The state of manufacturing? Unknown, if we are to judge by this morning’s competing headlines.
Manufacturing Sector Grows at Slower Pace says AP: “The nation’s manufacturing sector grew at a slower pace during October as companies increasingly felt the strain of a continuing rise in energy and raw materials prices.”
Factories hum in October proclaims Reuters: “The U.S. factory sector absorbed rising energy costs in October and ran at a robust pace, while construction spending hit a record high in September, according to data on Tuesday.”
Both stories reported on the Institute for Supply Management index of national factory activity, which was 59.1 in October compared to 59.4 in September.
The problem with both of these reports is that they are trying to read the tea leaves from a couple of specks of tea. And these specks could be seen as either showing the glass half full or half empty. Yes, the ISM numbers declined slightly, but they are still in the healthy range and didn’t drop as much as some feared.
For a real state of manufacturing, we need to look beyond the latest monthly figure. One view of the longer term is NAM’s recently released study: The Profit Squeeze for U.S. Manufacturers.
The recession that hammered so much of manufacturing from 2000 until 2003 and which saw the disappearance of three million industrial jobs has ended, although the jobs have not returned. However, some of the root causes of that recession remain and are continuing to have an adverse impact on America’s industrial base, particularly the durable goods sector.
. . .
The main conclusions of this analysis can be summarized quite succinctly:
• Manufacturing profits from 2000 to 2003 in the five industries shown in Table 1 [fabricated metal products, machinery, electrical equipment, motor vehicles, and chemicals] were 67.1 percent lower than they would have been were it not for adverse trends in benefits costs, materials and energy costs, and import prices/exchange rates since 1999.
• The manufacturing groups hardest hit by the profit squeeze are those for which import competition is fiercest–industrial machinery, computer and electronic equipment, electrical equipment, motor vehicles, and chemicals.
• In quantitative terms, the most important factor behind weak profits in recent years is the cyclical downturn (Table 1, page 4), which contributed 38.2 percent of the recent decline in manufacturing profits.
• Declining import prices, brought on by both increasing penetration of low-wage countries such as China and Mexico and an appreciation of the U.S. dollar, account for about one-quarter of profit weakness, with considerable variation across industries.
• Soaring health care and pension costs also account for nearly one-quarter of the profit squeeze. Chemical and motor vehicle manufacturers face the most daunting challenges.
• Soft pricing power has been exacerbated by increases in the price of intermediate inputs and energy (which together account for 13.2 percent of the profit decline). U.S. manufacturers have generally been unable to pass these increases on to their customers. Because these pressures have worsened in 2004 and 2005, the results shown in the table are in all likelihood understated relative to the current situation.
• Hefty increases in petroleum and natural gas prices have taken a heavy toll on the chemical industry in particular, accounting for nearly 10 percent of its recent profit weakness, which is concentrated in the basic chemicals group.
While the focus of this study is on those industries whose profitability has declined the most, several other industries have also seen such declines, albeit smaller in magnitude. Profit rates in nondurable industries have held up much better than in durable industries through the recent recession and recovery, but are nevertheless on average at their lowest levels in three decades. Because some nondurable industries face the same challenges of
international competition, rising production costs, and soft pricing as do durable manufacturers, the dynamics described in this paper are applicable to nondurable industries, albeit to a lesser degree.
Why worry about profits? Well, without profits there is neither investment nor any reason to stay in business. All companies compete for the most basic of commodities — money. If investors (like your pension fund) can get a better return investing somewhere else besides manufacturing, they will. Without that flow of investment, companies can expand, modernize or innovate. And those companies who can innovate, die.
Unfortunately, the report doesn’t explore the innovation issue, other than asserting that the industry continues to invest in capital equipment and R&D. And the thinly veiled “solutions” are targeted at the same old notions that have been pushed for years: the problems of employee benefits (especially health care); unfair exchange rates; taxes; and regulatory compliance, litigation, and other “hidden” costs.
The NAM report paints a picture of an industry in trouble. It doesn’t give us much guidance in creating a positive direction for the manufacturing sector. The implied solutions strike me more as an attempt to re-capture the glory days of the past – not a blueprint for future.
We desperately need that blueprint.