Rumors of the Industrial Sector's Demise Are Greatly ExaggeratedLearn more about this firm
- Outside of struggling oil companies, the U.S. industrial sector has a moderately positive outlook — a far cry from the popular narrative of recession.
- An improving industrial sector would pave the way for the Fed to raise rates faster than the market is currently expecting.
- As encouraging data keeps rolling in, we think market worries over an industrial recession will evaporate.
If there has been one narrative for the U.S. economy over the past several months, it is that the U.S. consumer is strong, but the industrial sector is experiencing near recession-level weakness due to global turbulence and low commodity prices. But with the narrative of “industrial demise” as deeply ingrained as it is, we think investors should question whether that assumption still holds true. As Mark Twain might have said, rumors of the industrial sector’s demise are greatly exaggerated.
It is worth considering why the industrial demise narrative has been so persistent. First, the numbers have deteriorated considerably over the last two years. Manufacturing PMI surveys in particular, widely viewed as a leading indicator for the industrial sector, have fallen from a high of 58.1 in August 2014 to 49.5 last month (less than 50 indicates contraction in the sector). With oil prices below breakeven prices for most U.S. oil producers and a long-awaited wave of defaults still on the horizon, numbers for this segment of industry are likely to remain soft. Topping it off, the U.S. dollar is at decade-highs, hurting companies’ export prospects.
Just as important in fueling this narrative is the fact that the industrial sector is a much larger part of financial markets than the economy as a whole. While approximately 65% of S&P500 earnings come from manufacturing and goods-producing industries, these sectors only make up 14% of U.S. employment. This is why the U.S. consumer can remain strong while the industrial sector is supposedly in its death throes. The exaggerated focus on the industrial sector due to overrepresentation in markets makes for a dire mood, even if it might not be warranted.
Here’s why investors should take these justifications for industrial demise with a grain of salt: U.S. manufacturing output is showing signs of life, even with global uncertainty and a strong dollar. Over the last 12 months, nominal U.S. manufacturing output has grown 3.3%, which is just slightly less than nominal GDP growth but not bad considering the tone of the market and the 6.1% fall in manufacturing exports (Exhibit 1). The U.S. manufacturing sector is growing, and it is because of the domestic demand — not exactly a sign of impending recession.
But why do major surveys like Manufacturing PMI paint such a different picture than the hard data? These surveys are susceptible to cognitive biases: the most recent and startling memories form opinions even if they are not the whole picture. In this case, it is the U.S. dollar rally. Since mid-2014 the Manufacturing PMI has fallen in lockstep with the U.S. dollar rally (which makes U.S. manufacturing exports less competitive). While the U.S. dollar has dented exports, the strong domestic economy has more than made up for it. Unfortunately, that message has not shown up in the survey data.
In addition, the macro backdrop for the industrial sector is improving: the domestic economy is steady, destinations for U.S. exports are growing faster, and U.S. manufacturers are more becoming more competitive. A major destination for exports, the euro area, is growing its fastest since the euro crisis and the latest European Central Bank policies ease credit availability for corporations. While the export market has been impacted by the strong dollar, that effect is partially offset by the U.S. becoming relatively more competitive than other manufacturing countries (Exhibit 2).
So what impact does dispelling the industrial demise narrative have on markets? In our view, it is the catalyst for the Federal Reserve to raise interest rates faster than the markets are currently expecting. As encouraging data keeps rolling in (as we have just started seeing in a few regional Federal Reserve manufacturing indicators), we think markets will wake up to a new narrative: low unemployment, inflation near the 2% target, and evaporating worries over an industrial recession.