a competitive edge for importers.
For now, the evidence is finally mounting that the highly anticipated new age in US manufacturing may be happening, though the jury is out on how long it will last.”
The chart below shows the recent surge in private non-residential fixed investment in industrial equipment.
While the surge in industrial equipment has certainly supported economic growth in recent quarters, as I suggest, it may be a sign of a late stage economic expansion rather than the “renaissance” of American manufacturing.
As shown in the chart above, since the turn of the century each peak in investment in industrial equipment has occurred just prior to the onset of an economic recession. This should not be surprising when one thinks about the normal business cycle.
During a recession, businesses contract spending as demand evaporates. As the economy begins to recover, businesses adapt to the increase in demand incrementally. It is in the later stage of an economic cycle where businesses are running at full capacity and are comfortable enough to spend capital to replace aging or outdated equipment.
The most recent economic recovery has been exacerbatingly slow, and businesses have been extremely cautious in making capital expenditures due to weak consumer demand. However, as the options for additional cost-cutting, have been exhausted, along with labor force reductions, businesses have had to start investing in equipment to increase productivity to help suppress labor costs. (This is why employment has effectively mirrored population growth, and full-time employment remains near its lows.)
The chart below shows total non-residential fixed investment as a percentage of real gross domestic product. I have included the annual change in real GDP for comparative purposes.
While there have been many claims that businesses are not investing, the reality is that they have been and continue to do so in order to suppress costs and increase profitability.
Ed Yardeni is correct that the recent surge in the US Dollar will likely suppress demand for exports, particularly with Japan, the Eurozone and China either in or near recessions. When you factor in that exports to our major trading partners comprise roughly 40% of domestic corporate profits, the impact to profitability could be greater than currently anticipated.
While none of this analysis suggests that a recession is imminent, it does suggest that the hopes that the U.S. can “decouple” from the rest of the world’s deflationary drags are likely misplaced.
The implications to investors is also important from the standpoint that the current growth in profits is one of the last remaining footholds of the “bulls.” With valuations now expensive, interest rates set to rise and yield spreads narrowing as the Fed removes monetary liquidity, the risks to markets have risen substantially since the beginning of the year.
This increase in risk, as the Federal Reserve extracts support from the markets and economy, is being reflected by the surge in the dollar as “safety” is sought. This has occurred each time QE has been extracted, and the surge in the dollar has been historically associated with market corrections.
With deflationary pressures surging in the Eurozone, China and Japan, it is unlikely that the U.S. manufacturing “renaissance” has finally arrived. The reality is that we are probably well advanced into the current economic expansion which has been weak and will likely remain so due to an aging demographic and a structural shift in employment and incomes.
The surge in the U.S. dollar is a reflection of the “flight to safety” and the belief that the domestic economy can decouple from a globally interconnected economic community is not a realistic one. With Q3 estimates already being ratcheted down, any impact from geopolitical unrest, weather or a misstep in monetary policy could have a substantial impact to already strained financial markets.
Images: Flickr (licence attribution)
About The Author
Lance Roberts – Host of StreetTalk Live
After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.
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