A slowing global economy and declining bond yields across the developed world—some negative—portend a deteriorating business climate ahead. To combat this broad slowdown, global central banks are shifting monetary policy toward more accommodative stances that include real negative rates, nominal negative rates, large-scale asset purchases and possibly further unorthodox policy moves such as temporary price-level targeting. The amount of government securities with negative yields globally now totals more than $13 trillion and is likely to remain a permanent feature of the global economic and financial landscape.
As global central banks, including the U.S. Federal Reserve, prepare to proactively stave off this slowdown, we turn our attention to the primary rationale behind the push to alter monetary policy: the global economic downturn in manufacturing.
In past slowdowns—particularly before China’s ascent to economic powerhouse—the global economy typically looked to the United States to kick-start economic recoveries. Even with the re-emergence of protectionism in developed economies, that co-dependency still exists, perhaps even more so with the maturation of global supply chains. For example, the chart below shows Boeing’s international suppliers, spread across every continent and into dozens of other countries.
Meanwhile, most economists are expecting a convergence of growth in the major economies of North America, Western Europe and Asia. Economic analysts surveyed by Bloomberg are projecting sub-2% growth in 2020-21 in North America and Western Europe, and for a slowdown in China to 6%, as well as a continuation of Japan’s malaise.
As these growth forecasts suggest, the economic community has integrated deteriorating conditions in the manufacturing sector into forecasts. Meanwhile, global business sentiment in the OECD economies has deteriorated to levels below 100, suggesting pessimism regarding future growth. This marks the first time since the European Debt Crisis and the collapse of commodity prices in 2015 that the index has dropped to pessimistic levels, suggesting that developed economies are nearing the end of the business cycle uptrend.
Most disturbing for the U.S. economy, the OECD business sentiment index has at times been a leading indicator of U.S. manufacturing sales, with sentiment indicators reported earlier than developments in the real economy. The relationship between global business sentiment and domestic manufacturing output can be attributed to the integration of the developed economies through global supply chains and the financial channel.
If U.S. manufacturing is so small, why is it so important?
The manufacturing sector has long been considered the backbone of the U.S. economy, attaining mythic status for generations of working-class households from Freehold, New Jersey to Gary, Indiana and Long Beach, California. At their peak, immediately after World War II, and following its resurgence in the early 1980s, manufacturing sales represented 12% to 14% of total U.S. nominal GDP. Since then, production has been impacted due to the first wave of automation and in some cases off-shored to centers with lower labor costs. U.S. manufacturing sales now account for only 7% of GDP within what today’s more diversified service and information-based economy.
The chart below shows the impact of the 2007-09 collapse of the financial sector on the real economy and the importance of the manufacturing sector on the direction of overall economic activity.
Neither the financial sector nor the manufacturing sector exists in isolation. Advances within the transportation industry and the digitalization of production controls have allowed for the development of interstate supply chains. The ripple effects of income derived from production now move beyond the plant’s immediate neighborhood to an out-of-state supplier.
On national accounts by industry basis, manufacturing accounts for only 11% of nominal GDP, down from 13% in 2005. So if manufacturing has occupied, at most, 14% of the space within a complex economy at its very peak, why is there such a strong relationship between the business cycle and the ups and downs of the manufacturing sector? In short, it’s because of economic interconnectivity.
In a recent paper by the Federal Reserve Bank of San Francisco, “How Have Changing Sectoral Trends Affected GDP Growth?”, Andrew Foerster, Andreas Hornstein, Pierre-Daniel Sarte, and Mark Watson, found three sectors that carried outsize influence on GDP growth based on how influential they are in the production of other sectors: construction, nondurable goods and professional and business services.
The aerospace industry is a good example of a global industry with international product and supply chains and interconnectivity. The demand for airplanes is reflective both of the discretionary income of consumers and the logistic needs of manufacturers; that is, moving people or manufactured goods from one place to another. The two biggest producers are Boeing (based in Seattle) and Airbus, the multi-national European company.
Yearly data from Airbus shows a declining trend in orders, with 2018 orders half of what they were at the peak in 2013. Monthly delivery data from Boeing indicates that orders have plummeted in 2019 relative to the same month of the previous year, and that orders in the first six months of 2019 were down more than 30% relative to the same period of 2018.
The equity market has been paying attention to the drop in airline orders, with Boeing share prices declining since January 2018, with the most recent price now lower than a year ago, both of which predated the 737 Max issues. More disturbing perhaps, is that the performance of Boeing share prices are symptomatic of the growth of overall U.S. manufacturing sales, with negative equity returns pointing to lower or negative growth in the manufacturing sector.
According to analysis by RTS, a financial resource for the transportation sector, there are “more than 1.7 million heavy-duty and tractor-trailer truck driving jobs today, with a total of 7.4 million American jobs tied to the trucking industry.” A recent study by National Public Radio found truck driver to be the most dominant job in 29 U.S. states, including California and Texas.
So imagine the consequences of a manufacturing slowdown or a trade war. With less materials to ship, the transportation sector is likely to see reduced income for its employees and less return on investment for its stockholders. A drop in the supply and demand for goods would directly affect an inordinate segment of the labor force, with repercussions rippling throughout the economy. The second-quarter earnings report from global transportation bellwether CSX have said exactly that in their forward-looking guidance, as the railroad contends with sharp declines in revenue and freight movement. Its stock fell recently to its lowest point in a decade.
Container activity at U.S. seaports
Because supply chain decisions are based on expectations of demand in future periods, trends in shipping container activity should be a leading indicator of overall economic activity. Container activity had been maintaining a 5% yearly growth rate from the last months of 2017 until the first months of this year. So the sharp break below that range and the negative growth of export and import containers handled by the seaports in April and May suggest: (1) an economy at the end of a business cycle that was propped up by a fiscal stimulus, (2) the first signs of the trade dispute, and (3) the potential for slower economic growth in future quarters.
Transportation equity prices
At the same time that GDP growth has been trending upward, transportation sector stocks have been signaling concern of a slowdown. The chart below shows that the Dow Jones Transportation and Transportation Services indices have plummeted since the third quarter of 2018, echoing drops that occurred during the Great Recession (2007-09), the European Debt Crisis (2011-13), and the commodity-price crash (2014-15).
What to watch
Our preferred recession probability model from the New York Federal Reserve is currently forecasting a 32.87% probability of a recession in the next 12 months. For now, the data indicate the slowdown is largely concentrated in global manufacturing. A closer look at manufacturing survey data in the U.S. shows the deterioration in sentiment here. The average of Federal Reserve regional business conditions surveys has deteriorated to below 50, indicating manufacturing is contracting. As well, the RSM US PMI has deteriorated to below 50.
Capacity utilization in manufacturing tends to move with the ups and downs of business cycles, but has been declining on trend since the late 1960s as the economy began its transition from being manufacturing-based to services-centered.
The latest drop in capacity utilization is a potential sign that the economy peaked in the third quarter and that the surge in economic growth in 2018 was a result of a fiscal stimulus, the effects of which are beginning to wane. The government’s capacity utilization report for July will be released on Aug. 15.
New manufacturing orders are forward-looking by definition; a merchant or down-stream producer considers the prospects for future profit and orders additional stock of goods if warranted.
As we show below, new orders for manufacturing of durable and non-durable goods rebounded after the 2000 recession and the shock of the 9-11 attacks. During the recovery from the 2007-09 Financial Crisis and Great Recession, however, new orders began pushing lower toward recession levels as manufacturing production moved off-shore. Manufacturing new orders reversed trend, increasing again from 2015 until the imposition of the trade tariffs in early 2018.
Meanwhile, new manufacturing orders have often been a leading indicator of U.S. economic growth, often moving lower or higher before the rest of the economy catches up. So the negative growth rate of new orders suggests that the straight-line increases in real GDP growth since 2016 are in jeopardy as manufacturers respond to the administration’s repeated threats to free trade.
The July preliminary report for new orders for durable goods will be released on Aug. 26.