Manufacturing's Mean-Reversion And Another Summer Slump
While not being cool enough to warrant instant-QE, the June employment report reinforced the sense that US growth has slowed further and that the labor market recovery remains sluggish. Besides the underwhelming employment report, this week’s releases offered more signs of slowing in the US manufacturing sector. The ISM manufacturing index falling below the symbolic 50 threshold for the first time since JUL09 and hard data on manufacturing activity, such as factory orders, have also cooled. Goldman's Zach Pandl notes that deteriorating external (Europe and China) demand is likely one factor behind the slowdown (with ISM new export orders index -11.5 points between APR and JUN) but suspects domestic factors could be at work as well. In particular, the slower growth in the US manufacturing sector could simply be that activity has already rebounded substantially since the recession (dominated by the channel-stuffing, China-dependent Autos sector). If the relatively fast growth in the manufacturing sector over the last few years reflected a “catch-up” from exceptional weakness in 2008-09, then this tailwind should gradually diminish and this led them to lower their Q2 GDP estimate to +1.5% as we face another sluggish summer.
Zach Pandl, Goldman Sachs: Less Manufacturing Momentum
Besides the underwhelming June employment report, this week’s releases offered more signs of slowing in the US manufacturing sector. The ISM manufacturing index declined to 49.7 for June, falling below the symbolic 50 threshold for the first time since July 2009. Hard data on manufacturing activity have also cooled. For instance, growth in domestic manufacturers’ orders has slowed to an annualized rate of -1.0% over the last six months in nominal terms, or -3.6% adjusting for inflation . The ISM survey’s new orders index as well as those from the regional manufacturing surveys suggest orders growth could remain weak for the time being.
Deteriorating external demand is likely one factor behind the manufacturing slowdown. US manufacturers export about 20% of their total output, and exports account for about 50% of final demand for US products (a large share of manufacturing output is used as an intermediate input in the production of other goods ). Therefore, slowing growth in foreign economies has likely weighed on firms’ orders and sales. This is certainly one of the messages from the latest survey data: the ISM new export orders index declined by 11.5 points between April and June, the largest two-month drop on record except for September-October 2008. Anecdotal commentary from ISM survey respondents also explicitly noted slowing growth in Europe and China as reasons for recent weakness.
However, we think domestic factors could be at work as well. In particular, one reason for slower growth in the US manufacturing sector could simply be that activity has already rebounded substantially since the recession. If the relatively fast growth in the manufacturing sector over the last few years reflected a “catch-up” from exceptional weakness in 2008-09, then this tailwind should gradually diminish.
The data seems to support the idea that a period of catch-up may have been an important driver of manufacturing output growth. For example, the decline in manufacturing production during the recession was well beyond what would be predicted by the sector’s “beta”—its normal responsiveness to changes in the overall economy. We estimated a simple regression model which explains quarterly changes in manufacturing industrial production with a constant and changes in real GDP (sample is 1970-2007). We then simulated the model-implied path for manufacturing production since 2007, based on known GDP data. Exhibit 1 (above) shows that manufacturing production declined much more than predicted, even after accounting for the sector’s high beta.
Manufacturing output has since increased sharply, but the level of activity was only recovering toward the model-implied level. Based on these simulations, it is not obvious that the manufacturing sector has outperformed the rest of the economy. Manufacturing output may simply have been very weak, and has normalized more recently. This is essentially the same argument that Chairman Bernanke has made about surprisingly large declines in the unemployment rate.
A breakdown of manufacturing growth by detailed sector looks consistent with this story. Exhibit 2 compares the recovery in output by type of product to the size of the decline during the recession (the size of the bubbles represents each product’s share of manufacturing output). The positively sloping relationship means that the sectors with the largest declines in output during the recession were also the ones with the strongest recoveries—motor vehicles being the most extreme example. There are a few sectors which had large production losses and little recovery (e.g. apparel and leather goods), but there are no examples of sectors with small production declines and rapid recoveries. Indeed, only 2 of the 20 detailed components of manufacturing industrial production have current levels of activity which exceed their pre-recession peaks.
Finally, it is noteworthy that the manufacturing sector has not yet grown as a share of the economy compared to pre-recession norms. According to new quarterly data published by the Commerce Department, gross value added of the manufacturing sector was 12.2% of GDP in Q4 2011, close to the average of 12.3% in 2005-2007 (Exhibit 3). With only a stabilization in the manufacturing share of output, it is not obvious whether fundamentals have changed for the sector, or whether solid growth over the last few years simply reflects the bounce back from a deep recession.