Jobs; it is all about jobs; and yesterday’s dismal payrolls print suggests that despite the orgasmic flourish of monetary policy (and fiscal deficits), things are not going so well. However, the clarion call for a pending manufacturing renaissance continues; the hope remains high that with just a little more time and little more money, we will revert to some pre-crisis utopia and the re-industrialization of America will begin. Be careful what you hope for is the message from Morgan Stanley’s Gerard Minack who warns that this ‘reindustrialization’ is bearish for stocks. The biggest medium-term issue for equity investors is whether current high profits can be sustained. One factor boosting margins was the Asian-led surge in global labour supply, which squeezed returns to labor and boosted returns to capital. This was particularly pronounced in America. Reindustrialisation implies that this process has run its course, suggesting that returns to capital will revert to normal over the medium term. Most see the prospect of America reindustrialising as bullish, but reindustrialisation may reverse the current mix: Economic growth may improve, but margins worsen.
Via Morgan Stanley’s Gerard Minack,
The reindustrialisation of America, if it occurs, will likely be bearish for US equities. The biggest medium-term issue for equity investors is whether current high profits can be sustained. One factor boosting margins was the Asian-led surge in global labor supply, which squeezed returns to labor and boosted returns to capital. This was particularly pronounced in America. Reindustrialisation implies that this process has run its course, suggesting that returns to capital will revert to normal over the medium term.
Most see the prospect of America reindustrialising as bullish. In my view, that depends on whether you are an economist or whether you are an investor. The ‘deindustrialisation’ of America was bad for economic growth, but the increased global supply of labor lifted margins and total profits. The effect of wider margins on profits far outweighed the effect of two weak US GDP cycles (the cycles following the 2001 and 2008-09 recessions). Reindustrialisation may reverse this mix: Economic growth may improve, but margins worsen.
The first point to note is that America hasn’t really deindustrialised. America remains the world’s largest manufacturer measured by value added (Exhibit 1).
Manufacturing has been falling as a share of GDP in most developed economies. The decline in manufacturing’s GDP share in the US is not out of line with the decline elsewhere in the G7 (Exhibit 2).
These are trends that pre-date the rise of Asia as a force in global trade. Manufacturing’s share of US GDP and profits has been declining since the early 1950s (Exhibit 3).
To be fair, those shares were unsustainable: They reflected, in part, the windfall to America from set-backs to several large competitor nations in 1939-45.
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The second point to note is that the fall in manufacturing profits over the past 25 years has been more than offset by rising profits in other US sectors (Exhibit 4).
Importantly, that offset was in large part due to an economy-wide squeeze on labor compensation.
As I’ve discussed before, one of the most important trends in the US has been the declining wage share of GDP. This decline was due to several factors, but the increase in global labor supply was clearly critical. What has been peculiar to the US, however, is that consumer spending remained strong in the face of declining wage income share (Exhibit 5).
This combination accounts for most, but not all, of the increase in profit share seen over the past 25 years. The increase in global supply of labor put structural downward pressure on the domestic price of labor in the US. Consequently, returns to capital have disconnected from the relative domestic supply of capital and labor. Exhibit 6 shows how the profit share historically tracked the relative utilization of American labor and capital. (The former is measured by the unemployment rate; the latter measured – admittedly imperfectly – by the Fed’s series of industry-wide capacity utilization.)
The final point to note is that the expansion in margins was a far more important driver of profit growth than the (relatively) minor reduction in trend sales growth. As a matter of arithmetic, margin expansion has accounted for half the growth in domestic profits over the past decade (Exhibit 7).
More importantly, the effect on sales of squeezing labor income was largely offset by the declining household saving rate (which explains much of the widening gap between spending and labor income shown in Exhibit 5). Looking ahead, reindustrialisation could contribute to these trends reversing.
On that basis, reindustrialisation would be bearish for equities.