The Battle Between Manufacturing And Services
Submitted by Peter Tchir of Brean Capital,
The Manufacturing Economy versus The Service Economy
As we start the new year, there is a debate raging within the market. No the debate isn’t whether there is weakness in the manufacturing economy, that is taken as a given, especially after Friday’s awful Chicago Purchasing Manager number of 42.9.
No, the debate boils down to this:
The bears will argue that
The U.S. economy has always done poorly when manufacturing has turned this weak
That never before has the Fed initiated a tightening cycle with manufacturing so weak
That making matters worse, it isn’t just the U.S. that is experiencing a manufacturing slowdown, but it is global in nature
Etc.
The bulls will argue that
The manufacturing economy is now dwarfed by the service economy and is to a large degree irrelevant
That the recovery that has taken place since the financial crisis has been without much support from the manufacturing sector, so why should it get derailed now
That even within the services sector, so many secular trends, like on-line shopping and the “sharing” economy don’t get picked up appropriately, understating the growth
That the clear definition between “manufacturing” and “service” has blurred as companies like Apple are far more difficult to characterize than what we consider “traditional” manufacturing or traditional “services”
Etc.
Which camp is right? That is the big dilemma facing market participants, along with the ongoing question of liquidity across all markets.
I believe that ultimately this question will be resolved by what I will call “The Wealth Economy” but before we get there, the path will include some more volatility.
Is the Service Economy a Closed System?
I think it is very easy to see how a strong manufacturing sector leads to a strong service sector. Someone produces something, they sell it to someone, generating profits, and at some point that person no longer has the time or desire to mow their own lawn or cook their own food (yes, overly simplistic but I think we all see how this positive feedback loop could work).
The question then, at least as far as the market is concerned, is can the service economy sustain itself without a strong manufacturing sector?
The Bear View
This is the “bear” case. That the manufacturing economy and the service economy act in conjunction with each other – that one cannot turn, without the other.
The Bull View
The bulls view each segment of the economy as relatively independent and they highlight the size of the service economy relative to the manufacturing.
But does this image make sense? Can the service economy really function on its own?
I keep thinking about the service economy as a closed system and I just can’t make it work. I do think the various parts of the economy are intertwined. Yes, this is an overly simplistic construction, but even if I was to analyze the service economy as its components, I would struggle to get past the concept that there is enough momentum within services on its own, to continue to generate the growth (or at least stability the market needs).
So while I can’t agree with the bulls under the simple view of the world, I also do not believe the weakness in the manufacturing sector will be enough to drag down the economy – so I will adapt the model to include the “Wealth Economy”.
The Wealth Economy Is The Missing Cog
I hate to use terms like “wealth” and “trickle down” as they seem to have so many political ramifications these days, but ultimately I think it is the “Wealth Economy” that can drive services regardless of the manufacturing economy.
What I term as the “Wealth Economy” includes
- The obvious, those wealthy enough that they just need or want stuff done, the exact level of wealth is not important, it is the concept that there is a portion of the population that will spend regardless and will start “priming the pump” so to speak
- Then there is the “global wealth” that is ever more important to the domestic economy. One trend we read a lot about, largely in regards to property prices, is the rush by rich people across the globe to buy property in the United States. What doesn’t get discussed is how much that feeds into the services economy. Not just the obvious real estate commissions or the attorney’s fees, but all the other people who earn a bit directly from such a transaction – especially if the person (or family) bothered to come to America to see what they were buying. Then how those fees trickle to the rest of the economy.
- Finally, the simple retiree who is getting a pension or. As baby boomers are retiring there is real money being paid to them that is making its way into the economy, and largely to services. As you add in products like HECM’s (which Brean is active in) you are seeing a variety of ways that money is coming into the system.
So in summary, I do not see the services economy as being able to be self-sustained, but as the manufacturing economy has shrunk in relevance, the wealth economy has been rising to take up the slack.
So maybe the right question isn’t whether the overall economy can withstand the slowdown of the manufacturing sector, but whether the wealth economy can continue to pick up the slack?
How Does This Play Out?
I will not inundate you with graphs demonstrating the weakness in the economy. You have probably seen a hundred such reports over the past two weeks, that I cannot improve on. You will also have seen a number of reports (though not as many) refuting the implications of recent manufacturing weakness, and even some weakness in various reports on the consumer. Again, I cannot improve on them.
So the starting point to the year is one where the evidence is pointing to serious manufacturing weakness, on a global basis, with hints that it could be hurting the consumer.
That is coming right as the Fed embarks on further “policy normalization”. Certainly the policy change was well telegraphed and arguably long overdue, but any weakness in economic data, or the markets will come with an added level of “fear” that the weakness is a result of a policy mistake. It doesn’t matter that it is almost impossible for the recent hike to have impacted the global economy significantly in such a short time, what matters is the perception that it could and the fear that it could get worse. So any weakness will create a lot of reports highlighting the possibility that the Fed made a mistake, which will accelerate any move to the downside.
The Santa Rally that never came has affected positioning. While I would agree that sentiment seems awful, I think that the risk of a rally into year-end has ensured that market bears are not positioned as bearish as their sentiment would have you believe. Shorting into a quiet period with strong seasonality is hardly a recipe for success, so look for bears to come out swinging given any excuse. Those who “bought the market for a trade” will be extremely nervous that the rally never really came, and the last two trading days of 2015 ended rather poorly. So while sentiment would indicate investors are underweight the market, I believe actual positioning coming into 2016 is overweight (or less short than they would like to be).
Then we need to figure out what is going on in the credit markets. For the past two weeks I have been arguing in favor of high yield (the view that the dispersion trade is overdone) and for at least two months I have been arguing that equities (at least large cap and tech) can largely ignore the weakness in high yield, but investment grade would be another story.
IG Bond Fund Flows
This chart makes me a little nervous. I think the market remains well positioned to soak up supply in the IG new issue space, but if retail starts exiting in real size it could hamper the IG market. So far this has been small, may be mixed up in some broad based bond funds flows – i.e. not IG specific, and hasn’t hit the IG ETF’s where LQD shares outstanding remain near their all-time highs. CDX IG remains well offered as well (looks like it closed the year 11 bps rich to fair value).
So right now, I continue to like high yield and don’t think that “credit is leading the way” but am closing watching the IG market to see if it gets hit at all – and if it does, that will hurt equities much more because
- The “buy back” piggy bank would be closed, taking away what has arguably been the biggest driver of many U.S. stocks
- It would signal growing concern about the economy
The Bottom Line
Expect weakness to start the year as all of the factors above come into play and push on the fear and positioning in the market, but be careful getting too bearish.
This will be more about the end of dispersion and the outperformers with extreme long positions getting hit, while the sectors that have been beaten down the most will offer some real opportunities.
(3 votes)
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Slightly OT…
According to the Daily Mail, Nigel Farage's car wheels 'were sabotaged in an assassination attempt': Ukip leader lost control of Volvo when wheel fell off on motorway... and police confirm foul play
I hope Nigel stays safe and watches his back. These bloody cunts won’t stop tryin’…
Looney
If I were Trump I would be paying attention
Service economy? Most service jobs exist to make your life hell. Bureaucrats, teachers, administrators, tax specialists, brokers, billing agents, inspectors, agents, attorneys, cops, committee members, etc. are all in the service sector. Unfortunately they are there to service the government and the 1%.
Everytime I hear about the "service economy" and those that tout it, I am reminded about the "Fat People in the Floaty Chairs on WALL-E".
When you can't win an argument through rational discussion, sabotage and murder are the only ways.
manufacturing is value added. services are an expense subtracted from the value added in the manufacturing process. the only mitigating factors in the case of the usa is the privelege of supplying the reserve currency and the global nature of the current economy so manufacturing in other countries supports the service industry in the consuming countries. regardless one cannot exist without the other and are directly related. when manufacturing goes down(globally) the service economy will suffer also.
That works as long as consumers in the US demand foreign manufactured goods. Although people still need the cheap basics to survive (for now), I believe growth in this model is dead forever.
The future is in local manufacturing (lead by 3D printers and other “smart” machines). With increasing automation, the cost of labor becomes a minor factor. What's more, these machines will be affordable to anyone with the skills to operate them so ownership won't be monopolized by wallstreet corporations.
The elite who began this cycle and sought to perpetuate it, figured underclasses in the West would just roll over and be mindless consumerist slugs content with the scraps until their untimely deaths. Newsflash to our "smart" overlords: Humanity is very adaptive, particularly White people.
The answer lies in the missing cog - the 'wealth' economy.
What about the "government" economy. It dwarfs all the other economies.
I'll have to dissent on the whole 'wealth economy' aspect. Wealth originated when the manufacturing economy generated more value than was consumed. The wealth economy therefore is equivalent to momentum; unless replenished by further excess manufacturing, the wealth economy will slowly shrink. Of course we now have governments/central banks creating new 'wealth' out of thin air (or maybe out of electronic digits) but ultimately that is not a useful type of wealth.
And if that 'wealth economy' cog really worked, the arrow indicating its direction of rotation would not be opposite that needed to mesh with the service economy cog. As drawn, all we can look forward to is stripped gears. So I guess the author wasn't entirely wrong.
The wealth and manufacturing economies are global, but the services sector is largely local or national. For example, most hookers don't cross state lines, let alone national ones. So, it it is possible for the US services sector to hold up as long as there are large monetary inflows to the US - even in a global recession.
The bears are right in their view of the economy. Look up GOFO. Manufacturing is more than 1/5 of the real economy.
January effect. New S&P 500 high's. So long... suckers...
And the "missing link" like the abominable snow man is the Us Oligarchy that wins/wins on outsourcing to China factory's low labour cost and ME/Africa/AMerindia's low RM costs, all the while using the WS beanstalk to ramp up its profits by destroying first world Middle Class; the useful idiots; who should vote but prefer to watch Kim K.
What could be wrong as long as Congress buys into the inverted totalitarian order. And the world buys into petrodollar.
And that is where the Achilles heel lies: If WS beanstalk moves to Shanghai !
(On the silk road where we are just now pumping the Oil pipes and networks to move towards Asia, away from Europe)...
Its game over for US Oligarchy !
But it is not game over for US leadership in Hi-tech if they can recoup after reset !
C'mon Elon and consorts. But stay away from the Congressional vampires.
The wealth factor can dissapear very quickly since most wealth is tied up in equities,bonds and RE. Fed is attempting to keep these markets afloat but at some point credit confidence will freeze and we will be forced to do our own lawns or worse----manufacture something of value that creates wealth anew other than military hardware.
"The manufacturing economy is now dwarfed by the service economy and is to a large degree irrelevant"
Makes.No.Sense. How does the math calculate with burger flippers, retail clerks, waitresses and bartenders and buying services? Daughter can't even buy a tire at $245 or new clutch for her Nissan Altima working at a f'g golf course. Even the inflated housing market with 30 year mortgages makes no sense relative to the so-called services economy.
What manufacturing?
Chipotle economy. BARF!
Moochers = Marxocrats getting voted into office = anti business tax and regulations = only thing produced is printed fiat currency to fund the government = more poor and business government moochers = a Paul Krugman utopian economy